diff --git a/raw/filings/0000110471/2000/0000905729-01-500086/filing.txt b/raw/filings/0000110471/2000/0000905729-01-500086/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..9d5cd358b03da17c8616fdffa3e8faa6e0b4d0f8 --- /dev/null +++ b/raw/filings/0000110471/2000/0000905729-01-500086/filing.txt @@ -0,0 +1,2989 @@ +10-K +1 +www10k.htm +FORM 10-K +Wolverine World Wide Form 10-K - 12-30-2000 +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +___________________ +Form 10-K +FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO +SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +[X] +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 30, 2000 +[ ] +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: 1-6024 +WOLVERINE WORLD WIDE, INC. +(Exact name of registrant as specified in its charter) +Delaware +(State or other jurisdiction of +incorporation or organization) +38-1185150 +(I.R.S. employer identification no.) +9341 Courtland Drive, Rockford, Michigan +(Address of principal executive offices) +49351 +(Zip code) +Registrant's telephone number, including area code: (616) 866-5500 +Securities registered pursuant to Section 12(b) of the Securities Exchange Act: +Title of each class +Name of each exchange on which registered +Common Stock, $1 Par Value +New York Stock Exchange/Pacific Exchange, Inc. +Securities registered pursuant to Section 12(g) of the Act: None +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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by +reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] +Number of shares outstanding of the registrant's Common Stock, $1 par value (excluding shares of treasury stock) as of March 23, 2001: 41,686,231. +The aggregate market value of the registrant's voting stock held by non-affiliates of the registrant based on the closing price on the New York Stock Exchange on March 23, 2001: $552,231,329. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the definitive proxy statement for the registrant's annual stockholders' meeting to be held April 26, 2001, are incorporated by reference into Part III of this report. +PART I +Item 1. Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The +Company, a Delaware corporation, is the successor of a 1969 reorganization of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Consumers around the world purchased more than 36 million pairs of Company branded footwear during fiscal 2000, making the Company a global leader among U.S. shoe companies in the marketing of branded casual, work +and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort. The products are marketed throughout the world under widely recognized brand names, including Bates ®, Caterpillar ®, Coleman ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Stanley® and Wolverine ®. The Company believes that its primary +competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. The Company's footwear products are organized under +three operating divisions: (i) the Wolverine Footwear Group, focusing on work, outdoor and lifestyle boots and shoes, (ii) the Performance Footwear Group, focusing on the Caterpillar ® and Merrell ® product lines of performance and lifestyle footwear and (iii) the Casual Footwear Group, focusing on Hush Puppies ® brand comfortable casual shoes, slippers and moccasins under the Hush +Puppies® brand and other private labels for third party retailers and children's footwear under various Company brands. The Company's Global Operations Group is responsible for manufacturing, sourcing and distribution in support of the various Company brands. +The Company's footwear is distributed domestically through 62 Company-owned retail stores and to accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of these retailers operate +multiple storefront locations. The Company's products are distributed worldwide in over 140 markets through licensees and distributors. +The Company, through its Wolverine Leathers Division, operates a Company-owned tannery and is one of the premier tanners of quality pigskin leather for the shoe and leather goods industries. The pigskin leather +tanned by the Company is used in a significant portion of the footwear manufactured and sold by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of shoes. In addition, Wolverine Procurement, Inc., a +Company-owned subsidiary, both performs skinning operations and purchases raw pigskins which it then cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company, which are attached as Appendix A to this Form 10-K. The Company has one reportable operating segment, Branded +Footwear. The "Branded Footwear" segment is engaged in the manufacture and marketing of branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear. The Company's "Other +Businesses" category consists of the Company's retail stores, apparel and accessory licensing, tannery and pigskin +procurement operations. Financial information regarding the Company's operating segments can be found in Note 9 to the consolidated financial statements of the Company, which are attached as Appendix A to this Form 10-K. +Branded Footwear. +The Company manufactures and markets a broad range of footwear styles including shoes, boots and sandals under many recognizable brand names including Bates ®, Caterpillar ®, Coleman ®, +Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Stanley® and Wolverine ®. The Company, through its wholly owned subsidiary, Wolverine Slipper Group, Inc., also manufactures constructed slippers and +moccasins and markets them under the Hush Puppies ®, Joe Boxer ®, and Turtle Fur ® trademarks and on a private label basis. The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications +at both Company-owned and independent manufacturing facilities. +The Company's three branded footwear operating divisions are described below. +1. The Wolverine Footwear Group . The Wolverine Footwear Group encompasses multiple brands designed with performance and comfort features to serve a variety of work, outdoor +and lifestyle functions. The Wolverine ® brand, which has been in existence for 118 years, is identified with performance and quality and markets work and outdoor footwear in two categories: (i) work and industrial footwear; and (ii) rugged outdoor and sport footwear. The +Wolverine Footwear Group also includes the Bates ® and HyTest ® product lines. These products feature quality materials and components and patented technologies and designs, such as DuraShocks ®, DuraShocks SR ™, Wolverine Fusion ™ and the +new Wolverine Durashocks Motion Control ™ sole, and unique proprietary technologies such as the SEMC ™ non-metallic composite safety toe. The Wolverine Footwear Group also markets Harley-Davidson® footwear. H +arley-Davidson® footwear styles include traditional motorcycle riding designs as well as contemporary fashion, military and western inspired footwear. The Wolverine Footwear Group also markets hiking and outdoor shoes, boots and sandals through the Coleman +® footgear line of products. In addition, the Wolverine Footwear Group markets Stanley® work boots and shoes. +Wolverine ® Work and Industrial Footwear . The Company believes the Wolverine ® brand has built its reputation by offering quality, durable and comfortable work boots and shoes. The +development of DuraShocks ® technology allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The recently developed Wolverine Fusion ™, Wolverine Durashocks Motion Control™ and +SEMC® composite safety toe technologies continue the Company's tradition of comfortable work and industrial footwear. The Wolverine® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female +industrial and farm workers. +Wolverine ® Rugged Outdoor and Sport Footwear . The Wolverine ® rugged outdoor and sport product lines incorporate DuraShocks ®, DuraShocks SR ™, Wolverine Fusion +™ and Wolverine +2 +Durashocks Motion Control ™ technology and other comfort features into products designed for rugged outdoor use. This broad product line targets active lifestyles and includes all-terrain sport boots, walking shoes, trail hikers, rugged +casuals and outdoor sandals. The Company also produces boots that target hunters, fishermen and other active outdoor users. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® and Thinsulate ® brand fabrics and the Company's performance leathers and patented DuraShocks ® technologies. +Bates ® Uniform Footwear . The Company's Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes +DuraShocks ®, DuraShocks SR ™, CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and oxfords including the Bates ® Enforcer Series ® and Special Ops ™ +footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and other governmental organizations to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial +occupations. Bates Uniform Footwear Division products are also distributed through specialty retailers and catalogs. +HyTest ®. The HyTest ® product line consists primarily of high quality work boots and shoes designed to protect male and female industrial workers from foot injuries. HyTest ® footwear +incorporates various safety features into its product lines, including steel toe, composite toe, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology and the proprietary SEMC® composite toe to provide comfort together with safety for working men and women. HyTest ® footwear is +distributed primarily through a network of independently owned Shoemobile ® mobile truck retail outlets providing direct sales to workers at industrial facilities. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson +® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a +network of approximately 650 independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. +Coleman ® Footgear . The Company has been granted the exclusive worldwide rights to manufacture, market, distribute and sell +3 +outdoor footwear under the Coleman ® brand. Coleman ® brand footwear products include lightweight hiking boots, outdoor sport boots, rubber footgear and outdoor sandals, which are sold primarily at value-oriented prices through +specialty retailers and mass merchants. +Stanley ® Footgear . Pursuant to a license arrangement completed in 2000 with The Stanley Works, the Company has an exclusive license to manufacture, market, +distribute and sell footwear under the Stanley® brand. The Stanley® Footgear line provides the Company with an entry into the value-price work footwear market. Stanley® Footgear is currently marketed in Payless ShoeSource, Inc. stores throughout the +United States. +2. The Performance Footwear Group . The Performance Footwear Group began operating as a separate division of the Company in 1999. The +Performance Footwear Group is comprised of two of the Company's performance-lifestyle brands, Caterpillar ® and Merrell ®. +Caterpillar ® Footwear . The Company has been granted the exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ®, CAT & Design ®, +Walking Machines ® and other trademarks. The Company believes the association with Caterpillar ® equipment enhances the reputation of its boots for quality, ruggedness and durability. Caterpillar ® brand footwear products include work boots and +shoes, sport boots, rugged casuals and lifestyle footwear. In addition, the Company also manufactures and markets CAT ® Marine Power footwear, designed for industrial and recreational marine uses. Caterpillar ® brand products target work and industrial users and active lifestyle users. Caterpillar® footwear is marketed in over 130 +countries worldwide. +Merrell ® Footwear . The Merrell ® product line consists primarily of technical hiking, rugged outdoor and outdoor inspired casual footwear designed for backpacking, day hiking and rugged +every day use. The Merrell ® product line also includes the "After-Sport" product line, incorporating Merrell ® Footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers™ and other technical materials to +create footwear with unique styling, performance and comfort features. Merrell ® products are sold primarily through outdoor specialty retailers, department stores and catalogs. +3. The Casual Footwear Group . The Casual Footwear Group consists of the Hush Puppies Company, Wolverine Slipper Group, Inc. and the +Children's Footwear Group. Each of these groups is described below. +The Hush Puppies Company . The Company believes that the 40-year heritage of the Hush Puppies ® brand as a pioneer of comfortable casual shoes positions the brand to capitalize on the global trend +toward +4 +more casual workplace and leisure attire. The diverse product line includes numerous styles for both work and casual wear and utilizes comfort features, such as the Comfort Curve ® sole, Float Fx™ , HPO2 ® cushioning, +patented Bounce ® technology and lightweight Zero-G ™ constructions. Hush Puppies ® shoes are sold to men, women and children in over 90 countries. +Wolverine Slipper Group, Inc. Through its wholly owned subsidiary, Wolverine Slipper Group, Inc., the Company is one of the leading suppliers of constructed slippers in the United States. The styling of +Wolverine Slipper Group's footwear reflects consumer demand for the "rugged indoor" look by using natural leathers such as moosehide, shearling and suede in constructed slipper and indoor and outdoor moccasin designs. Wolverine Slipper Group, Inc., +designs and manufactures constructed slippers, aftersport footwear and moccasins on a private label basis according to customer specifications. Such products are manufactured for leading United States retailers and catalogs, such as Nordstrom, L.L. Bean, +Eddie Bauer and Lands' End. In addition to its traditional line of private label slippers, Wolverine Slipper Group, Inc. also manufactures and markets slipper products under the popular Hush Puppies ®, Turtle Fur ® and Joe Boxer ® brands and has developed a College Clogs™ program for the sale of licensed collegiate slipper products. +The Children's Footwear Group. The Children's Footwear Group consists of the Company's Hush Puppies ® and Caterpillar ® children's footwear business together with the children's footwear +programs under the Coleman ®, Wolverine ®, and Harley-Davidson ® brands. The Company believes the consolidation of these brands into the Children's Footwear Group facilitates the dedicated marketing, sourcing and sales programs that are +necessary to extend the Company's high-profile, global brands into the children's footwear market segment. +Other Businesses. +In addition to the manufacture and marketing of the Company's footwear products that are reported in the Branded Footwear segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine +Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly owned subsidiary Wolverine Procurement, Inc., (iii) operates 62 domestic retail footwear stores, and (iv) licenses the Company's brand names for use +on non-footwear products. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces pigskin leathers primarily for use in the footwear industry. The Wolverine Leathers Division is +the largest domestic tanner of pigskin. Wolverine Leathers ® brand products are manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes these leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof, +stain resistant and washable leathers are featured in many of the Company's domestic footwear lines and many products +5 +offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it then cures and sells to the +Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +3. Retail Stores . The Company operated 62 domestic retail shoe stores as of March 23, 2001, under two formats, consisting of 60 factory outlet stores under the Hush Puppies +and Family name and two mall-based stores called Up Footgear ™. The Company expects the scope of its retail operations to remain relatively consistent in the foreseeable future. Most of the Company's 60 factory outlet stores +carry a large selection of first quality Company branded footwear at discounted retail prices. The Up Footgear ™ stores feature Company brands such as Wolverine ®, Merrell ®, Hush Puppies ®, Caterpillar ® and Harley-Davidson ®. These stores also carry a selection of branded footwear from +other manufacturers. +4. Apparel and Accessory Licensing . The Company's Apparel and Accessory Licensing Division licenses the Company's brands for use on non-footwear products including apparel, +eyewear, watches, socks, handbags and plush toys. Current licensing programs include Hush Puppies ® brand apparel, eyewear and plush toys and watches under the Wolverine ® and Hush Puppies ® brands. +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States market to foster a differentiated and globally consistent image for each of the +Company's core footwear brands. Each footwear brand group has its own marketing personnel who develop the marketing strategy for products within that group. Domestic marketing campaigns target both the Company's retail accounts and consumers, and strive +to increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's footwear. Components +of the brand-specific plans include print, radio and television advertising, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's footwear brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance provided +by the Company to its licensees and distributors are (i) direction concerning the categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation +specifications, blueprints and packaging, (v) sales materials, and (vi) consulting concerning retail store layout and design. The Company believes its footwear brand names provide a competitive advantage. In support of this belief, the Company makes +significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +6 +Domestic Sales and Distribution. +The Company uses a wide variety of distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses three primary distribution strategies. +• +Traditional wholesale distribution is used to service department stores (such as J.C. Penney, Sears and Nordstrom), large footwear chains (such as Famous Footwear), specialty retailers, catalog and independent retailers, and military outlets. A +dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide branded and private label footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchants and government customers. +• +A network of independent Shoemobile ® distribution outlets is primarily used to distribute and sell HyTest ® brand products. The Company also distributes work and occupational footwear under a number of the Company's other brands +through this independent distributor network. +In addition to its wholesale activities, the Company also operates domestic retail shoe stores as described above. The Company is developing various programs both independently and with its retail customers for the +distribution of its products over the Internet and in 2000 opened a direct to customer site at www.upfootgear.com . +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's net sales and other operating income in fiscal 2000. +Footwear sales are seasonal with significant increases in sales experienced during the fall hunting season, Christmas, Easter and back-to-school periods. Due to this seasonal nature of footwear sales, the Company +experiences some fluctuation in its levels of working capital. The Company provides working capital for such fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects the seasonal +sales pattern to continue in future years. +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of sales of branded footwear products generated from the Company's wholly owned operations in Canada and the United Kingdom, and from royalty +income through a network of independent licensees and distributors. The Company's owned operations include Hush Puppies (UK) Ltd., Merrell (Europe) Limited, Hush Puppies Canada Footwear, Ltd., and the Merrell Canada division. The Company's owned +operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of Company footwear bearing the Hush Puppies ®, Wolverine ®, Bates ®, HyTest ®, Merrell ® and other trademarks by +independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the Caterpillar ®, Coleman ® and Harley-Davidson ® trademarks through foreign distributors. License and +7 +distribution arrangements enable the Company to develop international markets without the capital commitment required to maintain inventories or fund localized marketing programs. In fiscal 2000, the Company's wholly owned foreign operations, together +with the Company's foreign licensees and distributors sold an estimated 18 million pairs of footwear, which is similar to the level of international sales in fiscal 1999. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent +with the global brand position. The licensees and distributors then purchase goods from either the Company or authorized third-party manufacturers pursuant to a distribution agreement or manufacture branded products consistent with Company standards +pursuant to a license agreement. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and manufacture of approximately 75% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the +pairs controlled by the Company, approximately 85% are purchased or sourced from third parties, the remainder are produced at Company-owned facilities. Footwear produced by the Company is manufactured at Company-owned facilities in several domestic and +certain affiliated foreign facilities located in Michigan, Arkansas, the Caribbean Basin and Mexico. For some of the Company-produced footwear, the Company has implemented a "twin plant" concept whereby a majority of the labor intensive cutting and +fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Caribbean Basin and Mexico and the technology intensive construction, or "bottoming," is performed at the Company's domestic facilities. +The Company's factories each have the flexibility to produce a variety of footwear, and depart from the industry's historic practice of dedicating a given facility to production of specific footwear products. This +flexibility allows the Company to quickly respond to changes in market preference and demand. The Company produces primarily slippers and work footwear in its domestic and international facilities, allowing the Company to respond to both market and +customer-specific demand. In fiscal 2000, the Company announced its intention to close its facilities in Malone, New York; Kirksville, Missouri; Aguadilla, Puerto Rico; San Jose, Costa Rica; and Ontario, Canada. Consolidating operations into the +remaining facilities allows the Company to take better advantage of sophisticated global sourcing alternatives. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, Central and South America, India and Europe. The Company maintains technical offices in +the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In +addition, the Company has developed its "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws +and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +8 +The Company's domestic manufacturing operations allow the Company to (i) reduce its lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and +(iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (i) benefit from lower labor costs, (ii) source the highest quality raw materials from around the world, and (iii) avoid additional capital +expenditures necessary for factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company maximum flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates through its Wolverine Leathers Division a pigskin tannery, which is one of the premier tanners of quality leather for the footwear industry. The Company and its licensees receive +virtually all of their pigskin requirements from the tannery. The Company believes the tannery provides a strategic advantage for the Company by producing leather using proprietary technology at prices below those available from other sources. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of shearling and +cowhide leather eliminates any reliance by the Company upon a sole supplier. Cowhide leather prices in the global market have increased and may continue to increase in 2001 due primarily to a reduction in supply in key cattlehide producing countries as a +result of disease and other factors. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over +30 years. Alternative sources of pigskin are available, however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, +none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war, political disturbances and similar events, the imposition of +trade barriers, quotas and tariffs and loss of most favored nation trading status. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products +currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could, particularly on a short-term basis, have an adverse impact on the Company's operations. +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear products. The trademarks that are most widely used by the Company include Hush Puppies ®, +Wolverine ®, Bates ®, Wolverine Fusion ™, DuraShocks ®, Hidden Tracks ®, Bounce ®, Comfort Curve ®, HPO2 ®, HyTest ®, Merrell ® and FootRests ®. +The Company has obtained the right to manufacture, market and distribute footwear throughout most countries of the world under the Caterpillar ®, Harley-Davidson ® and Coleman ® trademarks, the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark and the right to +manufacture, market and distribute slippers in the United States and certain other countries under the Turtle Fur ® and Joe Boxer ® trademarks pursuant to license arrangements with the respective trademark owners. With the exception of the Coleman ® license, all of the Company's licenses are long term and extend for three or +more years with renewal options. The Company's arrangement with the Coleman Company, Inc. expires on December 28, 2002, with possible renewal options if certain sales goals are achieved. The licenses are subject to customary approval, performance and +default provisions. Pigskin +9 +leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers ®, Weather Tight ® and All Season Weather Leathers ™. +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of ownership of +its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever possible and to vigorously defend its trademarks against infringement or other threats to the greatest +extent practicable under the laws of the United States and other countries. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent +practicable under applicable laws. +Order Backlog. +At March 24, 2001, the Company had a backlog of footwear orders of approximately $195 million compared with a backlog of approximately $159 million at March 25, 2000. Approximately two-thirds of the backlog increase +is related to orders for products expected to be shipped in the third and fourth quarters of 2001 and can be affected by the timing of customer requests for shipment of the ordered products. While orders in backlog are subject to cancellation by +customers, the Company has not experienced significant cancellation of orders in the past and the Company expects that substantially all of the orders will be shipped in fiscal 2001. The backlog at a particular time is affected by a number of factors, +including seasonality, retail conditions, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual +actual shipments. +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of +which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States. The Company has at least ten major competitors in connection with the sale of its work shoes and +boots, at least eight major competitors in connection with the sale of its sport boots, and at least fifteen major competitors in connection with the sale of its casual and dress shoes. Product performance and quality, including technological +improvements, product identity, competitive pricing, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer +preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing efficiencies, its tannery operations, and the style, comfort and value of its products. Future sales by the Company will be affected +by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and +no one company has a dominant market position. +10 +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to new and improved materials for use in its branded footwear and other +products and in the development and adaptation of new production techniques. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, +such as Bounce ®, DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development +costs do not represent a material portion of operating expenses. +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not +had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company. The Company uses and generates, and in the past has used and generated, certain substances and wastes that are regulated +or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites or other regulatory +issues. +Employees. +As of December 30, 2000, the Company had approximately 4,903 domestic and foreign production, office and sales employees. Approximately 677 employees were covered by five union contracts expiring at various dates +through March 31, 2004. The Company has experienced no work stoppages since 1990. The Company presently considers its employee relations to be good. +Item 2. Properties . +The Company either directly or through its subsidiaries owned or leased the following offices and manufacturing facilities as of December 30, 2000: +LOCATION +TYPE OF FACILITY +OWNED +LEASED +SQUARE +FOOTAGE +Rockford, MI +Administration/Sales +Owned +223,300 +Jonesboro, AR +Administration/Sales +Leased +5,680 +Malone, NY +Administration/Sales +Owned +11,718 +New York, NY +Administration/Sales +Leased +3,811 +St. Laurent, Quebec, Canada +Administration/Sales +Leased +2,800 +Saint-Sauveur-des-Monts, +Quebec, Canada +Administration/Sales +Leased +1,500 +Tai Chung, Taiwan +Administration/Sales +Leased +19,000 +Leicester, England, United Kingdom +Administration/Sales +Leased +13,250 +11 +Bristol, England, United Kingdom +Administration/Sales +Leased +2,200 +Total Administration/Sales +283,259 +Rockford, MI +Tannery +Owned +160,000 +Des Moines, IA +Procurement +Owned +6,200 +Dyersburg, TN +Procurement +Leased +12,000 +Durant, OK +Procurement +Leased +12,900 +Dennison, KS +Procurement +Leased +1,855 +Total Tannery and Procurement +192,955 +Jonesboro, AR +Manufacturing +Leased +79,197 +Jonesboro, AR +Manufacturing +Owned +11,680 +Monette, AR +Manufacturing +Owned +18,030 +Rockford, MI +Manufacturing +Owned +20,833 +Rockford, MI +Manufacturing +Owned +19,624 +Rockford, MI +Manufacturing +Owned +7,790 +Big Rapids, MI +Manufacturing +Owned +77,626 +Kirksville, MO +Manufacturing +Owned +104,000 +Malone, NY +Manufacturing +Owned +90,664 +Malone, NY +Manufacturing +Owned +37,596 +Malone, NY +Manufacturing +Owned +8,100 +Malone, NY +Manufacturing +Owned +27,125 +Bombay, NY +Manufacturing +Leased +58,980 +Monterrey, MX +Manufacturing +Leased +60,000 +Aguadilla, Puerto Rico +Manufacturing +Leased +62,100 +San Pedro, Dominican Republic +Manufacturing +Leased +65,111 +Santo Domingo, Dominican Republic +Manufacturing +Leased +54,332 +Cartago, Costa Rica +Manufacturing +Leased +88,308 +Total Manufacturing +891,096 +Jonesboro, AR +Warehouse +Leased +2,000 +Jonesboro, AR +Warehouse +Leased +19,500 +Jonesboro, AR +Warehouse +Owned +13,500 +Jonesboro, AR +Warehouse +Owned +15,478 +Rockford, MI +Warehouse +Owned +304,278 +Rockford, MI +Warehouse +Owned +93,140 +Rockford, MI +Warehouse +Owned +75,000 +Cedar Springs, MI +Warehouse +Leased +32,900 +Cedar Springs, MI +Warehouse +Leased +230,000 +Big Rapids, MI +Warehouse +Owned +39,800 +Howard City, MI +Warehouse +Leased +350,000 +12 +Malone, NY +Warehouse +Owned +115,211 +Bombay, NY +Warehouse +Leased +26,000 +St. Laurent, Quebec, Canada +Warehouse +Leased +33,000 +Total Warehouse +1,349,807 +In addition, the Company's subsidiary, Hush Puppies Retail, Inc., operates retail stores through leases with various third-party landlords. The Company believes that its current facilities are suitable and adequate +to meet its anticipated needs for the next twelve months. +Item 3. Legal Proceedings . +The Company is involved in litigation and various legal matters arising in the normal course of business, including certain environmental compliance activities. The Company has considered facts that have been +ascertained and opinions of counsel handling these matters, and does not believe the ultimate resolution of such proceedings will have a material adverse effect on the Company's financial condition or future results of operations. +Item 4. Submission of Matters to a Vote of Security Holders . +No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report. +Supplemental Item. Executive Officers of the Registrant . +The following table lists the names and ages of the Executive Officers of the Company as of the date of this Annual Report on Form 10-K, and the positions presently held with the Company. The information provided +below the table lists the business experience of each such Executive Officer during the past five years. All Executive Officers serve at the pleasure of the Board of Directors of the Company, or if not appointed by the Board of Directors, they serve at +the pleasure of management. +Name +Age +Positions held with the Company +Geoffrey B. Bloom +59 +Chairman of the Board +John Deem +45 +Executive Vice President and President, +Casual Footwear Group +Steven M. Duffy +48 +Executive Vice President and President, +Global Operations Group +V. Dean Estes +51 +Vice President and President, +Wolverine Footwear Group +Stephen L. Gulis, Jr. +43 +Executive Vice President, Chief Financial +Officer and Treasurer +Blake W. Krueger +47 +Executive Vice President, General Counsel +and Secretary +Thomas P. Mundt +51 +Vice President of Strategic Planning and +Corporate Communications +Timothy J. O'Donovan +55 +Chief Executive Officer and President +13 +Nicholas P. Ottenwess +38 +Corporate Controller +Robert J. Sedrowski +51 +Vice President of Human Resources +James D. Zwiers +33 +Associate General Counsel and Assistant +Secretary +Geoffrey B. Bloom has served the Company as Chairman of the Board since 1996. From 1996 to 2000 he served the Company as Chief Executive Officer and Chairman of the Board. From 1993 to 1996 he served the Company as +President and Chief Executive Officer. +John Deem has served the Company as Executive Vice President and President, Casual Footwear Group since July 1998. From 1996 to July 1998, he served as Vice President of Global Product Development. From 1992 to 1996 +he served as Executive Vice President of Product Development and Marketing at Dexter Shoe Company. +Steven M. Duffy has served the Company as Executive Vice President since April 1996 and is President of the Company's Global Operations Group. From 1993 to 1996 he served the Company as Vice President. +V. Dean Estes has served the Company as Vice President since 1995. Mr. Estes is also President of the Wolverine Footwear Group. Since he joined the Company in 1975, Mr. Estes has served in various positions relating +to the sales, marketing and product development functions of the Company's work boot and shoe and related businesses. +Stephen L. Gulis, Jr., has served the Company as Executive Vice President, Chief Financial Officer and Treasurer since April 1996. From 1994 to April 1996 he served the Company as Vice President and Chief Financial +Officer. +Blake W. Krueger has served the Company as Executive Vice President, General Counsel and Secretary since April 1996. From 1993 to April 1996 he served the Company as General Counsel and Secretary. From 1985 to 1996 +he was a partner with the law firm of Warner Norcross & Judd LLP. +Thomas P. Mundt has served the Company as Vice President of Strategic Planning and Corporate Communications since April 1996. From December 1993 to April 1996, he served the Company as Vice President of Strategic +Planning and Treasurer. +Timothy J. O'Donovan has served the Company as Chief Executive Officer and President since April 2000. From 1996 to April 2000 he served the Company as Chief Operating Officer and President. From 1982 to April 1996 +he served the Company as Executive Vice President. +Nicholas P. Ottenwess has served as Corporate Controller of the Company since September 1997. From 1993 to September 1997 he served as Vice President of Finance & Administration for The Hush Puppies Company. +Robert J. Sedrowski has served the Company as Vice President of Human Resources since October 1993. +14 +James D. Zwiers has served the Company as Associate General Counsel and Assistant Secretary since January 1998. From 1995 to 1998 he was an attorney with the law firm of Warner Norcross & Judd LLP. +PART II +Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. +Wolverine World Wide, Inc. common stock is traded on the New York Stock Exchange and the Pacific Exchange under the symbol "WWW." The following table shows the high and low sales prices on the New York Stock Exchange +and dividends declared by calendar quarter for 2000 and 1999. The number of stockholders of record on March 1, 2001, was 1,975. +2000 +1999 +High +Low +High +Low +First quarter +$13 3/8 +$ 9 +$13 1/2 +$8 7/8 +Second quarter +13 1/2 +10 3/16 +14 1/4 +9 1/8 +Third quarter +12 11/16 +9 +14 +9 7/8 +Fourth quarter +17 1/2 +8 9/16 +12 1/4 +9 +Cash Dividends Declared Per Share : +2000 +1999 +First quarter +$.035 +$.03 +Second quarter +.035 +.03 +Third quarter +.035 +.03 +Fourth quarter +.035 +.03 +Dividends of $.04 were declared in the first quarter of fiscal 2001. +Item 6. Selected Financial Data . +Five-Year Operating and Financial Summary (1) +(Thousands of Dollars, Except Per Share Data) +2000 +1999 +1998 +1997 +1996 +Summary of Operations +Net sales and other +operating income +$701,291 +$665,576 +$669,329 +$665,125 +$511,029 +Net earnings +10,690 +32,380 +41,651 +41,539 +32,856 +Per share of common stock: +Net earnings (2)(3) : +Basic +$.26 +$.80 +$1.00 +$1.00 +$.81 +Diluted +.26 +.78 +.97 +.96 +.76 +Cash dividends (3)(4) +.14 +.12 +.11 +.09 +.07 +15 +Financial Position at Year End +Total assets +$494,568 +$534,395 +$521,478 +$449,663 +$361,598 +Long-term debt +92,194 +139,201 +161,650 +94,264 +41,309 +Notes to Five-Year Operating and Financial Summary +1. +This summary should be read in conjunction with the consolidated financial statements of the Company and the notes thereto, which are attached as Appendix A to this Form 10-K. In particular, see the discussion of the nonrecurring charges in Note 11 to +the consolidated financial statements. +2. +Basic earnings per share are based on the weighted average number of shares of common stock outstanding during the year after adjustment for nonvested common stock. Diluted earnings per share assume the exercise of dilutive stock options and the +vesting of all common stock. +3. +On April 17, 1997 and July 11, 1996, the Company announced three-for-two stock splits on shares of common stock outstanding at May 2, 1997 and July 26, 1996, respectively. All share and per share data have been retroactively adjusted for the increased +shares resulting from these stock splits. +4. +Cash dividends per share represent the rates paid by the Company on the shares outstanding. +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. +Operations +Results of Operations--2000 Compared to 1999 +Net sales and other operating income increased 5.4% to $701.3 million in 2000 compared to $665.6 million in 1999. On a combined basis, net sales and other operating income for the Company's branded footwear +businesses, consisting of the Casual Footwear Group (comprised of The Hush Puppies Company, the Children's Footwear Group, the Wolverine Slipper Group and, in 1999, the Russian wholesale business), the Wolverine Footwear Group (comprised of the Wolverine® , HYTEST® , Stanley ®, Coleman® , Bates® and Harley-Davidson® brands), and the Performance Footwear Group (comprised of the CAT® and Merrell® brands) increased +$31.9 million (5.4%) in 2000 compared to 1999. The Company's other business units, consisting of Wolverine Retail, Apparel and Accessory Licensing, Wolverine Leathers and Wolverine Procurement operations, reported a $3.8 million (5.1%) increase in net +sales and other operating income in 2000 compared to 1999. +The Casual Footwear Group reported a decrease in net sales and other operating income of $18.5 million (8.9%) in 2000 compared to 1999. The decline was attributable to a decrease in shipments of adult and children's +Hush Puppies ® classic suede products to department stores in the United States and a reduction in sales to three large retailers in the United Kingdom as a result of the depressed retail activity in that market. This decrease was partially offset +by an increase in net sales and other operating income reported by the Wolverine Slipper Group as a result of expanded distribution efforts and new product offerings. +16 +The Wolverine Footwear Group's net sales and other operating income increased $13.2 million (4.9%) in 2000 compared to 1999. Harley-Davidson® footwear provided the majority of this increase with an +expanded distribution network in 2000. Stanley® footgear, a new footwear line for the Company, also contributed to the increase with a marketing arrangement launched with Payless ShoeSource, Inc. near the end of the third quarter of 2000. These increases were partially offset by the +Wolverine® and HYTEST® work boot businesses, which reported decreases in net sales and other operating income from 1999, primarily due to retailers reducing seasonal work boot reorders in an effort to manage their inventory levels. +The Performance Footwear Group reported record net sales and other operating income, reflecting an increase of $37.2 million (32.0%) for 2000 compared to 1999. The Merrell® outdoor footwear business +accounted for the increase in net sales and other operating income as a result of strong consumer demand for the brand, new product offerings and expansion of its domestic and international distribution. Partially offsetting this increase was a net sales +and other operating income decrease reported by Caterpillar® footwear. +The Company's other business units reported a combined $3.8 million (5.1%) increase in net sales and other operating income in 2000 compared to 1999. Wolverine Retail reported a $5.2 million increase in net sales and +other operating income in 2000 compared to 1999. This increase was partially offset by Wolverine Leathers, which recorded a decrease in net sales and other operating income primarily as a result of a decline in production of Hush Puppies® classic sueded product worldwide. Net sales and other operating income for the Apparel and Accessory Licensing and Wolverine Procurement operations remained flat for 2000 compared to 1999. +As discussed in Note 11 to the consolidated financial statements, on July 12, 2000, the Company announced a strategic realignment of its global sourcing and manufacturing operations. In connection with this +realignment, the Company decided to close five of its manufacturing facilities in New York, Missouri, Canada, Puerto Rico and Costa Rica, discontinue the production of certain footwear products and related raw material inventories, reduce administrative +support services and incur other nonrecurring charges. Accordingly, a nonrecurring, pre-tax charge to earnings of $45.0 million was recorded in 2000, of which $15.0 million was reflected in cost of products sold for inventory write-downs, $29.6 million +was recognized in selling and administrative expenses for severance, bad debt, loss on disposal of fixed assets and goodwill impairment, and $0.4 million was recorded in other expenses. These charges resulted in a $0.71 per share reduction of net earnings +for 2000. The realignment is expected to result in improved factory efficiencies, reduced factory and corporate overhead, and improved margins as the production of various footwear products shifts to lower cost offshore manufacturing facilities. It is +anticipated that a portion of these savings will be reinvested in future product development and marketing initiatives supporting the Company's branded footwear businesses. The realignment activities were primarily completed in the third and fourth +quarters of 2000. +Due to anticipated changes in the Company's overall business model and the decision to modify product mix, certain footwear products were discontinued in connection with the strategic realignment. The Company +analyzed raw materials, work in process and finished goods inventories related to these low or non-profitable footwear products and developed a liquidation plan to sell or dispose of inventories that would no longer be sold or used in production. +17 +The other nonrecurring charges relate primarily to customer charge-backs and other accounts receivable deductions. These amounts were deemed uncollectible as a result of failed customer negotiations and a decision to +no longer pursue collection based on staff reductions related to the strategic realignment. +Transition costs unrelated to the direct production of footwear were incurred in certain facilities that were scheduled to be closed or reconfigured. Such costs included under absorption of overhead in facilities +where production lines will be shut down, training costs associated with the reconfiguration of factories and the movement of machinery, equipment and inventory. Transition costs were expensed as incurred. +During 1999, the Company recorded a nonrecurring, pre-tax charge to earnings of $14.0 million related to the closing of its Russian wholesale footwear business, of which $6.9 million was reflected as a write-down in +cost of products sold for inventory, $6.6 million was recognized in selling and administrative expenses for goodwill impairment, bad debt, severance, and other exit costs, and $0.5 million was recorded in other expenses. These charges resulted in a $0.23 +per share reduction of earnings for 1999. The closure was completed in 1999. +The following table summarizes the effect of the 2000 and 1999 nonrecurring charges on reported results for those years (thousands of dollars, except per share data; percentages relate to total net sales and other +operating income): +2000 +Results +As Reported +Effect of +Nonrecurring +Charges +Results +Excluding +Nonrecurring Charges +Gross Margin +$ +223,973 +31.9 +% +$ +15,036 +$ +239,009 +34.1 +% +Selling and administrative expenses +198,953 +28.4 +% +29,589 +169,364 +24.2 +% +Other expenses +10,005 +1.4 +% +425 +9,580 +1.4 +% +Earnings before income taxes +15,015 +2.1 +% +45,050 +60,065 +8.6 +% +Net earnings +10,690 +1.5 +% +29,813 +40,503 +5.8 +% +Diluted earnings (loss) per share +$ +.26 +$ +(.71 +) +$ +.97 +1999 +Gross Margin +$ +220,344 +33.1 +% +$ +6,900 +$ +227,244 +34.1 +% +Selling and administrative expenses +159,749 +24.0 +% +6,600 +153,149 +23.0 +% +Other expenses +11,049 +1.7 +% +500 +10,549 +1.6 +% +Earnings before income taxes +49,546 +7.4 +% +14,000 +63,546 +9.6 +% +Net earnings +32,380 +4.9 +% +9,338 +41,718 +6.3 +% +Diluted earnings (loss) per share +$ +.78 +$ +(.23 +) +$ +1.01 +The analysis in this paragraph excludes the nonrecurring charges in 2000 and 1999. Gross margin as a percentage of net sales and other operating income remained flat at 34.1% for both 2000 and 1999. Gross margin +dollars increased $11.8 million or 5.2% in 2000 to $239.0 million compared to $227.2 million in 1999. The gross margin percentage for the branded footwear businesses increased to 33.5% in +18 +2000 from 33.0% in 1999. The increase in gross margins for the branded footwear businesses resulted primarily from increased shipments of higher margin Merrell® and Harley-Davidson® products. This increase was partially offset by +the strengthening of the U.S. dollar against European and Canadian currencies and additional markdowns taken to reduce inventory levels in 2000. The gross margin percentage for the other business units decreased to 38.5% in 2000 compared to 43.5% in 1999, +primarily due to an increase in raw stock prices experienced by Wolverine Leathers and Wolverine Procurement. +The analysis in this paragraph excludes the nonrecurring charges in 2000 and 1999. Selling and administrative expenses of $169.4 million for 2000 increased $16.3 million (10.6%) from the 1999 level of $153.1 million +and, as a percentage of net sales and other operating income, increased to 24.2% in 2000 from 23.0% in 1999. The change in selling and administrative expenses includes increased selling, advertising and administration costs of $12.6 million for Merrell® and Harley-Davidson® and increased depreciation expense of $2.7 million related to recent capital investments in distribution centers and information services. +Interest expense in 2000 was $10.3 million compared to $11.1 million in 1999. The decrease in interest expense reflected lower average borrowings in 2000 compared to 1999. This decrease was partially offset by a +slight increase in interest rates on the Company's revolving credit facility and lower capitalization of interest due to the completion of major capital projects during 1999. +The Company's 2000 effective income tax rate of 28.8% compared to 34.6% for 1999. The decrease is a result of earnings from certain foreign subsidiaries, which are taxed at lower rates, being a higher percentage of +total consolidated net earnings in 2000 and income tax benefits associated with the 2000 nonrecurring charges. +Net earnings were $10.7 million for 2000 compared to $32.4 million for 1999. Diluted earnings per share were $0.26 for 2000 compared to $0.78 for 1999. Excluding nonrecurring charges, net earnings were $40.5 million +for 2000 compared to $41.7 million for 1999 and diluted earnings per share were $0.97 for 2000 compared to $1.01 for 1999. +Results of Operations--1999 Compared to 1998 +Net sales and other operating income decreased 0.6% to $665.6 million in 1999 compared to $669.3 million in 1998. On a combined basis, net sales and other operating income for the Company's branded footwear +businesses decreased $5.7 million (1.0%) for 1999 compared to 1998. The Company's other business units reported a $1.9 million (2.7%) increase in net sales and other operating income in 1999 compared to 1998. +The Casual Footwear Group reported a $49.8 million (19.4%) decline in 1999 net sales and other operating income when compared to 1998. The decline was experienced primarily in The Hush Puppies Company, which reported +a net sales and other operating income decrease of $38.9 million in 1999 compared to 1998. This decrease related primarily to a shortfall in the U.S. wholesale operation as a result of a slowdown in the sales of Hush Puppies® classic suede casuals, along with the planned reduction in the specialty store distribution segment of the Hush Puppies U.K. wholesale operation. The closing of the Company's Russian wholesale footwear business accounted for an +additional $4.4 million decline. +19 +The Wolverine Footwear Group reported record net sales and other operating income, reflecting an increase of $15.4 million (6.1%) in 1999 compared to 1998. Harley-Davidson® footwear, which began operations +late in the third quarter of 1998, contributed a majority of this increase. The Bates® footwear division, including shipments to the United States Department of Defense, recognized a decrease in net sales and other operating income from the prior year as a result of a slowdown in draw orders against contracts. The work +boot business, comprised of Wolverine® Boots and Shoes and HYTEST® Boots and Shoes, reported a slight increase in net sales and other operating income over the 1998 level. +The Performance Footwear Group continued its strong growth, reflecting an increase in net sales and other operating income of $28.8 million (32.7%) for 1999 over 1998. The Merrell® outdoor footwear +business accounted for the increase as this business offered new products and expanded its retail distribution channels. +Within the Company's other business units, Wolverine Leathers and Wolverine Procurement accounted for substantially all of the $1.9 million increase in net sales and other operating income in 1999 over 1998. +Wolverine Retail and Apparel and Accessory Licensing reported flat net sales and other operating income in 1999 compared to 1998. +The analysis in this paragraph excludes the nonrecurring charge in 1999 related to the closing of the Company's Russian wholesale footwear business. Gross margin as a percentage of net sales and other operating +income was 34.1% in 1999 compared to the prior year's level of 33.7%. Gross margin dollars increased $1.6 million or 0.7% in 1999 to $227.2 million compared to $225.6 million in 1998. The gross margin percentage for the branded footwear businesses +increased to 33.0% in 1999 from 32.8% in 1998. Gross margins for the branded footwear businesses were favorably affected by the performance of the Wolverine Footwear and Performance Footwear Groups as their respective brands carry higher initial margins. +The gross margin percentage for the other business units increased to 43.5% for 1999 compared to 41.5% for 1998, which resulted primarily from higher margin achievement from Wolverine Leathers and Wolverine Procurement. +The analysis in this paragraph excludes the nonrecurring charge in 1999 related to the closing of the Company's Russian wholesale footwear business. Selling and administrative expenses of $153.1 million for 1999 +decreased $3.3 million (2.1%) from the 1998 level of $156.4 million. As a percentage of net sales and other operating income, these expenses decreased to 23.0% in 1999 from 23.4% in 1998. The change in selling and administrative expenses includes +increased depreciation expense of $1.5 million related to investments in warehousing infrastructure and information services and $4.7 million in employee benefits, that were offset by $9.5 million of cost reductions in travel, payroll and other selling +and administrative expenses. +Interest expense of $11.1 million was $2.6 million greater in 1999 than the 1998 level of $8.4 million. The increase in interest expense reflected a full year of additional borrowings on the Company's revolving +credit facility for the repurchase of 2.2 million shares of the Company's common stock during the last half of 1998, increased borrowings to support investments in working capital and lower capitalization of interest due to the completion of capital +projects during 1999. +20 +The 1999 effective income tax rate of 34.6% increased from 32.6% in 1998 primarily as a result of earnings from certain foreign subsidiaries, which are taxed generally at lower rates, being a smaller percentage of +total consolidated net earnings and other 1999 tax adjustments. +Net earnings for 1999 were $32.4 million compared to net earnings of $41.7 million reported in 1998. Diluted earnings per share for 1999 were $0.78 compared to $0.97 in 1998. Excluding the 1999 nonrecurring charge, +net earnings would have been $41.7 million or $1.01 diluted earnings per share in 1999. +Liquidity and Capital Resources +Net cash provided by operating activities was $71.0 million in 2000 compared to $47.2 million in 1999. Cash of $14.5 million was provided by reductions in working capital in 2000, whereas $23.4 million was used to +fund working capital requirements in 1999, a net improvement of $37.9 million. Accounts receivable of $162.0 million at December 30, 2000 reflected an $8.7 million (5.1%) decrease from the $170.7 million balance at January 1, 2000. Inventories of $144.2 +million at December 30, 2000 decreased $23.8 million (14.2%) from $168.0 million at January 1, 2000. The decline in accounts receivable and inventories was the result of a focused asset reduction program initiated at the beginning of 2000 and reductions +associated with the nonrecurring charges. Other accrued liabilities of $27.9 million at December 30, 2000 reflected a $4.1 million (17.3%) increase from the $23.8 million balance at January 1, 2000. The increase in other accrued liabilities was primarily +attributable to nonrecurring charges associated with the strategic realignment. +Additions to property, plant and equipment were $12.0 million in 2000 compared to $19.4 million in 1999. The majority of the Company's legacy information system replacement was completed prior to 2000, which accounts +for the decrease in property, plant and equipment additions. Depreciation and amortization expense of $17.7 million in 2000 compares to $14.9 million in 1999. The increase in depreciation resulted from the capital investments noted above. +In addition to a $6.7 million short-term loan maintained by the Company's Canadian subsidiary, the Company maintains commercial letter-of-credit facilities of $66.8 million, of which $27.0 million and $30.4 million +were outstanding at the end of 2000 and 1999, respectively. Long-term debt, including current maturities, of $92.2 million at the end of 2000 decreased $47.0 million from the $139.2 million balance at the end of 1999. The decrease in debt was the result +of improved operating cash flows that provided funds to pay down amounts borrowed. +Effective October 3, 2000, the Company's Board of Directors approved a common stock repurchase program authorizing the repurchase of up to 2.0 million shares of common stock over 24 months. The primary purpose of +this stock repurchase program is to increase shareholder value. Total cumulative common shares repurchased under the program were 25,900 as of December 30, 2000. The Company intends to continue to repurchase shares of its common stock in open market +transactions, from time to time, depending upon market conditions and other factors. +The Company has long-term revolving credit facilities of $175.5 million expiring in October 2001. The Company is currently negotiating the renewal of its existing credit facilities to ensure that proper credit +remains available for future growth. The revolving credit facilities are used to support working capital requirements. Proceeds from credit facilities and anticipated renewals along with cash +21 +flows from operations are expected to be sufficient to meet capital needs in the foreseeable future. Any excess cash flows from operations are expected to be used to pay down existing debt, fund growth initiatives and repurchase the Company's common stock. +The Company declared dividends of $5.8 million in 2000, or $0.14 per share, which reflected a 16.7% increase over the $4.9 million, or $0.12 per share, declared in 1999. Additionally, shares issued under stock +incentive plans provided cash of $0.2 million in 2000 compared to $1.4 million during 1999. +The current ratio was 6.0 to 1.0 at year-end 2000 compared to 7.2 to 1.0 at year-end 1999. The Company's total debt to total capital ratio decreased to .22 to 1.0 in 2000 from .30 to 1.0 in 1999. +Market Risk +The Company has assets, liabilities and inventory purchase commitments outside the United States that are subject to fluctuations in foreign currency exchange rates. A substantial portion of inventory sourced from +foreign countries is purchased in U.S. dollars and accordingly is not subject to exchange rate fluctuations. Similarly, revenues from products sold in foreign countries under licensing and distribution arrangements are denominated in U.S. dollars. As a +result, the Company engages in forward foreign exchange and other similar contracts to reduce its economic exposure to changes in exchange rates on a limited basis because the associated risk is not considered significant. Since a limited number of +hedging instruments were in place as of January 1, 2001, the adoption of Statements of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities , did not have a material effect on the Company's consolidated financial position or results of operations. +Assets and liabilities outside the United States are primarily located in Canada and the United Kingdom. The Company's investment in foreign subsidiaries with a functional currency other than the U.S. dollar are +generally considered long-term. Accordingly, the Company does not hedge these net investments. +Because the Company markets, sells and licenses its products throughout the world, it could be significantly affected by weak economic conditions in foreign markets that could reduce demand for its products. +The Company is exposed to changes in interest rates primarily as a result of its long-term debt requirements. The Company's interest rate risk management objectives are to limit the effect of interest rate changes on +earnings and cash flows and to lower overall borrowing costs. To achieve its objectives, the Company maintains substantially all fixed-rate debt to take advantage of lower relative interest rates currently available and finances seasonal working capital +needs with variable-rate debt. The Company has not historically utilized interest swap or similar hedging arrangements to fix interest rates, but in 1998 entered into an interest rate lock agreement to fix the interest rate prior to the issuance of 6.5% +senior notes in the amount of $75 million. The contract was settled in 1998 and resulted in a prepayment of $2.2 million that is being amortized over the term of the senior notes. The amortization of the prepayment creates an effective interest rate of +6.78% on the senior notes. +The following table provides principal cash flows and related interest rates of the Company's short- and long-term debt by fiscal year of maturity. For foreign currency-denominated debt, the +22 +information is presented in U.S. dollar equivalents. Variable interest rates are based on the weighted average rates of the portfolio at the respective consolidated balance sheet dates. +2000 +1999 +2001 +2002 +2003 +2004 +2005 +There- +after +Total +Fair +Value +Total +Fair +Value +(Millions of Dollars, Except Percentages) +Denominated in U.S. Dollars : +Fixed Rate +Average Interest Rate +$4.3 +7.8% +$15.0 +6.9% +$15.0 +6.9% +$15.0 +6.9% +$10.7 +6.5% +$32.1 +6.5% +$92.1 +6.7% +$92.3 +$96.8 +6.8% +$98.0 +Variable Rate +Average Interest Rate +$40.0 +6.5% +$40.0 +Denominated in Canadian Dollars: +Variable Rate +Average Interest Rate +$0.9 +7.4% +$0.9 +7.4% +$0.9 +Denominated in British Sterling +Variable Rate +Average Interest Rate +$2.5 +5.2% +$2.5 +The Company does not enter into contracts for speculative or trading purposes, nor is it a party to any leveraged derivative instruments. +Forward-Looking Statements +This Item 7 and other sections of this Form 10-K may contain forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the footwear +business, worldwide economics and the Company itself. Statements, including without limitation those related to: expected economic returns, product design strength, orders, and shipments; future sales, earnings, margins, product development, and marketing +investments; projected 2001 operating results; timing and amount of the beneficial impact and charges relating to the sourcing and factory realignment; anticipated product introductions or brand extensions; continued repurchases under the common stock +repurchase program; sufficiency of credit facilities; expected use of excess cash flow; liquidity; capital resources; and market risk are forward-looking statements. In addition, words such as "anticipates," "believes," "estimates," "expects," +"forecasts," "intends," "is likely," "plans," "predicts," "projects," "should," "will," variations of such words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and +involve certain risks, uncertainties and assumptions ("Risk Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed +or forecasted in such forward-looking statements. +Risk Factors include, but are not limited to, uncertainties relating to changes in demand for the Company's products; changes in consumer preferences or spending patterns; the cost and availability of inventories, +services, labor and equipment furnished to the Company; the cost and availability of contract manufacturers; the cost and availability of raw materials, including leather; the impact of competition and pricing by the Company's competitors; changes in +government and regulatory policies; foreign currency fluctuations; changes in trading policies or import and export regulations; changes in interest rates, tax laws, duties, tariffs, quotas or applicable assessments; technological developments; changes in +local, domestic or international economic and market conditions including the severity of the current slowdown in the U.S. economy; the size and growth of footwear markets; changes in the amount or severity of inclement weather; changes due to the growth +of Internet commerce; popularity of particular designs and +23 +categories of footwear; the ability of the Company to manage and forecast its growth and inventories; the ability to secure and protect trademarks, patents and other intellectual property; changes in business strategy or development plans; the ability to +attract and retain qualified personnel; loss of significant customers; dependence on international distributors and licensees and the Company's ability to meet at-once orders. These matters are representative of the Risk Factors that could cause a +difference between an ultimate actual outcome and a forward-looking statement. Historical operating results are not necessarily indicative of the results that may be expected in the future. The Risk Factors included here are not exhaustive. Other Risk +Factors exist, and new Risk Factors emerge from time-to-time, that may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on +forward-looking statements as a prediction of actual results. Furthermore, the Company undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. +Item 7A. Quantitative and Qualitative Disclosures About Market Risk. +The response to this Item is set forth under the caption " Market Risk " in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and is here incorporated by reference. +Item 8. Financial Statements and Supplementary Data . +The response to this Item is set forth in Appendix A of this Annual Report on Form 10-K and is here incorporated by reference. +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . +None. +PART III +Item 10. Directors and Executive Officers of the Registrant . +The information regarding directors of the Company contained under the caption "Wolverine's Board of Directors" and under the caption "Related Matters" under the subheading "Section 16(a) Beneficial Ownership +Reporting Compliance" in the definitive Proxy Statement of the Company dated March 16, 2001, is incorporated herein by reference. The information regarding Executive Officers is provided in the Supplemental Item following Item 4 of Part I above. +Item 11. Executive Compensation . +The information contained under the caption "Wolverine's Board of Directors" under the subheading "Compensation of Directors," under the caption "Related Matters" under the subheading "Compensation Committee +Interlocks and Insider Participation," and under the captions "Executive Compensation" and "Employment Agreements and Termination of Employment and Change in Control Arrangements" in the definitive Proxy Statement of the Company dated March 16, 2001, +is incorporated herein by reference. +24 +Item 12. Security Ownership of Certain Beneficial Owners and Management . +The information contained under the caption "Ownership of Wolverine Stock" contained in the definitive Proxy Statement of the Company dated March 16, 2001, is incorporated herein by reference. +Item 13. Certain Relationships and Related Transactions . +The information regarding certain employee loans following the caption "Executive Compensation," under the subheading "Stock Options," and the information contained under the caption "Wolverine's Board of Directors" +under the subheading "Compensation of Directors" and under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company dated March 16, 2001, are +incorporated herein by reference. +PART IV +Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K . +Item 14(a)(1). Financial Statements . Attached as Appendix A. +The following consolidated financial statements of Wolverine World Wide, Inc. and subsidiaries are filed as a part of this report: +• +Consolidated Balance Sheets as of December 30, 2000 and January 1, 2000. +• +Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Fiscal Years Ended December 30, 2000, January 1, 2000, and January 2, 1999. +• +Consolidated Statements of Operations for the Fiscal Years Ended December 30, 2000, January 1, 2000, and January 2, 1999. +• +Consolidated Statements of Cash Flows for the Fiscal Years Ended December 30, 2000, January 1, 2000, and January 2, 1999. +• +Notes to Consolidated Financial Statements as of December 30, 2000. +• +Report of Independent Auditors. +Item 14(a)(2). Financial Statement Schedules . Attached as Appendix B. +The following consolidated financial statement schedule of Wolverine World Wide, Inc. and subsidiaries is filed as a part of this report: +• +Schedule II--Valuation and qualifying accounts. +25 +All other schedules (I, III, IV, and V) for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are +inapplicable and, therefore, have been omitted. +Item 14(a)(3). Exhibits . +The following exhibits are filed as part of this report: +Exhibit +Number +Document +3.1 +Certificate of Incorporation, as amended. Previously filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 14, 1997. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here incorporated by reference. +4.1 +Certificate of Incorporation, as amended. See Exhibit 3.1 above. +4.2 +Rights Agreement dated as of April 17, 1997. Previously filed with the Company's Form 8-A filed April 12, 1997. Here incorporated by reference. +4.3 +Amendment No. 1 dated as of June 30, 2000, to the Rights Agreement dated as of April 17, 1997. +4.4 +Credit Agreement dated as of October 11, 1996, with NBD Bank as Agent. Previously filed as Exhibit 4.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1996. Here incorporated by reference. +4.5 +Note Purchase Agreement dated as of August 1, 1994, relating to 7.81% Senior Notes. +4.6 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. Previously filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here incorporated by +reference. +4.7 +Amendment No. 1 dated as of January 8, 1998, to the Credit Agreement dated as of October 11, 1996, with NBD Bank as Agent. Previously filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here +incorporated by reference. +4.8 +Amendment No. 2 dated as of March 5, 1999, to the Credit Agreement dated as of October 11, 1996, with NBD Bank as Agent. Previously filed as Exhibit 4.7 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2000. Here +incorporated by reference. +26 +4.9 +The Registrant has several classes of long-term debt instruments outstanding in addition to that described in Exhibits 4.4, 4.5 and 4.6 above. The amount of none of these classes of debt outstanding on March 24, 2001, exceeds 10% of the Company's +total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +10.1 +1993 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed June 22, 1993, Registration No. 33-64854. Here incorporated by reference. +10.2 +1988 Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed July 21, 1988, Registration No. 33-23196. Here incorporated by reference. +10.3 +Amended and Restated Directors Stock Option Plan.* +10.4 +Employees Pension Plan.* Previously filed as Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1998. Here incorporated by reference. +10.5 +Employment Agreement dated April 27, 1998, between the Company and Geoffrey B. Bloom.* Previously filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here incorporated by reference. +10.6 +1994 Directors' Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed on August 24, 1994, Registration No. 33-55213. Here incorporated by reference. +10.7 +Amended and Restated Stock Option Loan Program.* +10.8 +Executive Severance Agreement.* Previously filed as Exhibit 10.10 to the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1998. Here incorporated by reference. An updated participant schedule is attached as Exhibit 10.8. +10.9 +Amended and Restated Supplemental Executive Retirement Plan.* A participant schedule is attached to the Plan. +10.10 +1995 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed October 26, 1995, Registration No. 33-63689. Here incorporated by reference. +10.11 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. +10.12 +Benefit Trust Agreement dated May 19, 1987, and Amendments Number 1, 2, 3 and 4 +27 +thereto.* +10.13 +Outside Directors' Deferred Compensation Plan.* Previously filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 15, 1996. Here incorporated by reference. +10.14 +1984 Executive Incentive Stock Purchase Plan, and amendment.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed August 6, 1984, Registration No. 2-92600. Here incorporated by reference. +10.15 +1997 Stock Incentive Plan.* Previously filed as Appendix A to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 16, 1997. Here incorporated by reference. +10.16 +Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 16, 1997. Here incorporated by reference. +10.17 +Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Appendix C to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 16, 1997. Here incorporated by reference. +10.18 +Stock Incentive Plan of 1999.* Previously filed as Appendix A to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 23, 1999. Here incorporated by reference. +10.19 +Stock Incentive Plan of 2001.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 26, 2001. Here incorporated by reference. +21 +Subsidiaries of Registrant. +23 +Consent of Independent Auditors. +24 +Powers of Attorney. +____________________________ +*Management contract or compensatory plan or arrangement. +28 +The Company will furnish a copy of any exhibit listed above to any stockholder without charge upon written request to Mr. Blake W. Krueger, Executive Vice President, General Counsel and Secretary, 9341 Courtland +Drive, Rockford, Michigan 49351. +Item 14(b). Reports on Form 8-K . +A report on Form 8-K was filed in the fourth quarter of the fiscal year ended December 30, 2000. +Date Filed +Items Reported +Financial Statements +October 4, 2000 +Item 5 +None +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, +thereunto duly authorized. +WOLVERINE WORLD WIDE, INC. +Dated March 30, 2001 +By: +/s/Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, +Chief Financial Officer and Treasurer +(Principal Financial and Accounting Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and +on the dates indicated. +Signature +Title +Date +*/s/Geoffrey B. Bloom +Geoffrey B. Bloom +Chairman of the Board +of Directors +March 30, 2001 +*/s/Timothy J. O'Donovan +Timothy J. O'Donovan +Chief Executive Officer, +President and Director +March 30, 2001 +/s/Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, Chief +Financial Officer and Treasurer +(Principal Financial and Accounting +Officer) +March 30, 2001 +29 +*/s/Daniel T. Carroll +Daniel T. Carroll +Director +March 30, 2001 +*/s/Donald V. Fites +Donald V. Fites +Director +March 30, 2001 +*/s/Alberto L. Grimoldi +Alberto L. Grimoldi +Director +March 30, 2001 +*/s/David T. Kollat +David T. Kollat +Director +March 30, 2001 +*/s/Phillip D. Matthews +Phillip D. Matthews +Director +March 30, 2001 +*/s/David P. Mehney +David P. Mehney +Director +March 30, 2001 +*/s/Joseph A. Parini +Joseph A. Parini +Director +March 30, 2001 +*/s/Joan Parker +Joan Parker +Director +March 30, 2001 +*/s/Elizabeth A. Sanders +Elizabeth A. Sanders +Director +March 30, 2001 +*/s/Paul D. Schrage +Paul D. Schrage +Director +March 30, 2001 +*by/s/Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Attorney-in-Fact +30 +APPENDIX A +Wolverine World Wide, Inc. +Consolidated Balance Sheets +As of Fiscal Year End +2000 +1999 +Assets +( Thousands of Dollars) +Current assets: +Cash and cash equivalents +$ +8,434 +$ +1,446 +Accounts receivable, less allowances (2000 -- $6,147; 1999 -- $7,700) +161,957 +170,732 +Inventories: +Finished products +114,855 +128,458 +Raw materials and work-in-process +29,337 +39,553 +144,192 +168,011 +Refundable income taxes +1,302 +Deferred income taxes +4,032 +3,377 +Other current assets +6,471 +4,433 +Total current assets +325,086 +349,301 +Property, plant and equipment: +Land +1,105 +1,177 +Buildings and improvements +63,286 +64,848 +Machinery and equipment +119,828 +117,524 +Software +32,524 +29,217 +216,743 +212,766 +Less accumulated depreciation +114,078 +96,483 +102,665 +116,283 +Other assets: +Goodwill and other intangibles, less accumulated amortization +(2000 -- $4,545; 1999 -- $3,565) +14,328 +16,178 +Cash value of life insurance +18,307 +16,443 +Prepaid pension costs +20,376 +19,099 +Assets held for exchange +6,881 +7,706 +Notes receivable +3,580 +4,736 +Other +3,345 +4,649 +66,817 +68,811 +Total assets +$ +494,568 +$ +534,395 +Liabilities and Stockholders' Equity +Current liabilities: +Notes payable +$ +896 +$ +148 +Accounts payable +20,907 +20,252 +Salaries, wages and other compensation +8,444 +7,992 +Income taxes +1,508 +Taxes, other than income taxes +3,281 +2,368 +Other accrued expenses +14,652 +13,409 +Current maturities of long-term debt +4,316 +4,370 +Total current liabilities +54,004 +48,539 +Long-term debt, less current maturities +87,878 +134,831 +Deferred compensation +6,017 +6,076 +Deferred income taxes +9,431 +12,844 +Stockholders' equity: +Common stock, $1 par value: authorized 80,000,000 shares; +issued, including treasury shares: 2000 -- 44,785,009 shares; +1999 -- 44,426,322 shares +44,785 +44,426 +Additional paid-in capital +79,633 +76,752 +Retained earnings +260,158 +255,265 +Accumulated other comprehensive loss +(2,532 +) +(614 +) +Unearned compensation +(5,921 +) +(5,974 +) +Cost of shares in treasury: 2000 -- 3,232,172 shares; 1999 -- 3,125,952 shares +(38,885 +) +(37,750 +) +Total stockholders' equity +337,238 +332,105 +Total liabilities and stockholders' equity +$ +494,568 +$ +534,395 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +1 +Wolverine World Wide, Inc. +Consolidated Statements of Stockholders' Equity and Comprehensive Income +Fiscal Year +2000 +1999 +1998 +(Thousands of Dollars) +Common Stock +Balance at beginning of the year +$ +44,426 +$ +43,832 +$ +43,311 +Common stock issued under stock incentive +plans (2000 -- 358,687 shares; +1999 -- 594,252 shares; 1998 -- 521,352 shares) +359 +594 +521 +Balance at end of the year +44,785 +44,426 +43,832 +Additional Paid-In Capital +Balance at beginning of the year +76,752 +72,825 +64,912 +Proceeds over par value and income tax benefits +associated with common stock issued under +stock incentive plans +2,881 +3,927 +7,913 +Balance at end of the year +79,633 +76,752 +72,825 +Retained Earnings +Balance at beginning of the year +255,265 +227,829 +190,799 +Net earnings +10,690 +32,380 +41,651 +Cash dividends (2000 -- $.14 per share; +1999 -- $.12 per share; 1998 -- $.11 per share) +(5,797 +) +(4,944 +) +(4,621 +) +Balance at end of the year +260,158 +255,265 +227,829 +Accumulated Other Comprehensive Income (Loss) +Balance at beginning of the year +(614 +) +(1,014 +) +(68 +) +Foreign currency translation adjustments +(1,918 +) +400 +(946 +) +Balance at end of the year +(2,532 +) +(614 +) +(1,014 +) +Unearned Compensation +Balance at beginning of the year +(5,974 +) +(5,999 +) +(4,285 +) +Awards under stock incentive plans +(3,027 +) +(3,094 +) +(4,383 +) +Compensation expense +3,080 +3,119 +2,669 +Balance at end of the year +(5,921 +) +(5,974 +) +(5,999 +) +Cost of Shares in Treasury +Balance at beginning of the year +(37,750 +) +(37,153 +) +(12,239 +) +Common stock purchased for treasury +(2000 -- 106,220 shares; 1999 -- 58,775 shares; +1998 -- 2,309,064 shares) +(1,135 +) +(597 +) +(24,914 +) +Balance at end of the year +(38,885 +) +(37,750 +) +(37,153 +) +Total stockholders' equity at end of the year +$ +337,238 +$ +332,105 +$ +300,320 +Comprehensive Income +Net earnings +$ +10,690 +$ +32,380 +$ +41,651 +Foreign currency translation adjustments +(1,918 +) +400 +(946 +) +Total comprehensive income +$ +8,772 +$ +32,780 +$ +40,705 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +2 +Wolverine World Wide, Inc. +Consolidated Statements of Operations +Fiscal Year +2000 +1999 +1998 +(Thousands of Dollars, Except Per Share Data) +Net sales and other operating income +$ +701,291 +$ +665,576 +$ +669,329 +Cost and expenses: +Cost of products sold +477,318 +445,232 +443,727 +Selling and administrative expenses +198,953 +159,749 +156,402 +Interest expense +10,281 +11,074 +8,449 +Interest income +(372 +) +(728 +) +(1,170 +) +Other expenses -- net +96 +703 +113 +686,276 +616,030 +607,521 +Earnings before income taxes +15,015 +49,546 +61,808 +Income taxes +4,325 +17,166 +20,157 +Net earnings +$ +10,690 +$ +32,380 +$ +41,651 +Net earnings per share: +Basic +$ +.26 +$ +.80 +$ +1.00 +Diluted +.26 +.78 +.97 +See accompanying notes to consolidated financial statements. +3 +Wolverine World Wide, Inc. +Consolidated Statements of Cash Flows +Fiscal Year +2000 +1999 +1998 +( Thousands of Dollars) +Operating Activities +Net earnings +$ +10,690 +$ +32,380 +$ +41,651 +Adjustments necessary to reconcile net earnings +to net cash provided by (used in) operating activities: +Nonrecurring charges +45,050 +14,000 +Depreciation +16,495 +13,763 +11,606 +Amortization +1,200 +1,118 +1,430 +Deferred income taxes (credit) +(4,068 +) +9,597 +547 +Other +(3,483 +) +(292 +) +(5,025 +) +Changes in operating assets and liabilities: +Accounts receivable +2,175 +(20,822 +) +(21,322 +) +Inventories +11,678 +(7,872 +) +(17,043 +) +Other operating assets +3,632 +3,774 +1,657 +Accounts payable +655 +2,388 +(9,384 +) +Other operating liabilities +(13,055 +) +(820 +) +(8,588 +) +Net cash provided by (used in) operating activities +70,969 +47,214 +(4,471 +) +Investing Activities +Additions to property, plant and equipment +(11,978 +) +(19,447 +) +(32,376 +) +Proceeds from the sale of property, plant and equipment +707 +Other +268 +437 +(1,348 +) +Net cash used in investing activities +(11,003 +) +(19,010 +) +(33,724 +) +Financing Activities +Proceeds from short-term borrowings +3,797 +1,080 +12,739 +Payments of short-term debt +(3,049 +) +(7,478 +) +(9,444 +) +Proceeds from long-term borrowings +120,812 +72,622 +180,089 +Payments of long-term debt +(167,819 +) +(95,071 +) +(116,814 +) +Deferred financing and interest costs +(2,456 +) +Cash dividends +(5,797 +) +(4,944 +) +(4,621 +) +Purchase of common stock for treasury +(1,135 +) +(597 +) +(24,914 +) +Proceeds from shares issued under stock incentive plans +213 +1,427 +4,051 +Net cash provided by (used in) financing activities +(52,978 +) +(32,961 +) +38,630 +Increase (decrease) in cash and cash equivalents +6,988 +(4,757 +) +435 +Cash and cash equivalents at beginning of the year +1,446 +6,203 +5,768 +Cash and cash equivalents at end of the year +$ +8,434 +$ +1,446 +$ +6,203 +Other Cash Flow Information +Interest paid +$ +10,182 +$ +11,619 +$ +9,596 +Net income taxes paid (refund) +1,280 +(186 +) +10,751 +( ) Denotes reduction in cash and cash equivalents. +See accompanying notes to consolidated financial statements . +4 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements +1. Summary of Significant Accounting Policies +Principles of Consolidation +The consolidated financial statements include the accounts of Wolverine World Wide, Inc. and its wholly owned subsidiaries (collectively, the Company). Upon consolidation, all intercompany accounts, transactions and profits have been eliminated. +Fiscal Year +The Company's fiscal year is the 52- or 53-week period that ends on the Saturday nearest the end of December. Fiscal years presented herein include the 52-week periods ended December 30, 2000, January 1, 2000 and January 2, 1999. +Use of Estimates +The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. +Actual results could differ from those estimates. +Revenue Recognition +Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped and legal title has passed to the customer. Revenue generated through programs with licensees and distributors involving +products utilizing the Company's trademarks and brand names is recognized based on stated contractual arrangements. +Shipping and Handling Costs +Shipping and handling costs that are charged to and reimbursed by the customer are recognized as revenue, while the related expenses incurred by the Company are recorded as cost of products sold in the consolidated statements of operations. +Cash Equivalents +All short-term investments with a maturity of three months or less when purchased are considered cash equivalents. +Inventories +Inventories are valued at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for all domestic inventories. Foreign and retail inventories are valued using methods approximating cost under the first-in, first-out +(FIFO) method. +Property, Plant and Equipment +Property, plant and equipment are stated on the basis of cost and include expenditures for new facilities, major renewals, betterments and software. Normal repairs and maintenance are expensed as incurred. +Depreciation of plant, equipment and software is computed using the straight-line method. The depreciable lives range from five to forty years for buildings and improvements; from three to ten years for machinery and equipment; and from three to ten +years for software. +5 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +Goodwill and Other Intangibles +Goodwill represents the excess of the purchase price over the fair value of net tangible and identifiable intangible assets of acquired businesses and is amortized using the straight-line method over periods ranging up to fifteen years. Other intangibles +consist primarily of trademarks, brand names and patents that are being amortized using the straight-line method over periods ranging from four to fifteen years. The Company reviews the carrying amounts of goodwill and other intangible assets annually to +determine if they may be impaired. If the carrying amounts of these assets are not recoverable based upon an undiscounted cash flow analysis, they are reduced by the estimated shortfall of cash flows to fair value. +Advertising Costs +Advertising costs are expensed as incurred and totaled $27,514,000 in 2000, $21,889,000 in 1999 and $29,673,000 in 1998. +Income Taxes +The provision for income taxes is based on the earnings reported in the consolidated financial statements. A deferred income tax asset or liability is determined by applying currently enacted tax laws and rates to the cumulative temporary differences +between the carrying values of assets and liabilities for financial statement and income tax purposes. Deferred income tax expense (credit) is measured by the net change in deferred income tax assets and liabilities during the year. +Earnings Per Share +Basic earnings per share is computed based on weighted average shares of common stock outstanding during each year after adjustment for nonvested common stock issued under stock incentive plans. Diluted earnings per share assumes the exercise of dilutive +stock options and the vesting of all common stock. +The following table sets forth the reconciliation of weighted average shares used in the computation of basic and diluted earnings per share: +2000 +1999 +1998 +Weighted average shares outstanding during the year +41,517,846 +41,146,525 +42,218,378 +Adjustment for nonvested common stock +(911,412 +) +(843,849 +) +(697,962 +) +Denominator for basic earnings per share +40,606,434 +40,302,676 +41,520,416 +Effect of dilutive stock options +277,316 +339,909 +733,195 +Adjustment for nonvested common stock +911,412 +843,849 +697,962 +Denominator for diluted earnings per share +41,795,162 +41,486,434 +42,951,573 +Options to purchase 2,313,464 shares of common stock in 2000, 1,651,494 shares in 1999 and 989,662 shares in 1998 have not been included in the denominator for computation of diluted earnings per share because related exercise prices were greater than +the average market price for the period and, therefore, were antidilutive. +Financial Instruments and Risk Management +The Company's financial instruments consist of cash and cash equivalents, accounts and notes receivable, accounts and notes payable and long-term debt. The Company's estimate of the fair value of these +6 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +financial instruments approximates their carrying amounts at December 30, 2000, January 1, 2000 and January 2, 1999. Fair value was determined using discounted cash flow analyses and current interest rates for similar instruments. The Company does not +hold or issue financial instruments for trading purposes. +The Company periodically enters into foreign exchange contracts in anticipation of future changes in foreign exchange rates and to hedge against foreign currency fluctuations on third-party and intercompany transactions. At December 30, 2000, foreign +exchange contracts totaling $6,686,000 were outstanding to purchase various currencies (principally U.S. dollars and euros) with maturities ranging up to 180 days. +The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, which is effective for the Company in 2001. SFAS No. 133 requires +companies to record derivative instruments on the balance sheet at fair value and establishes accounting rules for changes in fair value that result from hedging activities. The Company does not currently engage in significant hedging activities that +require the use of derivative instruments, and as a result, the adoption of SFAS No. 133 will not have a material effect on its consolidated financial position or future results of operations. +The Company does not require collateral or other security on trade accounts receivable. +Comprehensive Income +Comprehensive income represents net earnings and any revenues, expenses, gains and losses that, under accounting principles generally accepted in the United States, are excluded from net earnings and recognized directly as a component of stockholders' +equity. +Reclassifications +Certain amounts previously reported in 1999 and 1998 have been reclassified to conform with the presentation used in 2000. +2. Inventories +Inventories of $110,986,000 at December 30, 2000 and $131,711,000 at January 1, 2000 have been valued using the LIFO method. If the FIFO method had been used, inventories would have been $11,743,000 and $11,219,000 higher than reported at December 30, +2000 and January 1, 2000, respectively. +3. Debt +Notes payable consist of unsecured short-term line-of-credit borrowings of the Company's Canadian subsidiary. The line-of-credit allows for maximum borrowings of $6,670,000 and bears interest of up to 1% over the foreign bank base rate (7.4% and 7.5% +at December 30, 2000 and January 1, 2000, respectively). +The Company also has commercial letter-of-credit facilities that allow for total borrowings up to $66,821,000 at December 30, 2000 ($69,055,000 at January 1, 2000). Amounts committed under these facilities totaled $27,024,000 and $30,446,000 at +December 30, 2000 and January 1, 2000, respectively. +7 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +Long-term debt consists of the following obligations: +2000 +1999 +( Thousands of Dollars) +6.5% senior notes payable +$ +75,000 +$ +75,000 +7.81% senior notes payable to insurance companies +17,143 +21,429 +Revolving credit obligations +42,453 +Other +51 +319 +92,194 +139,201 +Less current maturities +4,316 +4,370 +$ +87,878 +$ +134,831 +The 6.5% senior notes payable require payments of interest only through December 2002, at which time annual principal payments of $10,714,000 become due through the maturity date of December 8, 2008. In connection with the issuance of these senior +notes, the Company entered into an interest rate lock agreement with a bank that was settled in 1998 and resulted in a prepayment of $2,200,000. This prepayment is being amortized over the term of the notes using the effective interest method. +The 7.81% senior notes payable to insurance companies require equal annual principal payments of $4,285,000 through 2003, with the balance due on August 15, 2004. +The Company has domestic and foreign long-term revolving credit agreements that allow for borrowings up to $175,456,000 ($176,449,000 in 1999), of which $10,456,000 pertains to the Company's United Kingdom subsidiary. The agreements require that +interest be paid at variable rates based on both LIBOR and the domestic prime rate. There were no borrowings outstanding under the revolving credit agreements at December 30, 2000, and the weighted average interest rate of outstanding borrowings at +January 1, 2000 was 5.5%. The domestic and foreign revolving credit facilities expire in October 2001. +The long-term loan agreements contain restrictive covenants, which, among other things, require the Company to maintain certain financial ratios and minimum levels of tangible net worth. At December 30, 2000, unrestricted retained earnings were +$72,211,000. The agreements also impose restrictions on securing additional debt, sale and merger transactions and the disposition of significant assets. +Principal maturities of long-term debt during the four years subsequent to 2001 are as follows: 2002--$14,999,000; 2003 -- $14,999,000; 2004 -- $15,002,000; 2005 -- $10,714,000. +Interest costs of $286,000 in 2000, $563,000 in 1999 and $1,145,000 in 1998 were capitalized in connection with various capital improvement and computer hardware and software installation projects. +4. Leases +The Company leases machinery, transportation equipment and certain warehouse and retail store space under operating lease agreements, which expire at various dates through 2012. At December 30, 2000, minimum rental payments due under all noncancelable +leases are as follows: 2001-- $6,656,000; 2002-- $5,233,000; 2003-- $4,404,000; 2004-- $3,541,000; 2005-- $2,926,000; thereafter -- $11,401,000. +Rental expense under all operating leases consisted primarily of minimum rentals and totaled $10,845,000 in 2000, $10,249,000 in 1999 and $9,085,000 in 1998. +8 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +5. Capital Stock +The Company has 2,000,000 authorized shares of $1 par value preferred stock, of which none is issued or outstanding. +The Company has a preferred stock rights plan that is designed to protect stockholder interests in the event the Company is confronted with coercive or unfair takeover tactics. One right is associated with each share of common stock currently +outstanding. The rights trade with the common stock and become exercisable only upon the occurrence of certain triggering events. Each right, when exercisable, will entitle the holder to purchase one one-hundredth of a share of Series B junior +participating preferred stock for $120. The Company has designated 500,000 shares of preferred stock as Series B junior participating preferred stock for possible future issuance under the Company's preferred stock rights plan. Upon issuance for reasons +other than liquidation, each share of Series B junior participating preferred stock will have 100 votes and a preferential quarterly dividend equal to the greater of $21 per share or 100 times the dividend declared on common stock. +In the event the Company is a party to a merger or other business combination, regardless of whether the Company is the surviving corporation, right holders other than the party to the merger will be entitled to receive common stock of the surviving +corporation worth twice the exercise price of the rights. The plan also provides for protection against self-dealing transactions by a 15% stockholder or the activities of an adverse person (as defined). The Company may redeem the rights for $.01 each at +any time prior to a person being designated as an adverse person or fifteen days after a triggering event. Unless redeemed earlier, all rights expire on May 7, 2007. The Board of Directors can elect to exclude certain transactions from triggering the +exercise of preferred stock rights and other actions under the plan. +The Company has stock incentive plans under which options to purchase shares of common stock may be granted to officers, other key employees and nonemployee directors. Options granted are exercisable over ten years and vest over various periods. All +unexercised options are available for future grants upon their cancellation. +9 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +A summary of the transactions under the stock option plans is as follows: +Shares +Under +Options +Weighted- +Average +Option Price +Outstanding at January 3, 1998 +2,181,441 +$13.65 +Granted +1,171,967 +18.88 +Exercised +(328,899 +) +20.65 +Cancelled +(626,058 +) +25.48 +Outstanding at January 2, 1999 +2,398,451 +14.82 +Granted +967,592 +9.94 +Exercised +(264,334 +) +10.33 +Cancelled +(60,708 +) +13.62 +Outstanding at January 1, 2000 +3,041,001 +13.95 +Granted +857,709 +11.05 +Exercised +(78,394 +) +11.80 +Cancelled +(69,651 +) +13.32 +Outstanding at December 30, 2000 +3,750,665 +$13.49 +Shares available for grant under the stock option plans were 825,884 at December 30, 2000 and 1,894,747 at January 1, 2000. +The weighted-average grant-date fair value was $4.84 in 2000, $4.13 in 1999 and $7.37 in 1998 for stock options granted. +The exercise prices of options outstanding at December 30, 2000 range from $1.85 to $30.56. A summary of stock options outstanding at December 30, 2000 by range of option price is as follows: +Weighted-Average +Number of Options +Option Price +Remaining +Outstanding +Exercisable +Outstanding +Exercisable +Contractual Life +Less than $10 +1,189,394 +844,793 +$ +8.59 +$ +8.15 +6.3 years +$10 to $20 +1,942,933 +1,285,602 +12.52 +12.92 +7.7 years +Greater than $20 +618,338 +581,463 +25.72 +25.58 +5.9 years +3,750,665 +2,711,858 +$ +13.49 +$ +14.09 +7.0 years +The number of options exercisable at January 1, 2000 and January 2, 1999 totaled 2,066,411 and 1,614,838, respectively. +The Company has elected to follow Accounting Principles Board (APB) Opinion No. 25 , Accounting for Stock Issued to Employees , and related interpretations in accounting for its stock incentive plans because the alternative fair value accounting +provided for under SFAS No. 123, Accounting for Stock-Based Compensation , requires the use of option valuation models that were not specifically developed for valuing the types of stock incentive plans maintained by the Company. Under APB Opinion No. 25, compensation +10 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +expense is recognized when the market price of the underlying stock award on the date of grant exceeds any related exercise price. +Pro forma information regarding net earnings and earnings per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its stock awards using the fair value method. The fair value of these awards was estimated at +the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: risk-free interest rate of 6.1% (5.3% in 1999 and 5% in 1998); dividend yield of 0.5%; expected market price volatility factor of 0.495 (0.47 +in 1999 and 0.46 in 1998); and an expected option life of four years. +The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options which have no vesting provisions and are fully transferable. In addition, the model requires input of highly subjective assumptions. Because +the Company's stock options have characteristics significantly different from traded options and the input assumptions can materially affect the estimate of fair value, in management's opinion, the Black-Scholes option model does not necessarily provide a +reliable measure of the fair value of the Company's stock options. +For purposes of pro forma disclosures, the estimated fair values of stock options are amortized to expense over the related vesting periods. The Company's pro forma information under SFAS No. 123 is as follows: +2000 +1999 +1998 +( Thousands of Dollars, Except Per Share Data) +Pro forma net earnings +$ +6,459 +$ +28,750 +$ +39,130 +Pro forma net earnings per share: +Basic +$ +.16 +$ +.71 +$ +.94 +Diluted +.16 +.70 +.91 +The Company also has nonvested stock award plans for officers and other key employees. Common stock issued under these plans is subject to certain restrictions, including prohibition against any sale, transfer or other disposition by the officer or +employee (except for certain transfers for estate planning purposes for certain officers), and a requirement to forfeit the award upon termination of employment. These restrictions lapse over a three- to five-year period from the date of the award. Shares +aggregating 286,890 in 2000, 340,665 in 1999 and 195,625 in 1998 were awarded under these plans. The weighted-average award-date fair value was $10.95 in 2000, $10.02 in 1999 and $27.67 in 1998 for the shares awarded. There were no shares cancelled in +2000 and rights were cancelled to 11,956 shares in 1999 and 4,000 shares in 1998. Any future shares awarded reduce the number of shares identified as available for future grants in the stock option table. The market value of the shares awarded is +recognized as unearned compensation in the consolidated statements of stockholders' equity and is amortized to operations over the vesting period. +6. Retirement Plans +The Company has noncontributory, defined benefit pension plans covering a majority of its domestic employees. The Company's principal defined benefit pension plan provides benefits based on the employees' years of service and final average earnings +(as defined), while the other plans provide benefits +11 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +at a fixed rate per year of service. The Company intends to annually contribute amounts deemed necessary to maintain the plans on a sound actuarial basis. +The Company has a Supplemental Executive Retirement Plan for certain current and former employees that entitles them to receive payments from the Company following retirement based on the employees' years of service and final average earnings (as +defined). Under the plan, the employees are eligible for reduced benefits upon early retirement. The Company also has individual deferred compensation agreements with certain former employees that entitle them to receive payments from the Company for a +period of fifteen to eighteen years following retirement. The Company maintains life insurance policies with a cash surrender value of $18,005,000 at December 30, 2000 and $16,100,000 at January 1, 2000 that are intended to fund deferred compensation +benefits under the Supplemental Executive Retirement Plan and deferred compensation agreements. +The Company has a defined contribution money accumulation plan covering substantially all employees that provides for Company contributions based on earnings. This plan is combined with the principal defined benefit pension plan for funding purposes. +Contributions to the money accumulation plan were $1,570,000 in 2000 and $1,500,000 in 1999 and 1998. +The following summarizes the status of and changes in the Company's pension assets and related obligations for its defined benefit pension plans: +September 30 +2000 +1999 +(Thousands of Dollars) +Pension assets at fair value, including underfunded plan amounts of +$491 in 2000 and $6,788 in 1999 +$ +134,815 +$ +120,110 +Projected benefit obligation on services rendered to date for funded +defined benefit plans, including underfunded plan amounts of +$853 in 2000 and $7,114 in 1999 +(94,300 +) +(85,777 +) +Net pension assets of funded defined benefit plans +40,515 +34,333 +Projected benefit obligation on services rendered to date for unfunded +supplemental employee retirement plans +(10,530 +) +(12,713 +) +Net pension assets +29,985 +21,620 +Nonqualified trust assets (cash surrender value of life insurance) recorded +in other assets and intended to satisfy the projected benefit obligation of +supplemental employee retirement plans +6,584 +5,607 +Net pension and nonqualified trust assets +$ +36,569 +$ +27,227 +Components of net pension assets: +Prepaid pension costs +$ +19,454 +$ +18,934 +Unrecognized amounts, net of amortization: +Transition assets +53 +80 +Prior service costs +(5,667 +) +(7,384 +) +Net experience gains +16,145 +9,990 +Net pension assets +29,985 +21,620 +Nonqualified trust assets +6,584 +5,607 +Net pension and nonqualified trust assets +$ +36,569 +$ +27,227 +12 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +September 30 +2000 +1999 +(Thousands of Dollars) +Change in fair value of pension assets: +Fair value of pension assets at beginning of the year +$ +120,110 +$ +107,478 +Actual net investment income +19,255 +17,062 +Company contributions +1,008 +528 +Benefits paid to plan participants +(5,558 +) +(4,958 +) +Fair value of pension assets at end of the year +$ +134,815 +$ +120,110 +Components of prepaid pension costs (liability): +For overfunded plans +$ +29,205 +$ +25,728 +For underfunded plans +(9,751 +) +(6,794 +) +Prepaid pension costs +$ +19,454 +$ +18,934 +Change in projected benefit obligations: +Projected benefit obligations at beginning of the year +$ +98,490 +$ +100,322 +Service cost pertaining to benefits earned during the year +4,459 +4,571 +Interest cost on projected benefit obligations +7,841 +7,186 +Effect of changes in actuarial assumptions +339 +553 +Actuarial gains +(3,275 +) +(9,184 +) +Curtailment gain +(667 +) +Special termination benefits +3,201 +Benefits paid to plan participants +(5,558 +) +(4,958 +) +Projected benefit obligations at end of the year +$ +104,830 +$ +98,490 +The following is a summary of net pension income (expense) recognized by the Company: +2000 +1999 +1998 +(Thousands of Dollars) +Service cost pertaining to benefits earned during the year +$ +(4,459 +) +$ +(4,571 +) +$ +(4,249 +) +Interest cost on projected benefit obligations +(7,841 +) +(7,186 +) +(6,221 +) +Expected return on pension assets +12,526 +11,944 +11,409 +Net amortization +1,544 +3,078 +3,926 +Curtailment gain +667 +Special termination benefits +(3,201 +) +Net pension income (expense) +$ +(764 +) +$ +3,265 +$ +4,865 +In connection with the realignment of its manufacturing operations described in Note 11, certain of the Company's pension plans were amended to provide early retirement benefits. Special termination benefit costs of $3,201,000 and a curtailment gain +of $667,000 were recorded as a result of these changes in scheduled benefits. +The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligations were 8.1% and 4.5%, respectively, in 2000 and 8% and 4.5%, respectively, in 1999. The expected +long-term return on plan assets was 10% in each year. +13 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +Plan assets were invested in listed equity securities (79%), fixed income funds (16%) and short-term and other investments (5%). Equity securities include 788,512 shares of the Company's common stock with a fair value of $7,343,000 at September 30, +2000. Dividends paid on these shares of the Company's common stock were not significant. +7. Income Taxes +The provisions for income taxes consist of the following: +2000 +1999 +1998 +(Thousands of Dollars) +Currently payable: +Federal +$ +7,463 +$ +5,645 +$ +16,248 +State and foreign +930 +1,924 +3,362 +Deferred (credit) +(4,068 +) +9,597 +547 +$ +4,325 +$ +17,166 +$ +20,157 +A reconciliation of the Company's total income tax expense and the amount computed by applying the statutory federal income tax rate of 35% to earnings before income taxes is as follows: +2000 +1999 +1998 +(Thousands of Dollars) +Income taxes at statutory rate +$ +5,255 +$ +17,341 +$ +21,633 +State income taxes, net of federal income tax reduction +(20 +) +667 +899 +Nontaxable earnings of Puerto Rican subsidiary +and foreign affiliates +(1,916 +) +(1,729 +) +(2,211 +) +Foreign earnings taxed at rates differing from U.S. +statutory rate +163 +220 +77 +Other +843 +667 +(241 +) +$ +4,325 +$ +17,166 +$ +20,157 +Significant components of the Company's deferred income tax assets and liabilities as of the end of 2000 and 1999 are as follows: +2000 +1999 +( Thousands of Dollars) +Deferred income tax assets: +Accounts receivable and inventory valuation allowances +$ +991 +$ +1,030 +Deferred compensation accruals +2,590 +1,765 +Other amounts not deductible until paid +5,120 +4,845 +Total deferred income tax assets +8,701 +7,640 +Deferred income tax liabilities: +Tax over book depreciation +(6,867 +) +(9,221 +) +Prepaid pension costs +(6,170 +) +(6,845 +) +Unremitted earnings of Puerto Rican subsidiary +(918 +) +(839 +) +Other +(145 +) +(202 +) +Total deferred income tax liabilities +(14,100 +) +(17,107 +) +Net deferred income tax liabilities +$ +(5,399 +) +$ +(9,467 +) +14 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +The Company has provided for all taxes that would be payable if accumulated earnings of its Puerto Rican subsidiary were distributed. Similar taxes on the unremitted earnings of the Company's foreign affiliates have not been provided as such earnings +are considered permanently invested. The additional taxes that would be payable if unremitted earnings of its foreign affiliates were distributed approximate $9,909,000 at December 30, 2000 and $9,064,000 at January 1, 2000. +8. Litigation and Contingencies +The Company is involved in various environmental claims and other legal actions arising in the normal course of business. The environmental claims include sites where the Environmental Protection Agency has notified the Company that it is a +potentially responsible party with respect to environmental remediation. These remediation claims are subject to ongoing environmental impact studies, assessment of remediation alternatives, allocation of cost between responsible parties and concurrence +by regulatory authorities and have not yet advanced to a stage where the Company's liability is fixed. However, after taking into consideration legal counsel's evaluation of all actions and claims against the Company, management is currently of the +opinion that their outcome will not have a significant effect on the Company's consolidated financial position or future results of operations. +9. Business Segments +The Company has one reportable segment that is engaged in the manufacture and marketing of branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear, to the retail +sector. Revenues of this segment are derived from the sale of branded footwear products to external customers and the Company's retail division as well as royalty income from the licensing of the Company's trademarks and brand names to licensees and +distributors. The business units comprising the branded footwear segment manufacture or source, market and distribute products in a similar manner. Branded footwear is distributed through wholesale channels and under licensing and distributor arrangements. +The other business units in the following tables consist of the Company's retail, apparel and accessory licensing, tannery and pigskin procurement operations. The Company operated 58 domestic retail stores at December 30, 2000 that sell +Company-manufactured and sourced products, as well as footwear manufactured by unaffiliated companies. The other business units distribute products through retail and wholesale channels. +The Company measures segment profits as earnings before income taxes. The accounting policies used to determine profitability and total assets of the branded footwear and other business segments are the same as disclosed in Note 1. +15 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +Business segment information is as follows: +2000 +(Thousands of Dollars) +Branded +Footwear +Other +Businesses +Corporate +Consolidated +Net sales and other operating income +from external customers +$ +622,829 +$ +78,462 +$ +701,291 +Intersegment sales +17,617 +5,503 +23,120 +Interest expense (net) +13,561 +1,296 +$ +(4,948 +) +9,909 +Depreciation expense +7,106 +2,141 +7,248 +16,495 +Nonrecurring charges +45,050 +45,050 +Earnings (loss) before income taxes +9,918 +7,555 +(2,458 +) +15,015 +Assets +346,235 +37,546 +110,787 +494,568 +Additions to property, plant and equipment +3,156 +5,062 +3,760 +11,978 +1999 +Net sales and other operating income +from external customers +$ +590,906 +$ +74,670 +$ +665,576 +Intersegment sales +16,567 +5,563 +22,130 +Interest expense (net) +13,736 +1,539 +$ +(4,929 +) +10,346 +Depreciation expense +7,524 +1,459 +4,780 +13,763 +Nonrecurring charge +14,000 +14,000 +Earnings (loss) before income taxes +39,423 +11,210 +(1,087 +) +49,546 +Assets +391,447 +34,038 +108,910 +534,395 +Additions to property, plant and equipment +4,967 +1,684 +12,796 +19,447 +1998 +Net sales and other operating income +from external customers +$ +596,593 +$ +72,736 +$ +669,329 +Intersegment sales +18,417 +8,323 +26,740 +Interest expense (net) +12,728 +1,558 +$ +(7,007 +) +7,279 +Depreciation expense +6,787 +2,083 +2,736 +11,606 +Earnings (loss) before income taxes +53,086 +8,991 +(269 +) +61,808 +Assets +385,262 +33,178 +103,038 +521,478 +Additions to property, plant and equipment +17,160 +2,179 +13,037 +32,376 +16 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +Geographic information, based on shipping destination, related to net sales and other operating income included in the consolidated statements of operations is as follows: +2000 +1999 +1998 +(Thousands of Dollars) +United States +$ +598,115 +$ +564,374 +$ +568,730 +Foreign countries: +Europe +54,555 +60,274 +60,571 +Canada +30,766 +25,698 +19,384 +Central and South America +7,852 +8,347 +8,211 +Asia +7,274 +5,029 +4,271 +Middle East and Russia +2,729 +1,854 +8,162 +103,176 +101,202 +100,599 +$ +701,291 +$ +665,576 +$ +669,329 +The Company's long-lived assets (primarily intangible assets and property, plant and equipment) summarized between domestic and foreign locations are as follows: +2000 +1999 +1998 +(Thousands of Dollars) +United States +$ +157,291 +$ +165,203 +$ +157,152 +Foreign countries +12,191 +19,891 +23,348 +The Company does not believe that it is dependent upon any single customer, since none accounts for more than 10% of consolidated net sales and other operating income. +No product groups, other than footwear, account for more than 10% of consolidated net sales and other operating income. Revenues derived from the sale and licensing of footwear account for over 90% of net sales and other operating income in 2000, 1999 +and 1998. +Approximately 13.8% of the Company's employees are subject to bargaining unit contracts extending through various dates to 2004. +10. Quarterly Results of Operations (unaudited) +The Company generally reports its quarterly results of operations on the basis of 12-week periods for each of the first three quarters and a 16- or 17-week period for the fourth quarter. +The Company's unaudited quarterly results of operations are as follows: +2000 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Net sales and other operating income +$ +147,370 +$ +140,558 +$ +175,529 +$ +237,834 +Gross margin +48,893 +48,198 +47,033 +79,849 +Net earnings (loss) +4,795 +7,595 +(15,480 +) +13,780 +Net earnings (loss) per share: +Basic +$ +.12 +$ +.19 +$ +(.38 +) +$ +.33 +Diluted +.12 +.18 +(.37 +) +.33 +17 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +1999 +Net sales and other operating income +$ +136,193 +$ +131,444 +$ +170,482 +$ +227,457 +Gross margin +44,849 +39,265 +54,019 +82,211 +Net earnings (loss) +3,603 +(2,712 +) +11,521 +19,968 +Net earnings (loss) per share: +Basic +$ +.09 +$ +(.07 +) +$ +.29 +$ +.49 +Diluted +.09 +(.07 +) +.28 +.48 +As discussed in Note 11, the third and fourth quarters of 2000 were adversely affected by realignment and other nonrecurring charges totaling $0.71 per share. In addition, the second quarter of 1999 includes a charge totaling $0.23 per share related +to the closing of the Company's Russian wholesale footwear business. +Adjustments in the fourth quarter primarily relating to inventories resulted in a decrease in net earnings of $685,000 ($0.02 per share) in 2000 and an increase in net earnings of $2,188,000 ($0.05 per share) in 1999. +11. Nonrecurring Charges +On July 12, 2000, the Company announced a strategic realignment of its global sourcing and manufacturing operations. In connection with this realignment, the Company decided to close five of its manufacturing facilities in New York, Missouri, Canada, +Puerto Rico and Costa Rica, eliminate certain footwear product offerings and related raw material inventories, reduce administrative support services and incur other nonrecurring expenses. Workforce reductions totaling 1,391 employees are expected to +occur in the areas of manufacturing (1,272), general management (28) and administrative support (91). The realignment activities were primarily completed in the third and fourth quarters of 2000 with the balance to be completed in the first half of 2001. +The following table summarizes the sourcing realignment, impairment and other nonrecurring pre-tax charges recorded in the consolidated statement of operations for 2000 (thousands of dollars): +Sourcing realignment charges: +Severance and related costs +$ +11,723 +Inventories +12,141 +Other exit costs +4,263 +28,127 +Impairment charges: +Property, plant and equipment +8,126 +Goodwill +1,077 +9,203 +Other nonrecurring charges +7,720 +$ +45,050 +Severance and related costs associated with the sourcing realignment include involuntary and voluntary employee termination expenses. Inventory charges represent the write-down to net realizable value of raw +18 +Wolverine World Wide, Inc. +Notes to Consolidated Financial Statements (cont.) +materials that will no longer be used in production and certain finished footwear products that will be discontinued as part of the realignment plan. Other exit costs primarily represent expenses required under contractual arrangements that are expected +to be incurred after the manufacturing facilities cease operations through their estimated disposal dates. +Impairment charges consist of write-downs of property, plant and equipment to their fair values less costs to sell, close and reconfigure manufacturing facilities, and the write-off of goodwill previously recorded in connection with the purchase of +the manufacturing assets located in the Company's Costa Rican operation. +Other nonrecurring charges pertain to one-time costs that were expensed as incurred and consist primarily of the write-off of amounts for customer chargebacks and other deductions that the Company previously expected to collect, but will no longer +pursue. +Within the consolidated statements of operations for 2000, cost of products sold, selling and administrative expenses and other expenses include $15,036,000, $29,589,000 and $425,000, respectively, for the sourcing realignment and other nonrecurring +charges. These charges resulted in a $0.71 per share reduction of net earnings. The Company expects no significant additional charges to be incurred to complete the sourcing realignment and other ancillary activities. +The following table summarizes the activity and remaining liabilities associated with the sourcing realignment at December 30, 2000 and for the fiscal year then ended (thousands of dollars): +Severance and +Related Costs +Inventories +Other Exit +Costs +Total +Amounts recognized as charges in the +consolidated statement of operations +$ +11,723 +$ +12,141 +$ +4,263 +$ +28,127 +Disposal of inventories +(11,024 +) +(11,024 +) +Payments +(5,720 +) +(1,871 +) +(7,591 +) +Balance at December 30, 2000 +$ +6,003 +$ +1,117 +$ +2,392 +$ +9,512 +Workforce terminations totaling 1,018 employees occurred in 2000 in the areas of manufacturing (900), general management (28) and administrative support (90). +As a result of the continued significant deterioration in Russian economic and political conditions in early 1999, the Company approved a plan in the second quarter to close its Russian wholesale footwear business. In connection with the closure, the +Company recorded a nonrecurring, pre-tax charge to earnings of $14,000,000, of which $6,900,000 is reflected as a write-down in cost of products sold for inventory, $6,600,000 is recognized in selling and administrative expenses for goodwill impairment, +bad debt, severance, and other exit costs, and $500,000 is recorded in other expenses. The charge resulted in a reduction of net earnings of $0.23 per share. The closure was complete as of the end of 1999. +19 +Report of Independent Auditors +Board of Directors and Stockholders +Wolverine World Wide, Inc. +We have audited the accompanying consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of December 30, 2000 and January 1, 2000, and the related consolidated statements of stockholders' equity and comprehensive income, +operations and cash flows for each of the three fiscal years in the period ended December 30, 2000. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the +responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. +We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of +material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, +as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Wolverine World Wide, Inc. and subsidiaries at December 30, 2000 and January 1, 2000, and the consolidated +results of their operations and their cash flows for each of the three fiscal years in the period ended December 30, 2000, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial +statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +February 7, 2001 +20 +APPENDIX B +Schedule II -- Valuation and Qualifying Accounts of Continuing Operations +Wolverine World Wide, Inc. and Subsidiaries +Column A +Column B +Column C +Column D +Column E +Additions +Description +Balance at +Beginning of +Period +(1) +Charged to +Costs and +Expenses +(2) +Charged to +Other Accounts +(Describe) +Deductions +(Describe) +Balance at +End of +Period +Fiscal year ended December 30, 2000 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +6,977,000 +$ +10,864,000 +$ +12,805,000 +(A) +$ +5,036,000 +Allowance for cash discounts +723,000 +6,711,000 +6,323,000 +(B) +1,111,000 +Inventory valuation allowances +8,351,000 +8,503,000 +10,621,000 +(C) +6,233,000 +$ +16,051,000 +$ +26,078,000 +$ +29,749,000 +$ +12,380,000 +Fiscal year ended January 1, 2000 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +4,729,000 +$ +5,750,000 +$ +3,502,000 +(A) +$ +6,977,000 +Allowance for cash discounts +1,167,000 +6,529,000 +6,973,000 +(B) +723,000 +Inventory valuation allowances +9,257,000 +8,349,000 +9,255,000 +(C) +8,351,000 +$ +15,153,000 +$ +20,628,000 +$ +19,730,000 +$ +16,051,000 +Fiscal year ended January 2, 1999 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +6,038,000 +$ +1,035,000 +$ +2,344,000 +(A) +$ +4,729,000 +Allowance for cash discounts +1,254,000 +5,394,000 +5,481,000 +(B) +1,167,000 +Inventory valuation allowances +8,297,000 +1,572,000 +612,000 +(C) +9,257,000 +$ +15,589,000 +$ +8,001,000 +$ +8,437,000 +$ +15,153,000 +(A) +Accounts charged off, net of recoveries. +(B) +Discounts given to customers. +(C) +Adjustment upon disposal of related inventories. +Commission File No. 1-6024 +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +EXHIBITS +TO +FORM 10-K +For the Fiscal Year Ended +December 30, 2000 +Wolverine World Wide, Inc. +9341 Courtland Drive +Rockford, Michigan 49351 +EXHIBIT INDEX +Exhibit +Number +Document +3.1 +Certificate of Incorporation, as amended. Previously filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 14, 1997. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here incorporated by reference. +4.1 +Certificate of Incorporation, as amended. See Exhibit 3.1 above. +4.2 +Rights Agreement dated as of April 17, 1997. Previously filed with the Company's Form 8-A filed April 12, 1997. Here incorporated by reference. +4.3 +Amendment No. 1 dated as of June 30, 2000, to the Rights Agreement dated as of April 17, 1997. +4.4 +Credit Agreement dated as of October 11, 1996, with NBD Bank as Agent. Previously filed as Exhibit 4.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1996. Here incorporated by reference. +4.5 +Note Purchase Agreement dated as of August 1, 1994, relating to 7.81% Senior Notes. +4.6 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. Previously filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here incorporated by +reference. +4.7 +Amendment No. 1 dated as of January 8, 1998, to the Credit Agreement dated as of October 11, 1996, with NBD Bank as Agent. Previously filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here +incorporated by reference. +4.8 +Amendment No. 2 dated as of March 5, 1999, to the Credit Agreement dated as of October 11, 1996, with NBD Bank as Agent. Previously filed as Exhibit 4.7 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2000. Here +incorporated by reference. +4.9 +The Registrant has several classes of long-term debt instruments outstanding in addition to that described in Exhibits 4.4, 4.5 and 4.6 above. The amount of none of these classes of debt outstanding on March 24, 2001, exceeds 10% of the Company's +total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of +1 +holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +10.1 +1993 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed June 22, 1993, Registration No. 33-64854. Here incorporated by reference. +10.2 +1988 Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed July 21, 1988, Registration No. 33-23196. Here incorporated by reference. +10.3 +Amended and Restated Directors Stock Option Plan.* +10.4 +Employees Pension Plan.* Previously filed as Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1998. Here incorporated by reference. +10.5 +Employment Agreement dated April 27, 1998, between the Company and Geoffrey B. Bloom.* Previously filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here incorporated by reference. +10.6 +1994 Directors' Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed on August 24, 1994, Registration No. 33-55213. Here incorporated by reference. +10.7 +Amended and Restated Stock Option Loan Program.* +10.8 +Executive Severance Agreement.* Previously filed as Exhibit 10.10 to the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1998. Here incorporated by reference. An updated participant schedule is attached as Exhibit 10.8. +10.9 +Amended and Restated Supplemental Executive Retirement Plan.* A participant schedule is attached to the Plan. +10.10 +1995 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed October 26, 1995, Registration No. 33-63689. Here incorporated by reference. +10.11 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. +10.12 +Benefit Trust Agreement dated May 19, 1987, and Amendments Number 1, 2, 3 and 4 thereto.* +10.13 +Outside Directors' Deferred Compensation Plan.* Previously filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 15, 1996. Here incorporated by reference. +10.14 +1984 Executive Incentive Stock Purchase Plan, and amendment.* Previously filed as an +2 +exhibit to the Company's registration statement on Form S-8, filed August 6, 1984, Registration No. 2-92600. Here incorporated by reference. +10.15 +1997 Stock Incentive Plan.* Previously filed as Appendix A to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 16, 1997. Here incorporated by reference. +10.16 +Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 16, 1997. Here incorporated by reference. +10.17 +Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Appendix C to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 16, 1997. Here incorporated by reference. +10.18 +Stock Incentive Plan of 1999.* Previously filed as Appendix A to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 23, 1999. Here incorporated by reference. +10.19 +Stock Incentive Plan of 2001.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 26, 2001. Here incorporated by reference. +21 +Subsidiaries of Registrant. +23 +Consent of Independent Auditors. +24 +Powers of Attorney. +____________________________ +*Management contract or compensatory plan or arrangement. +3 \ No newline at end of file diff --git a/raw/filings/0000110471/2000/0000905729-01-500086/filing_metadata.csv b/raw/filings/0000110471/2000/0000905729-01-500086/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..a4e0678251a760271e8e2fdd19af976f3a49c6c1 --- /dev/null +++ b/raw/filings/0000110471/2000/0000905729-01-500086/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000110471,WWW,WOLVERINE WORLD WIDE INC /DE/,10-K,2001-03-30,2000-12-30,2001-03-30T05:00:00.000Z,0000905729-01-500086,www10k.htm,FORM 10-K,948726,0,0,https://www.sec.gov/Archives/edgar/data/110471/000090572901500086/www10k.htm,https://www.sec.gov/Archives/edgar/data/110471/000090572901500086/,2000,2000,1 diff --git a/raw/filings/0000110471/2000/0000905729-01-500086/item1.txt b/raw/filings/0000110471/2000/0000905729-01-500086/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..fb4cf79fb72495056c191a26d69e491676b78539 --- /dev/null +++ b/raw/filings/0000110471/2000/0000905729-01-500086/item1.txt @@ -0,0 +1,204 @@ +Item 1. Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The +Company, a Delaware corporation, is the successor of a 1969 reorganization of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Consumers around the world purchased more than 36 million pairs of Company branded footwear during fiscal 2000, making the Company a global leader among U.S. shoe companies in the marketing of branded casual, work +and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort. The products are marketed throughout the world under widely recognized brand names, including Bates ®, Caterpillar ®, Coleman ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Stanley® and Wolverine ®. The Company believes that its primary +competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. The Company's footwear products are organized under +three operating divisions: (i) the Wolverine Footwear Group, focusing on work, outdoor and lifestyle boots and shoes, (ii) the Performance Footwear Group, focusing on the Caterpillar ® and Merrell ® product lines of performance and lifestyle footwear and (iii) the Casual Footwear Group, focusing on Hush Puppies ® brand comfortable casual shoes, slippers and moccasins under the Hush +Puppies® brand and other private labels for third party retailers and children's footwear under various Company brands. The Company's Global Operations Group is responsible for manufacturing, sourcing and distribution in support of the various Company brands. +The Company's footwear is distributed domestically through 62 Company-owned retail stores and to accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of these retailers operate +multiple storefront locations. The Company's products are distributed worldwide in over 140 markets through licensees and distributors. +The Company, through its Wolverine Leathers Division, operates a Company-owned tannery and is one of the premier tanners of quality pigskin leather for the shoe and leather goods industries. The pigskin leather +tanned by the Company is used in a significant portion of the footwear manufactured and sold by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of shoes. In addition, Wolverine Procurement, Inc., a +Company-owned subsidiary, both performs skinning operations and purchases raw pigskins which it then cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company, which are attached as Appendix A to this Form 10-K. The Company has one reportable operating segment, Branded +Footwear. The "Branded Footwear" segment is engaged in the manufacture and marketing of branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear. The Company's "Other +Businesses" category consists of the Company's retail stores, apparel and accessory licensing, tannery and pigskin +procurement operations. Financial information regarding the Company's operating segments can be found in Note 9 to the consolidated financial statements of the Company, which are attached as Appendix A to this Form 10-K. +Branded Footwear. +The Company manufactures and markets a broad range of footwear styles including shoes, boots and sandals under many recognizable brand names including Bates ®, Caterpillar ®, Coleman ®, +Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Stanley® and Wolverine ®. The Company, through its wholly owned subsidiary, Wolverine Slipper Group, Inc., also manufactures constructed slippers and +moccasins and markets them under the Hush Puppies ®, Joe Boxer ®, and Turtle Fur ® trademarks and on a private label basis. The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications +at both Company-owned and independent manufacturing facilities. +The Company's three branded footwear operating divisions are described below. +1. The Wolverine Footwear Group . The Wolverine Footwear Group encompasses multiple brands designed with performance and comfort features to serve a variety of work, outdoor +and lifestyle functions. The Wolverine ® brand, which has been in existence for 118 years, is identified with performance and quality and markets work and outdoor footwear in two categories: (i) work and industrial footwear; and (ii) rugged outdoor and sport footwear. The +Wolverine Footwear Group also includes the Bates ® and HyTest ® product lines. These products feature quality materials and components and patented technologies and designs, such as DuraShocks ®, DuraShocks SR ™, Wolverine Fusion ™ and the +new Wolverine Durashocks Motion Control ™ sole, and unique proprietary technologies such as the SEMC ™ non-metallic composite safety toe. The Wolverine Footwear Group also markets Harley-Davidson® footwear. H +arley-Davidson® footwear styles include traditional motorcycle riding designs as well as contemporary fashion, military and western inspired footwear. The Wolverine Footwear Group also markets hiking and outdoor shoes, boots and sandals through the Coleman +® footgear line of products. In addition, the Wolverine Footwear Group markets Stanley® work boots and shoes. +Wolverine ® Work and Industrial Footwear . The Company believes the Wolverine ® brand has built its reputation by offering quality, durable and comfortable work boots and shoes. The +development of DuraShocks ® technology allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The recently developed Wolverine Fusion ™, Wolverine Durashocks Motion Control™ and +SEMC® composite safety toe technologies continue the Company's tradition of comfortable work and industrial footwear. The Wolverine® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female +industrial and farm workers. +Wolverine ® Rugged Outdoor and Sport Footwear . The Wolverine ® rugged outdoor and sport product lines incorporate DuraShocks ®, DuraShocks SR ™, Wolverine Fusion +™ and Wolverine +2 +Durashocks Motion Control ™ technology and other comfort features into products designed for rugged outdoor use. This broad product line targets active lifestyles and includes all-terrain sport boots, walking shoes, trail hikers, rugged +casuals and outdoor sandals. The Company also produces boots that target hunters, fishermen and other active outdoor users. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® and Thinsulate ® brand fabrics and the Company's performance leathers and patented DuraShocks ® technologies. +Bates ® Uniform Footwear . The Company's Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes +DuraShocks ®, DuraShocks SR ™, CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and oxfords including the Bates ® Enforcer Series ® and Special Ops ™ +footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and other governmental organizations to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial +occupations. Bates Uniform Footwear Division products are also distributed through specialty retailers and catalogs. +HyTest ®. The HyTest ® product line consists primarily of high quality work boots and shoes designed to protect male and female industrial workers from foot injuries. HyTest ® footwear +incorporates various safety features into its product lines, including steel toe, composite toe, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology and the proprietary SEMC® composite toe to provide comfort together with safety for working men and women. HyTest ® footwear is +distributed primarily through a network of independently owned Shoemobile ® mobile truck retail outlets providing direct sales to workers at industrial facilities. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson +® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a +network of approximately 650 independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. +Coleman ® Footgear . The Company has been granted the exclusive worldwide rights to manufacture, market, distribute and sell +3 +outdoor footwear under the Coleman ® brand. Coleman ® brand footwear products include lightweight hiking boots, outdoor sport boots, rubber footgear and outdoor sandals, which are sold primarily at value-oriented prices through +specialty retailers and mass merchants. +Stanley ® Footgear . Pursuant to a license arrangement completed in 2000 with The Stanley Works, the Company has an exclusive license to manufacture, market, +distribute and sell footwear under the Stanley® brand. The Stanley® Footgear line provides the Company with an entry into the value-price work footwear market. Stanley® Footgear is currently marketed in Payless ShoeSource, Inc. stores throughout the +United States. +2. The Performance Footwear Group . The Performance Footwear Group began operating as a separate division of the Company in 1999. The +Performance Footwear Group is comprised of two of the Company's performance-lifestyle brands, Caterpillar ® and Merrell ®. +Caterpillar ® Footwear . The Company has been granted the exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ®, CAT & Design ®, +Walking Machines ® and other trademarks. The Company believes the association with Caterpillar ® equipment enhances the reputation of its boots for quality, ruggedness and durability. Caterpillar ® brand footwear products include work boots and +shoes, sport boots, rugged casuals and lifestyle footwear. In addition, the Company also manufactures and markets CAT ® Marine Power footwear, designed for industrial and recreational marine uses. Caterpillar ® brand products target work and industrial users and active lifestyle users. Caterpillar® footwear is marketed in over 130 +countries worldwide. +Merrell ® Footwear . The Merrell ® product line consists primarily of technical hiking, rugged outdoor and outdoor inspired casual footwear designed for backpacking, day hiking and rugged +every day use. The Merrell ® product line also includes the "After-Sport" product line, incorporating Merrell ® Footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers™ and other technical materials to +create footwear with unique styling, performance and comfort features. Merrell ® products are sold primarily through outdoor specialty retailers, department stores and catalogs. +3. The Casual Footwear Group . The Casual Footwear Group consists of the Hush Puppies Company, Wolverine Slipper Group, Inc. and the +Children's Footwear Group. Each of these groups is described below. +The Hush Puppies Company . The Company believes that the 40-year heritage of the Hush Puppies ® brand as a pioneer of comfortable casual shoes positions the brand to capitalize on the global trend +toward +4 +more casual workplace and leisure attire. The diverse product line includes numerous styles for both work and casual wear and utilizes comfort features, such as the Comfort Curve ® sole, Float Fx™ , HPO2 ® cushioning, +patented Bounce ® technology and lightweight Zero-G ™ constructions. Hush Puppies ® shoes are sold to men, women and children in over 90 countries. +Wolverine Slipper Group, Inc. Through its wholly owned subsidiary, Wolverine Slipper Group, Inc., the Company is one of the leading suppliers of constructed slippers in the United States. The styling of +Wolverine Slipper Group's footwear reflects consumer demand for the "rugged indoor" look by using natural leathers such as moosehide, shearling and suede in constructed slipper and indoor and outdoor moccasin designs. Wolverine Slipper Group, Inc., +designs and manufactures constructed slippers, aftersport footwear and moccasins on a private label basis according to customer specifications. Such products are manufactured for leading United States retailers and catalogs, such as Nordstrom, L.L. Bean, +Eddie Bauer and Lands' End. In addition to its traditional line of private label slippers, Wolverine Slipper Group, Inc. also manufactures and markets slipper products under the popular Hush Puppies ®, Turtle Fur ® and Joe Boxer ® brands and has developed a College Clogs™ program for the sale of licensed collegiate slipper products. +The Children's Footwear Group. The Children's Footwear Group consists of the Company's Hush Puppies ® and Caterpillar ® children's footwear business together with the children's footwear +programs under the Coleman ®, Wolverine ®, and Harley-Davidson ® brands. The Company believes the consolidation of these brands into the Children's Footwear Group facilitates the dedicated marketing, sourcing and sales programs that are +necessary to extend the Company's high-profile, global brands into the children's footwear market segment. +Other Businesses. +In addition to the manufacture and marketing of the Company's footwear products that are reported in the Branded Footwear segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine +Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly owned subsidiary Wolverine Procurement, Inc., (iii) operates 62 domestic retail footwear stores, and (iv) licenses the Company's brand names for use +on non-footwear products. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces pigskin leathers primarily for use in the footwear industry. The Wolverine Leathers Division is +the largest domestic tanner of pigskin. Wolverine Leathers ® brand products are manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes these leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof, +stain resistant and washable leathers are featured in many of the Company's domestic footwear lines and many products +5 +offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it then cures and sells to the +Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +3. Retail Stores . The Company operated 62 domestic retail shoe stores as of March 23, 2001, under two formats, consisting of 60 factory outlet stores under the Hush Puppies +and Family name and two mall-based stores called Up Footgear ™. The Company expects the scope of its retail operations to remain relatively consistent in the foreseeable future. Most of the Company's 60 factory outlet stores +carry a large selection of first quality Company branded footwear at discounted retail prices. The Up Footgear ™ stores feature Company brands such as Wolverine ®, Merrell ®, Hush Puppies ®, Caterpillar ® and Harley-Davidson ®. These stores also carry a selection of branded footwear from +other manufacturers. +4. Apparel and Accessory Licensing . The Company's Apparel and Accessory Licensing Division licenses the Company's brands for use on non-footwear products including apparel, +eyewear, watches, socks, handbags and plush toys. Current licensing programs include Hush Puppies ® brand apparel, eyewear and plush toys and watches under the Wolverine ® and Hush Puppies ® brands. +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States market to foster a differentiated and globally consistent image for each of the +Company's core footwear brands. Each footwear brand group has its own marketing personnel who develop the marketing strategy for products within that group. Domestic marketing campaigns target both the Company's retail accounts and consumers, and strive +to increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's footwear. Components +of the brand-specific plans include print, radio and television advertising, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's footwear brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance provided +by the Company to its licensees and distributors are (i) direction concerning the categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation +specifications, blueprints and packaging, (v) sales materials, and (vi) consulting concerning retail store layout and design. The Company believes its footwear brand names provide a competitive advantage. In support of this belief, the Company makes +significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +6 +Domestic Sales and Distribution. +The Company uses a wide variety of distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses three primary distribution strategies. +• +Traditional wholesale distribution is used to service department stores (such as J.C. Penney, Sears and Nordstrom), large footwear chains (such as Famous Footwear), specialty retailers, catalog and independent retailers, and military outlets. A +dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide branded and private label footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchants and government customers. +• +A network of independent Shoemobile ® distribution outlets is primarily used to distribute and sell HyTest ® brand products. The Company also distributes work and occupational footwear under a number of the Company's other brands +through this independent distributor network. +In addition to its wholesale activities, the Company also operates domestic retail shoe stores as described above. The Company is developing various programs both independently and with its retail customers for the +distribution of its products over the Internet and in 2000 opened a direct to customer site at www.upfootgear.com . +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's net sales and other operating income in fiscal 2000. +Footwear sales are seasonal with significant increases in sales experienced during the fall hunting season, Christmas, Easter and back-to-school periods. Due to this seasonal nature of footwear sales, the Company +experiences some fluctuation in its levels of working capital. The Company provides working capital for such fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects the seasonal +sales pattern to continue in future years. +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of sales of branded footwear products generated from the Company's wholly owned operations in Canada and the United Kingdom, and from royalty +income through a network of independent licensees and distributors. The Company's owned operations include Hush Puppies (UK) Ltd., Merrell (Europe) Limited, Hush Puppies Canada Footwear, Ltd., and the Merrell Canada division. The Company's owned +operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of Company footwear bearing the Hush Puppies ®, Wolverine ®, Bates ®, HyTest ®, Merrell ® and other trademarks by +independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the Caterpillar ®, Coleman ® and Harley-Davidson ® trademarks through foreign distributors. License and +7 +distribution arrangements enable the Company to develop international markets without the capital commitment required to maintain inventories or fund localized marketing programs. In fiscal 2000, the Company's wholly owned foreign operations, together +with the Company's foreign licensees and distributors sold an estimated 18 million pairs of footwear, which is similar to the level of international sales in fiscal 1999. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent +with the global brand position. The licensees and distributors then purchase goods from either the Company or authorized third-party manufacturers pursuant to a distribution agreement or manufacture branded products consistent with Company standards +pursuant to a license agreement. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and manufacture of approximately 75% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the +pairs controlled by the Company, approximately 85% are purchased or sourced from third parties, the remainder are produced at Company-owned facilities. Footwear produced by the Company is manufactured at Company-owned facilities in several domestic and +certain affiliated foreign facilities located in Michigan, Arkansas, the Caribbean Basin and Mexico. For some of the Company-produced footwear, the Company has implemented a "twin plant" concept whereby a majority of the labor intensive cutting and +fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Caribbean Basin and Mexico and the technology intensive construction, or "bottoming," is performed at the Company's domestic facilities. +The Company's factories each have the flexibility to produce a variety of footwear, and depart from the industry's historic practice of dedicating a given facility to production of specific footwear products. This +flexibility allows the Company to quickly respond to changes in market preference and demand. The Company produces primarily slippers and work footwear in its domestic and international facilities, allowing the Company to respond to both market and +customer-specific demand. In fiscal 2000, the Company announced its intention to close its facilities in Malone, New York; Kirksville, Missouri; Aguadilla, Puerto Rico; San Jose, Costa Rica; and Ontario, Canada. Consolidating operations into the +remaining facilities allows the Company to take better advantage of sophisticated global sourcing alternatives. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, Central and South America, India and Europe. The Company maintains technical offices in +the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In +addition, the Company has developed its "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws +and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +8 +The Company's domestic manufacturing operations allow the Company to (i) reduce its lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and +(iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (i) benefit from lower labor costs, (ii) source the highest quality raw materials from around the world, and (iii) avoid additional capital +expenditures necessary for factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company maximum flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates through its Wolverine Leathers Division a pigskin tannery, which is one of the premier tanners of quality leather for the footwear industry. The Company and its licensees receive +virtually all of their pigskin requirements from the tannery. The Company believes the tannery provides a strategic advantage for the Company by producing leather using proprietary technology at prices below those available from other sources. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of shearling and +cowhide leather eliminates any reliance by the Company upon a sole supplier. Cowhide leather prices in the global market have increased and may continue to increase in 2001 due primarily to a reduction in supply in key cattlehide producing countries as a +result of disease and other factors. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over +30 years. Alternative sources of pigskin are available, however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, +none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war, political disturbances and similar events, the imposition of +trade barriers, quotas and tariffs and loss of most favored nation trading status. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products +currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could, particularly on a short-term basis, have an adverse impact on the Company's operations. +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear products. The trademarks that are most widely used by the Company include Hush Puppies ®, +Wolverine ®, Bates ®, Wolverine Fusion ™, DuraShocks ®, Hidden Tracks ®, Bounce ®, Comfort Curve ®, HPO2 ®, HyTest ®, Merrell ® and FootRests ®. +The Company has obtained the right to manufacture, market and distribute footwear throughout most countries of the world under the Caterpillar ®, Harley-Davidson ® and Coleman ® trademarks, the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark and the right to +manufacture, market and distribute slippers in the United States and certain other countries under the Turtle Fur ® and Joe Boxer ® trademarks pursuant to license arrangements with the respective trademark owners. With the exception of the Coleman ® license, all of the Company's licenses are long term and extend for three or +more years with renewal options. The Company's arrangement with the Coleman Company, Inc. expires on December 28, 2002, with possible renewal options if certain sales goals are achieved. The licenses are subject to customary approval, performance and +default provisions. Pigskin +9 +leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers ®, Weather Tight ® and All Season Weather Leathers ™. +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of ownership of +its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever possible and to vigorously defend its trademarks against infringement or other threats to the greatest +extent practicable under the laws of the United States and other countries. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent +practicable under applicable laws. +Order Backlog. +At March 24, 2001, the Company had a backlog of footwear orders of approximately $195 million compared with a backlog of approximately $159 million at March 25, 2000. Approximately two-thirds of the backlog increase +is related to orders for products expected to be shipped in the third and fourth quarters of 2001 and can be affected by the timing of customer requests for shipment of the ordered products. While orders in backlog are subject to cancellation by +customers, the Company has not experienced significant cancellation of orders in the past and the Company expects that substantially all of the orders will be shipped in fiscal 2001. The backlog at a particular time is affected by a number of factors, +including seasonality, retail conditions, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual +actual shipments. +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of +which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States. The Company has at least ten major competitors in connection with the sale of its work shoes and +boots, at least eight major competitors in connection with the sale of its sport boots, and at least fifteen major competitors in connection with the sale of its casual and dress shoes. Product performance and quality, including technological +improvements, product identity, competitive pricing, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer +preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing efficiencies, its tannery operations, and the style, comfort and value of its products. Future sales by the Company will be affected +by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and +no one company has a dominant market position. +10 +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to new and improved materials for use in its branded footwear and other +products and in the development and adaptation of new production techniques. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, +such as Bounce ®, DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development +costs do not represent a material portion of operating expenses. +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not +had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company. The Company uses and generates, and in the past has used and generated, certain substances and wastes that are regulated +or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites or other regulatory +issues. +Employees. +As of December 30, 2000, the Company had approximately 4,903 domestic and foreign production, office and sales employees. Approximately 677 employees were covered by five union contracts expiring at various dates +through March 31, 2004. The Company has experienced no work stoppages since 1990. The Company presently considers its employee relations to be good. \ No newline at end of file diff --git a/raw/filings/0000110471/2000/0000905729-01-500086/item13.txt b/raw/filings/0000110471/2000/0000905729-01-500086/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..3ebbabea3f23a68aac625d9a1ccdbfe29ca854f1 --- /dev/null +++ b/raw/filings/0000110471/2000/0000905729-01-500086/item13.txt @@ -0,0 +1,4 @@ +Item 13. Certain Relationships and Related Transactions . +The information regarding certain employee loans following the caption "Executive Compensation," under the subheading "Stock Options," and the information contained under the caption "Wolverine's Board of Directors" +under the subheading "Compensation of Directors" and under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company dated March 16, 2001, are +incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000110471/2000/0000905729-01-500086/item9a.txt b/raw/filings/0000110471/2000/0000905729-01-500086/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000110471/2000/0000905729-01-500086/rpt_disclosure.txt b/raw/filings/0000110471/2000/0000905729-01-500086/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..7e1e1da0a2d895190db9935fda3a62c0202ab086 --- /dev/null +++ b/raw/filings/0000110471/2000/0000905729-01-500086/rpt_disclosure.txt @@ -0,0 +1,61 @@ +Certain Relationships and Related Transactions +During 2000, Wolverine engaged J. Walter Thompson, an +international advertising firm, to perform public relations and +marketing services. Wolverine paid $200,214 in fees and expenses +to J. Walter Thompson. Ms. Joan Parker, a director of +Wolverine, is a Senior Partner with J. Walter Thompson. +Wolverine anticipates continuing its relationship with +J. Walter Thompson during the current year. +Wolverine has entered into agreements with Grimoldi, S.A., an +Argentinean corporation of which Mr. Alberto Grimoldi, a +director of Wolverine, is a large shareholder, granting to +Grimoldi, S.A. the exclusive rights to distribute and sell +footwear products in Argentina under the Hush Puppies®, +Wolverine®, Caterpillar®, Harley-Davidson®, +and Merrell® trademarks. Wolverine and Grimoldi, +S.A. have executed a similar agreement that grants similar +rights with respect to Brazil, which was subsequently assigned +to a wholly-owned subsidiary of Grimoldi, S.A. Under these +agreements, Grimoldi, S.A., or its subsidiary, pays Wolverine +royalties and certain sublicense fees based on sales or +purchases of footwear products in Argentina and Brazil. +Under the agreements described above, Grimoldi, S.A. was +obligated to pay to Wolverine royalties, sublicense fees and +service fees in 2000 totaling $1,144,463. These agreements were +made under terms and conditions customary for other +international licensees and distributors, and all payments due +under these agreements were invoiced or paid in accordance with +Wolverine’s customary terms and practices. +In the ordinary course of their business, Wolverine and its +subsidiaries sell footwear for resale, samples, components of +footwear products (such as leather and shoe soles), advertising +materials and miscellaneous items to licensees, distributors and +customers. In 2000, purchases of such items by Grimoldi, S.A. +totaled $402,157 (including any applicable sublicense fees for +products containing licensed proprietary technology). All of +these purchases were made pursuant to Wolverine’s customary +trade terms and were invoiced or paid in accordance with +Wolverine’s customary payment terms and schedules +applicable to all licensees, distributors and customers. +All of the transactions described above occurred pursuant to +continuing contractual arrangements between Wolverine and +Grimoldi, S.A. Wolverine expects similar transactions to occur +between Grimoldi, S.A. and Wolverine and its subsidiaries during +2001. +Compensation Committee Interlocks and Insider +Participation +Wolverine’s Compensation Committee consists of +Donald V. Fites, Phillip D. Matthews, David P. +Mehney, Elizabeth A. Sanders, and Paul D. Schrage. +While Mr. Matthews was not at any time an employee of +Wolverine or its subsidiaries, he served as Chairman of the +Board of Wolverine from 1993 until 1996. Daniel T. Carroll, +a current director of Wolverine, was Chairman of +Wolverine’s Compensation Committee until April 13, +2000. Mr. Carroll no longer serves on Wolverine’s +Compensation Committee. Mr. Carroll is also Chairman of the +Board of Comshare, Inc. and receives compensation from Comshare +in that capacity. Geoffrey B. Bloom, Wolverine’s +Chairman of the Board and former Chief Executive Officer, is a +director of Comshare and serves as Chairman of Comshare’s +Compensation Committee. \ No newline at end of file diff --git a/raw/filings/0000110471/2002/0000905729-03-000154/filing.txt b/raw/filings/0000110471/2002/0000905729-03-000154/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..b560ff38d0f429d4f7dc2dc1a92b4a36e2419592 --- /dev/null +++ b/raw/filings/0000110471/2002/0000905729-03-000154/filing.txt @@ -0,0 +1,2649 @@ +10-K +1 +www10k_ye2002.htm +Wolverine World Wide, Inc. Form 10-K (Y/E 12/31/02) +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +___________________ +Form 10-K +[X] +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 28, 2002 +[ ] +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: 1-6024 +WOLVERINE WORLD WIDE, INC. +(Exact name of registrant as specified in its charter) +Delaware +(State or other jurisdiction of +incorporation or organization) +38-1185150 +(I.R.S. employer identification no.) +9341 Courtland Drive, Rockford, Michigan +(Address of principal executive offices) +49351 +(Zip code) +Registrant's telephone number, including area code: (616) 866-5500 +Securities registered pursuant to Section 12(b) of the Securities Exchange Act: +Title of each class +Name of each exchange on which registered +Common Stock, $1 Par Value, Non-Cumulative +New York Stock Exchange/Pacific Exchange, Inc. +Securities registered pursuant to Section 12(g) of the Act: None +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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X ] +Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). +Yes +X +No +The aggregate market value of the registrant's voting stock held by non-affiliates of the registrant based on the closing price on the New York Stock Exchange on June 14, 2002, the last business day of the registrant's most recently completed second fiscal quarter: $665,102,583. +Number of shares outstanding of the registrant's Common Stock, $1 par value (excluding shares of treasury stock) as of March 20, 2003: 39,809,925. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the definitive proxy statement for the registrant's annual stockholders' meeting to be held April 24, 2003, are incorporated by reference into Part III of this report. +FORWARD-LOOKING STATEMENTS +This Report on Form 10-K contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the footwear business, worldwide economics and the Company itself. Statements, including without limitation, those related to: future revenue, earnings, margins, growth and cash flows; expected economic returns; projected 2003 operating results and dividend rates; continued supply to the U.S. military and significant customers; future strength of the Company; the establishment or growth of the retail presence for Company brands; the introduction of new lines or categories of products; future growth or success in specific countries, categories or market sectors; continued or expected distribution at specific retailers; liquidity; capital resources and market risk are forward-looking statements. In addition, words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "predicts," "projects," "should," "will," variations of such words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("Risk Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. +Risk Factors include, but are not limited to, uncertainties relating to changes in demand for the Company's products; changes in consumer preferences or spending patterns; the cost and availability of inventories, services, labor and equipment furnished to the Company; the cost and availability of contract manufacturers; the cost and availability of raw materials, including leather; the impact of competition and pricing by the Company's competitors; changes in government and regulatory policies; foreign currency fluctuations; changes in trading policies or import and export regulations; changes in interest rates, tax laws, duties, tariffs, quotas or applicable assessments; technological developments; changes in local, domestic or international economic and market conditions including the severity of the continued weakness in the U.S. economy; the size and growth of footwear markets; changes in the amount or severity of inclement weather; changes due to the growth of Internet commerce; popularity of particular designs and categories of footwear; the ability of the Company to manage and forecast its growth and inventories; the ability to secure and protect trademarks, patents and other intellectual property; integration of operations of newly acquired businesses; changes in business strategy or development plans; the ability to attract and retain qualified personnel; the ability to retain rights to brands licensed by the Company; loss of significant customers; performance of international distributors and licensees; the Company's ability to meet at-once orders; the risk of doing business in developing countries and economically volatile areas; retail buying patterns; consolidation in the retail sector; and the acceptability of U.S. brands in international markets. Additionally, the terrorist attacks on September 11, 2001, the continuing war on terrorism, the ongoing war in Iraq, and subsequent events have created significant global economic and political uncertainties that may have material and adverse effects on consumer demand, foreign sourcing of footwear, shipping and transportation, product imports and exports and the sale of products in the United States and foreign markets. These matters are representative of the Risk Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement. Historical operating results are not necessarily indicative of the results that may be expected in the future. The Risk Factors included here are not exhaustive. Other Risk Factors exist, and new Risk Factors emerge from time-to-time, that may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. Furthermore, the Company undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. +PART I +Item 1. Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The Company, a Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Consumers around the world purchased more than 37 million pairs of Company branded footwear during fiscal 2002, making the Company a global leader among U.S. footwear companies in the marketing of branded casual, work and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort and performance. The products are marketed throughout the world under widely recognized brand names, including Bates ®, CAT ®, Coleman ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Stanley® and Wolverine ®. The Company believes that its primary competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary designs and comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. The Company's footwear products are organized under five operating divisions: (i) the Wolverine Footwear Group, focusing on work, outdoor and lifestyle boots and shoes, (ii) the Merrell Performance Footwear Group, focusing on the Merrell ® product lines of performance and lifestyle footwear, (iii) the CAT Footwear Group, focusing on the CAT ® product lines of work and lifestyle footwear, (iv) the Hush Puppies Company, focusing on Hush Puppies ® brand comfortable casual and dress shoes, and (v) the Wolverine Slipper Group, focusing on moccasins and slippers under the Hush Puppies ® and Karen Neuburger ® brands and other labels for third party retailers. The Company's Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support for the various Company brands. The Company's footwear is distributed domestically through 63 Company-owned retail stores and to numerous accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of the retailers to whom Wolverine distributes operate multiple storefront locations. The Company's products are distributed worldwide in over 130 markets through licensees and distributors. +The Company, through its Wolverine Leathers Division, operates a Company-owned tannery and is one of the premier tanners of quality pigskin leather for the shoe and leather goods industries. Pigskin leather tanned by the Company is used in a significant portion of the footwear marketed by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of shoes. In addition, Wolverine Procurement, Inc., a Company-owned subsidiary, performs skinning operations and purchases raw pigskins which it then cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company, which are attached as Appendix A to this Form 10-K. The Company has one reportable operating segment, Branded Footwear. The Branded Footwear segment is engaged in the manufacture +2 +and marketing of branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear. The Company's Other Businesses category consists of the Company's retail stores, apparel and accessory licensing, tannery and pigskin procurement operations. Financial information regarding the Company's operating segments and financial information about geographic areas is found in Note 9 to the consolidated financial statements of the Company, which are attached as Appendix A to this Form 10-K. +Branded Footwear. +The Company sources and markets a broad range of footwear styles including shoes, boots and sandals under many recognizable brand names including Bates ®, CAT ®, Coleman ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Stanley ® and Wolverine ®. The Company, through its wholly owned subsidiary, Wolverine Slipper Group, Inc., also sources constructed slippers and moccasins and markets them under the Hush Puppies ® and Karen Neuburger ® trademarks and on a private label basis. The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications at both Company-owned and independent manufacturing facilities. +The Company's five branded footwear operating divisions are described below. +1. Wolverine Footwear Group . The Wolverine Footwear Group encompasses footwear under the Wolverine ®, Bates ®, HyTest ®, Harley-Davidson ®, Coleman ® and Stanley ® brands and markets footwear designed with performance and comfort features to serve a variety of work, outdoor and lifestyle functions. +Wolverine ® Work and Industrial Footwear . The Wolverine ® brand has built its reputation by offering high quality work boots and shoes that incorporate innovative technologies to deliver comfort and durability. The Wolverine ® brand, which has been in existence for 120 years, markets work and outdoor footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® technology allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The Wolverine Fusion ®, DuraShocks SR™, SEMC ™ composite safety toe and Wolverine Compressor™ technologies continue the Company's tradition of comfortable work and industrial footwear. The Wolverine® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female industrial and farm workers. The Wolverine ® rugged casual and outdoor sport product lines also incorporate DuraShocks ® technology and other comfort features into products designed for casual and outdoor sport use. The rugged casual line targets active lifestyles and includes walking shoes, rugged casuals and outdoor sandals. The outdoor sport line is designed to meet the demands of hunters, fishermen and other active outdoor sportsmen and women. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® and Thinsulate ® brand fabrics, the Company's performance leathers and patented DuraShocks ® technologies. +3 +Bates ® Uniform Footwear . The Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes DuraShocks ®, DuraShocks SR ™, CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and oxfords including the Bates ®, Enforcer Series ® and Special Ops ™ footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and the militaries of several foreign countries to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial occupations. Bates Uniform Footwear Division products are also distributed through specialty retailers and catalogs. +HyTest ®. The HyTest ® product line consists primarily of high quality work boots and shoes designed to protect male and female industrial workers from foot injuries. HyTest ® footwear incorporates various specialty safety features into its product lines, including steel toe, composite toe, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology and the proprietary SEMC ™ composite toe to provide comfort together with safety for working men and women. HyTest ® footwear is distributed primarily through a network of independently owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company's occupational and work footwear brands to workers at industrial facilities and also through direct sales arrangements with large industrial customers. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson ® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work, military and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a network of independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. +Coleman ® Footgear . The Company has been granted the exclusive rights to manufacture, market, distribute and sell outdoor footwear under the Coleman ® brand in Europe, Asia and the Middle East. Coleman ® brand footwear products include lightweight hiking boots, outdoor sport boots, rubber footgear and outdoor sandals, which are sold primarily at value-oriented prices through specialty retailers and mass merchants. +4 +Stanley ® Footgear . Pursuant to a license arrangement with The Stanley Works, the Company has exclusive rights to manufacture, market, distribute and sell footwear under the Stanley ® brand. The Stanley ® Footgear line is designed primarily for and marketed in the value-priced work footwear market. Stanley ® Footgear is currently sold in Payless ShoeSource, Inc. stores throughout the United States. +2. Merrell Performance Footwear Group . The Merrell Performance Footwear Group was established as a separate division of the Company in October 2002. The Merrell ® product line consists primarily of technical hiking, rugged outdoor and outdoor inspired casual footwear designed for backpacking, day hiking and every day use. The Merrell ® product line also includes the "After-Sport" product line, incorporating Merrell ® footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers™ and other technical materials to create footwear with unique styling, performance and comfort features. Merrell ® products are sold primarily through outdoor specialty retailers, department stores and catalogs. Merrell ® footwear is marketed in over 120 countries worldwide. +3. CAT Footwear Group . The CAT Footwear Group was established as a separate division of the Company in October 2002. Pursuant to a license arrangement with Caterpillar Inc., the Company has exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ®, CAT & Design ®, Walking Machines ® and other trademarks. The Company believes the association with CAT ® equipment enhances the reputation of its boots for quality, ruggedness and durability. CAT ® brand footwear products include work boots and shoes, sport boots, rugged casuals and lifestyle footwear. In addition, the Company also manufactures and markets CAT ® Marine Power footwear, designed for industrial and recreational marine uses. CAT ® footwear products target work and industrial users and active lifestyle users. CAT ® footwear is marketed in over 130 countries worldwide. +4. The Hush Puppies Company . Over its 45-year heritage, the Hush Puppies ® brand has been a pioneer of comfortable casual shoes. The diverse product line includes numerous styles for both dress and casual wear and utilizes comfort features, such as the Comfort Curve ® sole, Float Fx ® , patented Bounce ® technology and lightweight Zero-G ™ constructions. Hush Puppies ® shoes are sold to men, women and children in over 96 countries through department stores, catalogs, and independent retailers. +5. Wolverine Slipper Group, Inc. Through its wholly owned subsidiary, Wolverine Slipper Group, Inc., the Company is one of the leading suppliers of constructed slippers in the United States. The styling of Wolverine Slipper Group's footwear reflects consumer demand for the "rugged indoor" look by using natural leathers such as moosehide, shearling and suede in constructed slipper and indoor and outdoor moccasin designs. The Wolverine Slipper Group designs and manufactures constructed slippers, aftersport footwear, moccasins and children's footwear on a private label basis according to customer specifications. In addition to its traditional line of private label products, the Wolverine Slipper Group also manufactures and markets slipper products under the famous Hush Puppies ® brand and has developed a College Clogs™ program for the sale of licensed collegiate slipper products. In addition, the Wolverine Slipper Group markets Karen Neuburger ® slipper products pursuant to a license arrangement completed in the first quarter of 2002. +5 +Other Businesses. +In addition to the manufacture and marketing of the Company's footwear products that are reported in the Branded Footwear segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly owned subsidiary Wolverine Procurement, Inc., (iii) operates 63 domestic retail footwear stores, and (iv) licenses the Company's brand names for use on non-footwear products. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces pigskin leathers primarily for use in the footwear industry. Wolverine Leathers® brand products are manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes these leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof, stain resistant and washable leathers are featured in many of the Company's domestic footwear lines and many products offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +3. Retail Stores . The Company operates 63 domestic retail shoe stores as of February, 2003, consisting of 61 factory outlet stores under the Hush Puppies and Family name, and two mall-based stores under the Track 'N Trail® name. The Company expects the scope of its retail operations to remain relatively consistent in the foreseeable future. Most of the Company's 61 factory outlet stores carry a large selection of first quality Company branded footwear at discounted retail prices. The Track 'N Trail® stores feature Company brands such as Wolverine® , Merrell® , Hush Puppies® , CAT® and Harley-Davidson® . These stores also carry a selection of branded footwear from other manufacturers. +4. Apparel and Accessory Licensing . The Company's Apparel and Accessory Licensing Division licenses the Company's brands for use on non-footwear products including apparel, eyewear, watches, socks, handbags and plush toys. Current significant licensing programs include Hush Puppies® brand apparel, eyewear, watches and plush toys, and Wolverine® brand apparel, gloves and watches. +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States and international markets to foster a differentiated and consistent image for each of the Company's core footwear brands. Each footwear brand group has its own marketing personnel who develop the marketing strategy for products within that group. Marketing campaigns and strategies vary by brand and may target accounts and/or end users as they strive to increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's footwear. Components of the brand-specific plans vary and may +6 +include print, radio and television advertising, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's footwear brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance that may be provided by the Company to its licensees and distributors are (i) direction on the categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting on retail store layout and design. The Company believes its footwear brand names provide a competitive advantage and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution. +The Company uses a wide variety of distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses three primary distribution strategies. +• +Traditional wholesale distribution is used to service department stores, large footwear chains, specialty retailers, catalogs, independent retailers and uniform outlets. A dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide branded and private label footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchant and government customers. +• +A network of independent Shoemobile ® distribution outlets is used to distribute the Company's work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and enters bids for contracts to supply specific footwear products. +In addition to its wholesale activities, the Company also operates domestic retail shoe stores as described above. The Company is developing various programs both independently and with its retail customers for the distribution of its products over the Internet and operates direct to customer sites at www.upfootgear.com, www.hytest.com, www.wolverinebootsandshoes.com, www.trackandtrail.com, www.hushpuppies.com and www.catfootwear.com. +A broad distribution base insulates the Company from dependence on any one customer . No customer of the Company accounted for more than 10% of the Company's revenue in fiscal 2002. +Footwear sales are seasonal with significant increases in sales experienced during the U.S. fall and spring seasons. Due to this seasonal nature of footwear sales, the Company experiences some fluctuation in its levels of working capital. The Company provides working capital for such fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects the seasonal sales pattern to continue in future years. +7 +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of sales of branded footwear products generated from the Company's owned operations in Canada, the United Kingdom, France, Germany, The Netherlands, Belgium and Luxemburg and from royalty income through a network of independent licensees and distributors. The Company's owned operations include Hush Puppies (UK) Ltd., Merrell Europe B.V., Merrell (Europe) Limited, Hush Puppies Canada Footwear, Ltd., and the Merrell Canada division. In addition, in January 2002, the Company established a new subsidiary to manage the CAT® footwear brand in the European market. This new subsidiary, Wolverine Europe Limited, purchased on-going operations and assets of the European CAT ® footwear business from Overland Group Limited of London, England. The markets served directly by Wolverine Europe Limited include Austria, France, Germany, The Netherlands, the United Kingdom and Switzerland, and it will continue to coordinate and oversee support for other European markets served by independently-owned distributors. The Company's owned operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of Company footwear bearing the Hush Puppies ®, Wolverine ®, Bates ®, HyTest ®, Merrell ® and other trademarks by independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the CAT ®, Coleman ® and Harley-Davidson ® trademarks through foreign distributors. License and distribution arrangements enable the Company to develop sales in international markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. In fiscal 2002, the Company's wholly owned foreign operations, together with the Company's foreign licensees and distributors sold an estimated 17 million pairs of footwear, which is consistent with the level of international sales in fiscal 2001. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent with the global brand position. Independent licensees and distributors purchase goods from either the Company or authorized third-party manufacturers pursuant to distribution agreements or manufacture branded products consistent with Company standards pursuant to license agreements. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and manufacture of approximately 75% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the pairs controlled by the Company, approximately 85% are purchased or sourced from third parties, with the remainder produced at Company-owned facilities. Footwear produced by the Company is manufactured at Company-owned facilities in several domestic and certain affiliated foreign facilities located in Michigan, Arkansas, the Dominican Republic and Mexico. For some of the Company-produced footwear, a "twin plant" concept is utilized whereby a majority of the labor intensive cutting and fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Dominican Republic, Arkansas and Mexico and the technology intensive construction, or "bottoming," is performed at the Company's Michigan facilities. +8 +The Company's factories each have the flexibility to produce a variety of footwear, and depart from the industry's historical practice of dedicating a given facility to production of specific footwear products. This flexibility allows the Company to quickly respond to changes in market preference and demand. The Company primarily produces slippers, work and military footwear in its domestic and Caribbean facilities, allowing the Company to respond to both market and customer-specific demand. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, Central and South America, India and Europe. The Company maintains technical offices in the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In addition, the Company has adopted "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +The Company's domestic manufacturing operations allow the Company to (i) reduce its production lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and (iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (i) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (ii) source the highest quality raw materials from around the world, and (iii) avoid additional capital expenditures necessary for owned factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company maximum flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates a pigskin tannery through its Wolverine Leathers Division, which is one of the premier tanners of quality leather for the footwear industry. The Company and its licensees receive virtually all of their pigskin requirements from the tannery. The Company believes the tannery provides a strategic advantage for the Company by producing leather using proprietary technology at prices below those available from other sources. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of common upper materials and specialty leathers eliminates any reliance by the Company upon a sole supplier. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over 30 years. Alternative sources of pigskin are available; however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas and tariffs, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could have an adverse impact on the Company's operations and financial condition. +9 +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear products. The owned trademarks that are most widely used by the Company include Hush Puppies ®, Wolverine ®, Bates ®, Wolverine Fusion ™, DuraShocks ®, Wolverine Compressor™, Hidden Tracks ®, Bounce ®, Comfort Curve ®, HyTest ®, Merrell ®, Track 'N Trail ® and FootRests ®. The Company has obtained license rights to manufacture, market and distribute footwear throughout most countries of the world under the CAT ® and Harley-Davidson ® trademarks; the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark; the right to manufacture, market and distribute slippers in the United States and certain other countries under the Karen Neuburger® trademark; and the right to manufacture, market and distribute footwear in Europe, Asia and the Middle East under the Coleman ® trademark -- all pursuant to license arrangements with the respective trademark owners. All of the Company's licenses are long term and extend for three or more years with conditional renewal options, with the exception of the Karen Neuburger ® license which expires in 2004. Pigskin leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers ®, Weather Tight ® and All Season Weather Leathers ™. +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of ownership of its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever possible and to vigorously defend its trademarks against infringement or other threats to the greatest extent practicable under the laws of the United States and other countries. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent practicable under applicable laws. +Order Backlog. +At March 22, 2003, the Company had a backlog of footwear orders of approximately $266 million compared with a backlog of approximately $233 million at March 23, 2002. Approximately 60 percent of the backlog is related to orders for products expected to be shipped in the third and fourth quarters of 2003 and the first quarter of 2004 and can be affected by the timing of customer requests for shipment of the ordered products. While orders in backlog are subject to cancellation by customers, the Company has not experienced significant cancellation of orders in the past and the Company expects that substantially all of the orders will be shipped in fiscal 2003. The backlog at a particular time is affected by a number of factors, including seasonality, retail conditions, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments. +10 +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States and Europe. The Company has at least ten major competitors in connection with the sale of its work shoes and boots, at least ten major competitors in connection with the sale of its sport boots, and at least thirty major competitors in connection with the sale of its casual, work and outdoor shoes. Product performance and quality, including technological improvements, product identity, competitive pricing, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing efficiencies, its tannery operations, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and no one company has a dominant market position. +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to new and improved materials for use in its branded footwear and other products and in the development and adaptation of new production techniques. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, such as Bounce ®, DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company uses and generates certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites and other regulatory issues. +Employees. +As of December 28, 2002, the Company had approximately 4,426 domestic and foreign production, office and sales employees. Approximately 767 employees were covered by five union +11 +contracts expiring at various dates through March 31, 2004. The Company has experienced no work stoppages since 1990. The Company presently considers its employee relations to be good. +Available Information. +Information about the Company is available at its website, http://www.wolverineworldwide.com . The Company makes available on or through its website, free of charge, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports (along with certain other Company filings with the Securities and Exchange Commission) as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the Securities and Exchange Commission. These filings are also accessible on the SEC's website at www.sec.gov. +Item 2. Properties . +The Company operates its domestic administration, sales and marketing operations primarily from an owned facility of approximately 225,000 square feet in Rockford, Michigan. The Company's manufacturing operations are primarily conducted at its owned Pigskin Tannery in Rockford, Michigan, and a combination of leased and owned footwear manufacturing facilities in Arkansas; Michigan; Monterey, Mexico; and the Dominican Republic. The Company operates its warehousing operations primarily through owned warehouses in Rockford, Michigan, totaling approximately 475,000 square feet, a leased warehouse in Cedar Springs, Michigan, of approximately 362,000 square feet and a leased warehouse in Howard City, Michigan, of approximately 350,000 square feet. +The Company also leases and owns various other offices and warehouses in the United States to meet its operational requirements. In addition, the Company's subsidiary, Hush Puppies Retail, Inc., operates retail stores through leases with various third-party landlords. International operations are conducted in Canada, England, and Europe through leased warehouses, offices and showrooms. The Company believes that its current facilities are suitable and adequate for its current needs. +Item 3. Legal Proceedings . +The Company is involved in litigation and various legal matters arising in the normal course of business, including certain environmental compliance activities. The Company has considered facts related to legal and regulatory matters and opinions of counsel handling these matters, and does not believe the ultimate resolution of such proceedings will have a material adverse effect on the Company's financial condition or future results of operations. +Item 4. Submission of Matters to a Vote of Security Holders . +No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report. +Supplemental Item. Executive Officers of the Registrant . +The following table lists the names and ages of the Executive Officers of the Company as of December 28, 2002, and the positions presently held with the Company. The information provided below the table lists the business experience of each such Executive Officer during the past five years. All +12 +Executive Officers serve at the pleasure of the Board of Directors of the Company, or if not appointed by the Board of Directors, they serve at the pleasure of management. +Name +Age +Positions held with the Company +Steven M. Duffy +50 +Executive Vice President and President, +Global Operations Group +V. Dean Estes +53 +Vice President and President, +Wolverine Footwear Group +Stephen L. Gulis, Jr. +45 +Executive Vice President, Chief Financial +Officer and Treasurer +Blake W. Krueger +49 +Executive Vice President, General Counsel +and Secretary +Timothy J. O'Donovan +57 +Chief Executive Officer and President +Nicholas P. Ottenwess +40 +Vice President of Finance and Corporate +Controller +Robert J. Sedrowski +53 +Vice President of Human Resources +James D. Zwiers +35 +Associate General Counsel and Assistant +Secretary +Steven M. Duffy has served the Company as Executive Vice President since April 1996 and is President of the Company's Global Operations Group. From 1993 to 1996 he served as Vice President. From 1989 to April 1993 he served in various senior manufacturing positions. +V. Dean Estes has served the Company as Vice President since 1995. Mr. Estes is also President of the Wolverine Footwear Group. Since he joined the Company in 1975, Mr. Estes has served in various positions relating to the sales, marketing and product development functions of the Company's work boot and shoe and related businesses. +Stephen L. Gulis, Jr., has served the Company as Executive Vice President, Chief Financial Officer and Treasurer since April 1996. From 1994 to April 1996 he served as Vice President and Chief Financial Officer. From 1993 to 1994 he served as Vice President of Finance and Corporate Controller and from 1986 to 1993 he was the Vice President of Administration and Controller for the Hush Puppies Company. +Blake W. Krueger has served the Company as Executive Vice President, General Counsel and Secretary since April 1996. From 1993 to April 1996 he served as General Counsel and Secretary. From 1985 to 1996 he was a partner with the law firm of Warner Norcross & Judd LLP. +Timothy J. O'Donovan has served the Company as Chief Executive Officer and President since April 2000. From 1996 to April 2000 he served as Chief Operating Officer and President. From 1982 to April 1996 he served as Executive Vice President. +Nicholas P. Ottenwess has served the Company as Vice President of Finance and Corporate Controller since June 2001. From September 1997 to June 2001 he served as Corporate Controller. From 1993 to September 1997 he served as Vice President of Finance and Administration for The Hush Puppies Company. +13 +Robert J. Sedrowski has served the Company as Vice President of Human Resources since October 1993. From 1990 to 1993 he served as Director of Human Resources. +James D. Zwiers has served the Company as Associate General Counsel and Assistant Secretary since January 1998. From 1995 to 1998 he was an attorney with the law firm of Warner Norcross & Judd LLP. +PART II +Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. +Wolverine World Wide, Inc. common stock is traded on the New York Stock Exchange and the Pacific Exchange under the symbol "WWW." The following table shows the high and low sales prices on the New York Stock Exchange and dividends declared by calendar quarter for 2002 and 2001. The number of stockholders of record on March 3, 2003, was 1,721. +2002 +2001 +High +Low +High +Low +First quarter +$ +18.23 +$ +14.00 +$ +19.56 +$ +12.96 +Second quarter +19.25 +15.80 +18.49 +13.30 +Third quarter +17.72 +12.55 +19.50 +15.00 +Fourth quarter +17.24 +13.42 +16.98 +12.25 +Cash Dividends Declared Per Share: +2002 +2001 +First quarter +$ +.045 +$ +.04 +Second quarter +.045 +.04 +Third quarter +.045 +.04 +Fourth quarter +.045 +.04 +Dividends of $.055 were declared in the first quarter of fiscal 2003. +See Item 12 for information with respect to the Company's equity compensation plans. +14 +Item 6. Selected Financial Data . +Five-Year Operating and Financial Summary (1) +(Thousands of Dollars, Except Per Share Data) +2002 +2001 +2000 +1999 +1998 +Summary of Operations +Revenue +$827,106 +$720,066 +$701,291 +$665,576 +$669,329 +Net earnings +47,912 +45,240 +10,690 +32,380 +41,651 +Per share of common stock: +Net earnings, as reported: (2) +Basic +$1.19 +$1.11 +$.26 +$.80 +$1.00 +Diluted +1.15 +1.07 +.26 +.78 +.97 +Cash dividends declared +.18 +.16 +.14 +.12 +.11 +Financial Position at Year End +Total assets +$531,994 +$543,678 +$494,568 +$534,395 +$521,478 +Long-term debt +72,915 +90,848 +92,194 +139,201 +161,650 +Notes to Five-Year Operating and Financial Summary +1. +This summary should be read in conjunction with the consolidated financial statements and the notes thereto, which are attached as Appendix A to this Form 10-K. In particular, see the discussions of the 2000 realignment charge in Note 11 to the consolidated financial statements, the $14.0 million realignment charge to exit the Company's Russian wholesale footwear operation as discussed in the Company's 1999 Form 10-K filed with the Securities and Exchange Commission and business acquisitions in Note 12. +2. +Basic earnings per share are based on the weighted average number of shares of common stock outstanding during the year after adjustment for nonvested common stock. Diluted earnings per share assume the exercise of dilutive stock options and the vesting of all outstanding common stock. +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. +Operations +Results of Operations--2002 Compared to 2001 +Revenue of $827.1 million in 2002 increased $107.0 million (14.9%) as compared to $720.1 million in 2001, of which 10.0 percent of 2002 revenue was related to the European acquisitions discussed in Note 12 to the consolidated financial statements. On a combined basis, revenue for the Company's branded footwear businesses, consisting of The Hush Puppies Company, Wolverine Slippers, the Wolverine Footwear Group (comprised of the Wolverine®, Hytest®, Stanley®, Bates® and Harley-Davidson® brands), the Merrell Performance Footwear Group and the CAT Footwear Group, increased $101.4 million (15.7%) in 2002 compared to 2001. The Company's other business units, consisting of Hush Puppies Retail, Apparel and Accessory Licensing, Wolverine Leathers and Wolverine Procurement, reported an increase in revenue of $5.6 million (7.5%) in 2002 compared to 2001. +15 +The Hush Puppies Company reported an increase in revenue of $2.2 million (1.7%) in 2002 compared to 2001. The increase was generated primarily from the Hush Puppies U.K. and Hush Puppies Canada wholesale operations as a result of expanded product distribution and heightened consumer demand. Hush Puppies International recorded a double-digit increase in revenue for 2002 as compared to 2001, reflecting strong licensing results in Germany, Mexico and Australia. Hush Puppies U.S. reported a middle single-digit decline in revenue for the full year of 2002 as compared with 2001, as management continued to execute the repositioning of the brand's product line, distribution channels and identity. Management believes these initiatives are taking hold as Hush Puppies U.S. reported a low single-digit increase in revenue for the second half of 2002 as compared to 2001. Wolverine Slippers' 2002 revenue decreased $2.8 million (7.3%) as a result of reduced retailer demand. +The Wolverine Footwear Group's revenue decreased $2.5 million (0.9%) in 2002 compared to 2001. Harley-Davidson Footwear reported double-digit revenue gains due to increased product demand from the Harley-Davidson® specialty retailer network and expanded distribution in the department store channel. Bates® also generated a double-digit increase in revenue as a result of fulfilling contractual orders from the Department of Defense and increased demand in the civilian sector. Wolverine® Boots and Shoes (including Hytest®) experienced a decline in revenue resulting from a planned exit and refocusing of underperforming product lines, a general softness in the industrial work boot market and a shift in product mix toward lower price point products. Stanley® Footgear reported a small reduction in revenue reflecting cautious inventory purchases made by its primary retail customer during the first three quarters of 2002. +Merrell Performance Footwear reported the sixth consecutive year of double-digit revenue growth, reflecting an increase of $45.0 million (33.3%) for 2002 when compared to 2001. The Merrell® U.S. footwear business accounted for approximately 70% of the increase as a result of strong consumer demand and the expansion of product offerings with existing footwear retailers. The Merrell® international businesses accounted for the remaining increase, posting double-digit revenue gains for 2002 as compared to 2001, benefiting from the full year results of the 2001 Merrell Europe acquisition. +The CAT Footwear Group recorded a $61.9 million (130.8%) increase in revenue for 2002 as compared to 2001. The European CAT® footwear business, which was acquired in January 2002, accounted for the increase. The CAT® footwear wholesale business in the U.S. reported a decrease in revenue for 2002 as compared to 2001. However, the CAT® U.S. business experienced a double-digit revenue increase in the second half of 2002 resulting from a new strategic brand plan focused on a younger lifestyle consumer. The CAT® international distribution business reported decreased revenue for 2002 as compared to 2001, reflecting a reduction of pairs sold in Mexico, South America and the Pacific Rim. +The Company's other business units reported a combined $5.6 million (7.5%) increase in revenue in 2002 compared to 2001. Hush Puppies Retail reported a $0.3 million (0.8%) increase in revenue in 2002 compared to 2001. Wolverine Leathers recorded an increase in 2002 revenue of $6.6 million. The increase related to both improved demand for Wolverine Performance Leathers™ from external branded footwear companies and third party contract manufacturers that produce footwear under the Company's branded labels. Wolverine Procurement reported a reduction in revenue of $1.2 million in 2002 compared to 2001. Revenue for Apparel and Accessory Licensing increased $0.2 million (7.9%) for 2002 compared to 2001. +16 +Gross margin as a percentage of revenue was 35.6% and 35.7% in 2002 and 2001, respectively. The margin decline in 2002 was primarily due to liquidating excess inventories as the Company refocused the product lines of its newly acquired European businesses. Excluding the European acquisitions, 2002 gross margins were 36.2% compared to 35.7% for 2001, a 50 basis point improvement, reflecting an improved mix of higher margin lifestyle products and improved margins from the Company's other business units. Gross margin dollars in 2002 increased $16.7 million or 6.5% to $273.7 million compared to $257.0 million in 2001. The gross margin percentage for the branded footwear businesses decreased to 35.2% in 2002 from 35.6% in 2001. The decrease in gross margins for the branded footwear businesses resulted primarily from the actions taken to liquidate excess inventory in the Company's newly acquired European businesses, as noted above. Excluding the European acquisitions, 2002 gross margins for the branded footwear businesses were 35.9% compared to 35.6% for 2001, a 30 basis point improvement, reflecting increased shipments of higher margin lifestyle products under the Merrell® and Harley-Davidson® brands. The gross margin percentage for the other business units increased to 39.2% in 2002 compared to 36.6% in 2001. The improvement in margins was primarily due to increased volume and improved efficiencies from the Wolverine Leathers operations and improvements reported by the Apparel and Accessory Licensing division. +Selling and administrative expenses of $217.2 million for 2002 increased $35.0 million (19.2%) from the 2001 level of $182.2 million and, as a percentage of revenue, increased to 26.3% in 2002 from 25.3% in 2001. The dollar change in selling and administrative expenses includes increases of $19.8 million related to the acquired European entities, $2.8 million related to increased employee benefit costs and $4.0 million in additional pension expense. The remaining $8.4 million relates to variable costs associated with the revenue increase. +Interest expense in 2002 was $6.7 million compared to $7.2 million in 2001. The decrease in interest expense reflects a reduction in senior notes outstanding due to principal payments made during the year and lower average borrowings and interest rates under the Company's revolving credit facility. +The change in other (income) expense primarily relates to the change in realized gains or losses on foreign currency transactions. +The Company's 2002 effective income tax rate of 32.9% compared to 34.0% for 2001. The decrease in the 2002 effective tax rate from 2001 relates to a higher percentage of income being generated in foreign jurisdictions with lower tax rates. +Net earnings of $47.9 million for 2002 compares to $45.2 million for 2001. Diluted earnings per share of $1.15 for 2002 compares to $1.07 for 2001. The non-amortization provisions of Statement of Financial Accounting Standard (SFAS) No. 142 apply to 2002 results and application of the non-amortization provisions to results for 2001 would have resulted in an increase in 2001 net earnings of $731,000 ($0.02 per share). +Results of Operations--2001 Compared to 2000 +Revenue increased 2.7% to $720.1 million in 2001 compared to $701.3 million in 2000. On a combined basis, revenue for the Company's branded footwear businesses, consisting of the Casual Footwear Group (comprised of The Hush Puppies Company, the Children's Footwear Group, and the Wolverine Slipper Group), the Wolverine Footwear Group (comprised of the Wolverine® Boots and +17 +Shoes, HYTEST®, Stanley®, Coleman®, Bates® and Harley-Davidson® brands), and the Performance Footwear Group (comprised of the CAT® and Merrell® brands) increased $22.0 million (3.5%) in 2001 compared to 2000. The Company's other business units, consisting of Wolverine Retail, Apparel and Accessory Licensing, Wolverine Leathers and Wolverine Procurement, reported a $3.2 million (4.1%) decrease in revenue in 2001 compared to 2000. +The Casual Footwear Group reported a decrease in revenue of $12.0 million (6.4%) in 2001 compared to 2000. Revenue for the Hush Puppies Company decreased from 2000 levels as Hush Puppies U.S. experienced soft sales as a result of a weak retail environment. Many retailers remained reluctant to place reorders due to concerns about the economy and rising inventory levels. Hush Puppies Canada recorded a 4.6% increase in revenue due to the successful launch of Steps by Hush Puppies™, a middle market product for men and women. Hush Puppies U.K. experienced a slight decline for the year due to the loss of its largest customer during the second quarter of 2001. This customer transitioned its business to the discount retail market, which is not serviced by the Company. The Children's Footwear Group experienced a decrease in revenue for 2001 as a result of losing several customers that exited the childrens' footwear business. Revenue for the Wolverine Slipper Group was generally consistent with 2000 levels. +The Wolverine Footwear Group's revenue increased $5.5 million (2.0%) in 2001 compared to 2000. Wolverine® Boots and Shoes, Harley-Davidson® and Stanley® footwear provided the increase with expanded distribution networks in 2001. In 2001, Stanley® footgear, a new footwear line for the Company as of the third quarter of 2000, expanded its distribution network to include the Hytest® mobile retail units in addition to its current distribution to Payless ShoeSource, Inc. These increases were partially offset by Bates®, which reported a 3.4% decrease in revenue from 2000, primarily due to the timing of contract awards for the Department of Defense. Also reporting a decrease in revenue was the HYTEST® work boot business. HYTEST® sells primarily to employees of large manufacturing companies that were adversely affected by the weakened economy. +The Performance Footwear Group reported record revenue, reflecting an increase of $28.5 million (18.5%) for 2001 compared to 2000. The Merrell® outdoor footwear business accounted for the increase as a result of strong consumer demand for the brand, new product offerings and expansion of its domestic and international distribution. Partially offsetting the Merrell® increase was a decrease in revenue reported by CAT® footwear due to retail account closings, weak retail performance and a decline in the European business. +The Company's other business units reported a combined $3.2 million (4.1%) decrease in revenue in 2001 compared to 2000. Wolverine Retail reported a $0.8 million (1.9%) increase in revenue in 2001 compared to 2000. Wolverine Procurement's revenue increased $2.4 million in 2001 over 2000 due to an increase in the market price for sow skins. These increases were offset by Wolverine Leathers, which recorded a $5.8 million decrease in revenue primarily as a result of a decline in production of Hush Puppies® and CAT® products worldwide. Revenue for Apparel and Accessory Licensing increased slightly for 2001 compared to 2000. +As discussed in Note 11 to the consolidated financial statements, on July 12, 2000, the Company announced a strategic realignment of its global sourcing and manufacturing operations. In connection with this realignment, the Company closed manufacturing facilities in New York, Missouri, Canada, Puerto Rico and Costa Rica in the second half of 2000. A pre-tax charge to earnings of $45.0 million was recorded in 2000, of which $15.0 million was reflected in cost of products sold for inventory write- +18 +downs, $29.6 million was recognized in selling and administrative expenses for severance, bad debt, loss on disposal of fixed assets and goodwill impairment, and $0.4 million was recorded in other expenses. These charges resulted in a $0.71 per share reduction of net earnings for 2000. The realignment activities were primarily completed in the third and fourth quarters of 2000 and the first half of 2001. Remaining liabilities of $2.8 million associated with the sourcing realignment include pension benefits for certain terminated employees and lease termination costs. +The analysis in this paragraph excludes the realignment charge in 2000. Gross margin as a percentage of revenue was 35.7% and 34.1% in 2001 and 2000, respectively. Gross margin dollars in 2001 increased $18.0 million or 7.5% to $257.0 million compared to $239.0 million in 2000. The gross margin percentage for the branded footwear businesses increased to 35.6% in 2001 from 33.5% in 2000. The increase in gross margins for the branded footwear businesses resulted primarily from initial pricing margin improvements and benefits from the 2000 realignment discussed above. Additionally, increased shipments of higher margin Merrell® and Harley-Davidson® products improved the mix of overall margins. The gross margin percentage for the other business units decreased to 36.6% in 2001 compared to 38.5% in 2000, primarily due to a reduction in process efficiencies resulting from a decline in sales volume at Wolverine Leathers. +The analysis in this paragraph excludes the realignment charge in 2000. Selling and administrative expenses of $182.2 million for 2001 increased $12.8 million (7.6%) from the 2000 level of $169.4 million and, as a percentage of revenue, increased to 25.3% in 2001 from 24.2% in 2000. The change in selling and administrative expenses primarily includes increases of $2.2 million in advertising costs and $10.1 million in selling and administrative costs related to the expansion of the Merrell®, Harley-Davidson® and Stanley® brands. +Interest expense in 2001 was $7.2 million compared to $10.3 million in 2000. The decrease in interest expense reflected lower average borrowings and declining interest rates in 2001 compared to 2000. +The Company's 2001 effective income tax rate of 34.0% compared to 28.8% for 2000. The increase is due to income tax benefits from nontaxable earnings of foreign affiliates representing a smaller percentage of taxable income in 2001. +Net earnings were $45.2 million for 2001 compared to $10.7 million for 2000. Diluted earnings per share were $1.07 for 2001 compared to $0.26 for 2000. Excluding the 2000 realignment charges, net earnings were $40.5 million and diluted earnings per share were $0.97 for 2000. +Liquidity and Capital Resources +Net cash provided by operating activities was $88.3 million in 2002 compared to $53.9 million in 2001. Cash of $20.6 million was generated from working capital in 2002, primarily related to the reduction in inventories, compared to $11.6 million that was used in 2001. Cash at December 28, 2002 was $27.1 million. +Accounts receivable of $156.3 million at December 28, 2002 increased $4.0 million, a 2.6% increase, from the $152.3 million balance at December 29, 2001. The accounts receivable balance at December 28, 2002 included $13.9 million relating to the acquired European businesses. Excluding the acquisitions, accounts receivable decreased by $11.5 million (7.6%) from the balance at December 29, +19 +2001 as a result of a focused asset management program. The number of days sales outstanding at December 28, 2002 was 71 days, compared with 81 days at December 29, 2001. No single customer accounted for more than 5% of the outstanding accounts receivable balance at December 28, 2002. +Inventories of $169.0 million at December 28, 2002 decreased $8.0 million (4.5%) from $177.0 million at December 29, 2001. Excluding the European acquisitions, which added $22.8 million of inventory as of December 28, 2002, total inventories decreased 16.6%. Significant decreases in inventories were experienced in Merrell® U.S., Wolverine® Boots and Shoes and Hush Puppies® U.S. resulting from an asset management program focused on improving inventory turns. Total inventory turns were 2.9 times in 2002, compared with 2.7 times in 2001. As of December 28, 2002, the Company's backlog was 19% higher than the prior year-end's level. +Accounts payable of $29.5 million at December 28, 2002 increased $1.1 million (4.2%) over the $28.4 million balance at December 29, 2001. Other accrued liabilities of $35.6 million at December 28, 2002 reflected a $4.6 million (14.7%) increase from the $31.0 million balance at December 29, 2001. The increases in accounts payable and other accrued liabilities compared to the 2001 level were primarily attributable to the European CAT® footwear business acquired in 2002. +Additions to property, plant and equipment were $13.9 million in 2002 compared to $11.3 million in 2001. The majority of capital expenditures were for information system enhancements, distribution equipment and building improvements. Depreciation and amortization expense of $16.9 million in 2002 compares to $17.6 million in 2001. The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2018. +The Company has a long-term revolving credit agreement that expires in May 2006 and allows for borrowings up to $150.0 million, of which $10.0 million is allocated for the Company's Canadian subsidiary. Of the remaining $140.0 million facility, $35.0 million can be used by the Company's European subsidiaries. The revolving credit facility is used to support working capital requirements. Proceeds from existing credit facilities and anticipated renewals, along with cash flows from operations, are expected to be sufficient to meet capital needs in the forseeable future. Any excess cash flows from operating activities are expected to be used to purchase property, plant and equipment, pay down existing debt, fund growth initiatives, pay dividends and repurchase the Company's common stock. +Long-term debt, including current maturities, of $72.9 million at the end of 2002, decreased $17.9 million from the $90.8 million balance at the end of 2001. The decrease in debt was the result of annual principal payments on senior notes and the reduction of revolving working capital debt. The Company had commercial letter of credit facilities outstanding of $8.4 million and $18.4 million at the end of 2002 and 2001, respectively. The decrease in letters of credit is due to transitioning a majority of footwear suppliers to open account. Total debt to total capital ratio for the Company was 16.5% in 2002 and 19.6% in 2001. +Assets held for exchange in the amount of $4.7 million represent barter credits that were acquired in exchange for inventories in December 1997. Such credits are redeemable through 2005 for a percentage of supplies purchased from certain vendors. The Company evaluates the recoverability of such assets on a quarterly basis and expects to utilize all available credits prior to their expiration. Barter credits of $3.2 million have been utilized through December 28, 2002. +20 +The Company has significant pension benefit costs and credits that are developed from actuarial valuations. Inherent in these valuations are key assumptions, including discount rates and expected returns on plan assets. The Company is required to consider market conditions, including changes in interest rates, in selecting these assumptions. Pre-tax charges resulting from the Company's qualified defined benefit pension plans, excluding the effect of special termination gains and expenses, increased $4.0 million ($0.06 per share) for 2002 when compared to 2001 due to market conditions and declining interest rates that adversely affected asset values of plan investments and the Company's estimated accumulated benefit obligation. As a result of these factors, the Company estimates that pre-tax charges relating to its qualified defined benefit pension plans will increase by an additional $7.1 million (approximately $0.11 per share) in fiscal 2003 as compared to fiscal 2002. Also, based on the decline in the market valuation of the pension assets, the Company recorded an additional minimum pension liability in the 2002 fourth quarter that resulted in a $25.3 million net change to the other comprehensive loss component of stockholders' equity. This adjustment had no impact on the net earnings or cash flows of the Company. +Applying SFAS 87 and SFAS 132, the Company's qualified pension plans were underfunded by $17.6 million in 2002 and overfunded by $9.1 million in 2001. However, under the Employee Retirement Income Security Act of 1974 (ERISA), the Wolverine Employees' Pension Plan (representing 92% of the Company's pension benefit obligation) had no minimum funding requirements. A $2.1 million cash contribution was made in 2002 to provide long-term stability to the plan. No contributions were made in 2001. The Company also maintains three separate defined benefit pension plans for certain bargaining units and hourly employees (representing 8% of the Company's pension benefit obligation) which required funding of $0.4 million in 2002 and $0.5 million in 2001 under ERISA. +Effective October 3, 2000, the Company's Board of Directors approved a common stock repurchase program authorizing the repurchase of up to 2.0 million shares of common stock over 24 months. This program expired on October 3, 2002 with 1,476,300 shares ($22.8 million in market price) repurchased during 2002 and 1,971,800 total cumulative shares ($29.6 million in market price) repurchased under the program. Effective August 19, 2002, the Company's Board of Directors approved an additional common stock repurchase program authorizing the repurchase of an additional 2.0 million shares of common stock over a 24-month period. There were 569,800 shares ($9.0 million in market price) repurchased during fiscal 2002 under the program. The primary purpose of these stock repurchase programs is to increase stockholder value. The Company intends to continue to repurchase shares of its common stock in open market transactions, from time to time, depending upon market conditions and other factors. +The Company declared dividends of $7.2 million in 2002, or $0.18 per share, which reflected a 12.5% increase over the $6.6 million, or $0.16 per share, declared in 2001. On February 18, 2003, the Company declared a quarterly cash dividend of $0.055 per share of common stock, an increase of 22.2% as compared to the same period of 2002. The quarterly dividend is payable on May 1, 2003, to stockholders of record on April 1, 2003. +On January 16, 2002, the Company acquired, through a newly formed subsidiary, Wolverine Europe Limited, certain assets totaling $21.2 million and assumed certain liabilities of $8.5 million of the European CAT® footwear business from Overland Group Limited of London, England. Cash and other consideration paid totalled $27.8 million, resulting in goodwill of $15.1 million after allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. On October 17, 2001, the Company acquired, through a newly formed subsidiary, +21 +Merrell Europe B.V., assets from certain European distributors for cash and other consideration of $2.2 million. These acquisitions are discussed further in Note 12 to the consolidated financial statements. +Critical Accounting Policies +The preparation of the Company's consolidated financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an on-going basis, management evaluates these estimates. Estimates are based on historical experience, when available, and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. +Management believes that an understanding of the following critical accounting policies is important to an overall understanding of the consolidated financial statements. +ACCOUNTS RECEIVABLE +The Company records provisions against gross revenue for estimated stock returns and cash discounts in the period when the related revenue is recorded. These estimates are based on factors that include, but are not limited to, historical stock returns, historical discounts taken, analysis of credit memorandum activity and customer demand. Corporate management evaluates the allowance for uncollectible accounts receivable, discounts and stock returns based on a review of current customer status and historical collection experience. At December 28, 2002 and December 29, 2001, management believes that it has provided sufficient reserves to address future collection uncertainties. +INVENTORY +The Company values its inventory using actual costs on a last-in, first-out (LIFO) basis for the majority of its inventory and a first-in, first-out (FIFO) basis for foreign, retail and certain other domestic inventories, less allowances to reflect the lower of cost or market. The Company reduces the value of its inventories to the lower of cost or market for excess or obsolete inventories based upon assumptions about future demand and market conditions. Inventory quantities are verified at various times throughout the year by performing physical and perpetual inventory cycle count procedures. +22 +INCOME TAXES +The Company operates in multiple tax jurisdictions both inside and outside the United States. Accordingly, management must determine the appropriate allocation of income in accordance with local law for each of these jurisdictions. The Company believes its tax accruals are adequate to cover exposures related to changes in income allocation between tax jurisdictions. The carrying value of the Company's deferred tax assets assumes that the Company will be able to generate sufficient taxable income in future years to utilize these deferred tax assets. If these assumptions change, the Company may be required to record valuation allowances against its gross deferred tax assets in future years. Management evaluates the potential for realizing gross deferred tax assets and assesses the need for valuation allowances on a quarterly basis. The Company did not record a valuation allowance in 2002, 2001 or 2000. +Quantitative and Qualitative Disclosures About Market Risk +As of the beginning of fiscal 2001, the Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS Nos. 137 and 138. These provisions require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings or recognized in accumulated other comprehensive gain (loss) until the hedged item is recognized in earnings. +The Company conducts wholesale operations outside of the United States in Europe and Canada where the functional currencies are primarily the British Pound, Canadian Dollar and euro. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with foreign currency inventory purchases made by non-U.S. wholesale operations in the normal course of business. At December 28, 2002 and December 29, 2001, the Company had outstanding forward currency exchange contracts to purchase $24.0 million and $9.0 million, respectively, of various currencies (principally U. S. dollars) with maturities ranging up to 180 days. +The Company also has production facilities in the Dominican Republic and Mexico where financial statements are prepared in the functional currency of the U.S. dollar; however, operating costs are paid in the local currencies. Revenue from products sold in foreign countries under distribution arrangements are denominated in U.S. dollars. However, royalty revenue generated by the Company from third party foreign licensees are measured in the licensees' local currencies. Accordingly, the Company could be subject to related foreign currency remeasurement gains and losses in 2003 and beyond. +Assets and liabilities outside the United States are primarily located in Canada, the United Kingdom and The Netherlands. The Company's investments in foreign subsidiaries with a functional currency other than the U.S. dollar are generally considered long-term. Accordingly, the Company does not hedge these net investments. For the year ended December 28, 2002, the strengthening of foreign currencies increased the value of these investments in net assets by $6.1 million. This gain resulted in cumulative foreign currency translation adjustments at December 28, 2002 of $3.1 million that are deferred and recorded as a separate component of stockholders' equity. +23 +Because the Company markets, sells and licenses its products throughout the world, it could be significantly affected by weak economic conditions in foreign markets that could reduce demand for its products. +The Company is exposed to changes in interest rates primarily as a result of its long-term debt requirements. The Company's interest rate risk management objectives are to limit the effect of interest rate changes on earnings and cash flows and to effectively manage overall borrowing costs. To achieve its objectives, the Company maintains substantially all fixed-rate debt to take advantage of lower relative interest rates currently available and finances seasonal working capital needs with variable-rate debt. The Company has not historically utilized interest rate swaps or similar hedging arrangements to fix interest rates; however, in 1998 the Company entered into an interest rate lock agreement to fix the interest rate prior to the issuance of 6.5% senior notes in the amount of $75 million. The contract was settled in 1998 and resulted in a prepayment of $2.2 million that is being amortized over the term of the senior notes. The amortization of the prepayment creates an effective interest rate of 6.78% on the senior notes. +The following table lists required principal payments and related interest rates for the Company's short- and long-term debt by fiscal year of maturity. For foreign currency-denominated debt, the information is presented in U.S. dollar equivalents. Variable interest rates are based on the weighted average rates of the portfolio at the respective consolidated balance sheet dates. +2002 +2001 +2003 +2004 +2005 +2006 +2007 +There- +After +Total +Fair +Value +Total +Fair +Value +(Millions of Dollars, except percentages) +Denominated in U.S. Dollars: +Fixed rate +$15.0 +$15.0 +$10.7 +$10.7 +$10.7 +$10.8 +$72.9 +$77.5 +$87.9 +$88.2 +Average interest rate +6.9 +% +6.9 +% +6.5 +% +6.5 +% +6.5 +% +6.5 +% +6.7 +% +-- +6.7 +% +-- +At December 29, 2001, variable rate debt totaling $2.9 million denominated in British Pounds Sterling was outstanding at an average interest rate of 4.8%. The fair value of these borrowings approximated carrying value. +The Company does not enter into contracts for speculative or trading purposes, nor is it a party to any leveraged derivative instruments. The Company's future contractual obligations for agreements with initial terms greater than one year are summarized as follows (millions of dollars): +24 +Payment Period +2003 +2004 +2005 +2006 +2007 +Thereafter +Long-term debt +$15.0 +$15.0 +$10.7 +$10.7 +$10.7 +$10.8 +Operating leases +7.9 +6.7 +5.9 +4.7 +4.1 +19.1 +Should additional funds be required, the Company had $172.9 million of additional borrowing capacity available under all of its existing credit facilities at December 28, 2002. The Company's additional borrowing capacity is summarized as follows (millions of dollars): +Expiration of Availability +Total +Commitments +Available +Less than +1 Year +1 Year or +Greater +Revolving credit +$150.0 +$ -- +$150.0 +Lines of credit +19.6 +19.6 +-- +Standby letters of credit +3.3 +3.3 +-- +Item 7A. Quantitative and Qualitative Disclosures About Market Risk. +The response to this Item is set forth under the caption " Quantitative and Qualitative Disclosures About Market Risk " in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and is incorporated herein by reference. +Item 8. Financial Statements and Supplementary Data . +The response to this Item is set forth in Appendix A of this Annual Report on Form 10-K and is incorporated herein by reference. +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . +None. +25 +PART III +Item 10. Directors and Executive Officers of the Registrant . +The information regarding directors of the Company contained under the caption "Election of Directors" and under the caption "Wolverine's Board of Directors" under the subheadings "Nominees for Terms Expiring in 2006," "Continuing Directors -- Terms Expiring in 2005," and "Continuing Directors -- Terms Expiring in 2004" in the definitive Proxy Statement of the Company dated March 17, 2003, is incorporated herein by reference. In addition to the directors discussed in the definitive Proxy Statement, the Company's Board of Directors currently includes Joan Parker (age 67), whose term expires at this year's annual meeting. Ms. Parker is retiring after 22 years of service as a director. Ms. Parker is President of Parker & Associates, an international public relations firm. She has held that position since April 2002. Prior to this position, Ms. Parker was a Senior Partner with J. Walter Thompson, an international advertising firm, from 1995 to April 2002. +The information regarding directors and Executive Officers of the Company under the caption "Related Matters" under the subheading "Section 16(a) Beneficial Ownership Reporting Compliance" in the definitive Proxy Statement of the Company dated March 17, 2003, is incorporated herein by reference. Additional information regarding Executive Officers is provided in the Supplemental Item following Item 4 of Part I above. +Item 11. Executive Compensation . +The information contained under the caption "Wolverine's Board of Directors" under the subheading "Compensation of Directors," under the caption "Related Matters" under the subheading "Compensation Committee Interlocks and Insider Participation," and under the captions "Executive Compensation" (excluding information under the subheading "Equity Compensation Plan Information") and "Employment Agreements and Termination of Employment and Change in Control Arrangements" in the definitive Proxy Statement of the Company dated March 17, 2003, is incorporated herein by reference. +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters . +The information contained under the caption "Ownership of Wolverine Stock" and under the caption "Executive Compensation" under the subheading "Equity Compensation Plan Information" contained in the definitive Proxy Statement of the Company dated March 17, 2003, is incorporated herein by reference. +Item 13. Certain Relationships and Related Transactions . +The information regarding certain loans following the caption "Executive Compensation," under the subheading "Stock Options," and the information contained under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company dated March 17, 2003, are incorporated herein by reference. +26 +Item 14. Controls and Procedures . +Within 90 days prior to the date of filing this report, an evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on and as of the time of such evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filing with the Securities and Exchange Commission. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to the time of such evaluation. +PART IV +Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K . +Item 15(a)(1). Financial Statements . Attached as Appendix A. +The following consolidated financial statements of Wolverine World Wide, Inc. and subsidiaries are filed as a part of this report: +• +Consolidated Balance Sheets as of December 28, 2002 and December 29, 2001. +• +Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Fiscal Years Ended December 28, 2002, December 29, 2001, and December 30, 2000. +• +Consolidated Statements of Operations for the Fiscal Years Ended December 28, 2002, December 29, 2001, and December 30, 2000. +• +Consolidated Statements of Cash Flows for the Fiscal Years Ended December 28, 2002, December 29, 2001, and December 30, 2000. +• +Notes to Consolidated Financial Statements as of December 28, 2002. +• +Report of Independent Auditors. +Item 15(a)(2). Financial Statement Schedules . Attached as Appendix B. +The following consolidated financial statement schedule of Wolverine World Wide, Inc. and subsidiaries is filed as a part of this report: +• +Schedule II--Valuation and qualifying accounts. +All other schedules (I, III, IV, and V) for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. +27 +Item 15(a)(3). Exhibits . +The following exhibits are filed as part of this report: +Exhibit +Number +Document +3.1 +Certificate of Incorporation, as amended. Previously filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.1 +Certificate of Incorporation, as amended. See Exhibit 3.1 above. +4.2 +Amended and Restated By-laws. See Exhibit 3.2 above. +4.3 +Rights Agreement dated as of April 17, 1997. Previously filed with the Company's Form 8-A filed April 12, 1997. Here incorporated by reference. +4.4 +Amendment No. 1 dated as of June 30, 2000, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.5 +Second Amendment dated as of February 11, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.6 +Third Amendment dated as of December 10, 2002, to the Rights Agreement dated as of April 17, 1997. +4.7 +Note Purchase Agreement dated as of August 1, 1994, relating to 7.81% Senior Notes. Previously filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.8 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. Previously filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here incorporated by reference. +4.9 +The Registrant has several classes of long-term debt instruments outstanding in addition to those described in Exhibits 4.7, 4.8 and 4.10. The authorized amount of none of these classes of debt exceeds 10% of the Company's total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +28 +4.10 +Credit Agreement dated as of May 29, 2001, with Bank One, Michigan, as agent. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 16, 2001. Here incorporated by reference. +4.11 +First Amendment dated as of February 8, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.12 +Second Amendment dated as of August 30, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.13 +Third Amendment dated as of December 19, 2002, to the Credit Agreement dated as of May 29, 2001. +10.1 +1988 Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed July 21, 1988, Registration No. 33-23196. Here incorporated by reference. +10.2 +1993 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed June 22, 1993, Registration No. 33-64854. Here incorporated by reference. +10.3 +1995 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed October 26, 1995, Registration No. 33-63689. Here incorporated by reference. +10.4 +1997 Stock Incentive Plan.* Previously filed as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2001. Here incorporated by reference. +10.5 +Stock Incentive Plan of 1999.* Previously filed as Appendix A to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 23, 1999. Here incorporated by reference. +10.6 +Stock Incentive Plan of 2001.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 26, 2001. Here incorporated by reference. +10.7 +Amended and Restated Directors Stock Option Plan.* Previously filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.8 +Amended and Restated Directors' Stock Option Plan.* Previously filed as Appendix D to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +29 +10.9 +Amended and Restated Outside Directors' Deferred Compensation Plan.* Previously filed as Appendix E to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.10 +Supplemental Director's Fee Arrangement dated April 27, 1993, between the Company and Phillip D. Matthews.* (Reflects the grant of a currently oustanding stock option to Mr. Matthews. This agreement is otherwise no longer in effect.) +10.11 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.12 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Appendix C to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.13 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +10.14 +Executive Severance Agreement.* Previously filed as Exhibit 10.10 to the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1998. Here incorporated by reference. An updated participant schedule is attached as Exhibit 10.14. +10.15 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. Previously filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.16 +Benefit Trust Agreement dated May 19, 1987, and Amendments Number 1, 2, 3 and 4 thereto.* Previously filed as Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.17 +Amended and Restated Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. An updated participant schedule is attached as Exhibit 10.17. +10.18 +Employees' Pension Plan (Restated as Amended through December 13, 2001).* Previously filed as Exhibit 10.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2001. Here incorporated by reference. +10.19 +Fiftieth Amendment dated as of July 9, 2002, to the Employees' Pension Plan. +30 +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +99.1 +Certification pursuant to 18 U.S.C. § 1350. This exhibit is furnished, not filed, in accordance with SEC Release Number 33-8212. +____________________________ +*Management contract or compensatory plan or arrangement. +The Company will furnish a copy of any exhibit listed above to any stockholder without charge upon written request to Mr. Blake W. Krueger, Executive Vice President, General Counsel and Secretary, 9341 Courtland Drive, Rockford, Michigan 49351. +Item 15(b). Reports on Form 8-K . +No reports on Form 8-K were filed in the fourth quarter of the fiscal year ended December 28, 2002. +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +WOLVERINE WORLD WIDE, INC. +Dated March 27, 2003 +By: +/s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, +Chief Financial Officer and Treasurer +(Principal Financial Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. +Signature +Title +Date +*/s/ Geoffrey B. Bloom +Chairman of the Board +of Directors +March 27, 2003 +Geoffrey B. Bloom +31 +/s/ Timothy J. O'Donovan +Chief Executive Officer, +President (Principal Executive Officer) +and Director +March 27, 2003 +Timothy J. O'Donovan +/s/ Stephen L. Gulis, Jr. +Executive Vice President, Chief +Financial Officer and Treasurer +(Principal Financial Officer) +March 27, 2003 +Stephen L. Gulis, Jr. +/s/ Nicholas P. Ottenwess +Vice President of Finance and +Corporate Controller (Principal +Accounting Officer) +March 27, 2003 +Nicholas P. Ottenwess +*/s/ Donald V. Fites +Director +March 27, 2003 +Donald V. Fites +*/s/ Alberto L. Grimoldi +Director +March 27, 2003 +Alberto L. Grimoldi +*/s/ David T. Kollat +Director +March 27, 2003 +David T. Kollat +*/s/ Phillip D. Matthews +Director +March 27, 2003 +Phillip D. Matthews +*/s/ David P. Mehney +Director +March 27, 2003 +David P. Mehney +*/s/ Joseph A. Parini +Director +March 27, 2003 +Joseph A. Parini +*/s/ Joan Parker +Director +March 27, 2003 +Joan Parker +*/s/ Elizabeth A. Sanders +Director +March 27, 2003 +Elizabeth A. Sanders +32 +*/s/ Paul D. Schrage +Director +March 27, 2003 +Paul D. Schrage +*by /s/ Stephen L. Gulis, Jr. +Executive Vice President, Chief +Financial Officer and Treasurer +(Principal Financial Officer) +March 27, 2003 +Stephen L. Gulis, Jr. +Attorney-in-Fact +33 +CERTIFICATIONS +I, Timothy J. O'Donovan, certify that: +1. I have reviewed this annual report on Form 10-K of Wolverine World Wide, Inc.; +2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; +3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; +4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: +(a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; +(b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and +(c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; +5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): +(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and +(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and +6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. +34 +Date: March 27, 2003 +/s/ Timothy J. O'Donovan +Timothy J. O'Donovan +President and Chief Executive Officer +Wolverine World Wide, Inc. +I, Stephen L. Gulis, Jr., certify that: +1. I have reviewed this annual report on Form 10-K of Wolverine World Wide, Inc.; +2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; +3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; +4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: +(a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; +(b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and +(c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; +5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): +(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and +35 +(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and +6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. +Date: March 27, 2003 +/s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, Chief Financial +Officer and Treasurer +Wolverine World Wide, Inc. +36 +APPENDIX A +Financial Statements +CONSOLIDATED BALANCE SHEETS +As of Fiscal Year End +2002 +2001 +(Thousands of Dollars) +Assets +Current assets: +Cash and cash equivalents +$ +27,078 +$ +35,820 +Accounts receivable, less allowances (2002--$10,191; 2001--$7,382) +156,285 +152,330 +Inventories: +Finished products +146,229 +151,612 +Raw materials and work-in-process +22,769 +25,429 +168,998 +177,041 +Deferred income taxes +2,992 +2,927 +Other current assets +7,992 +6,684 +Total current assets +363,345 +374,802 +Property, plant and equipment: +Land +1,104 +1,105 +Buildings and improvements +62,982 +63,675 +Machinery and equipment +123,499 +114,018 +Software +38,389 +34,751 +225,974 +213,549 +Less accumulated depreciation +128,700 +114,555 +97,274 +98,994 +Other assets: +Goodwill and other non-amortizable intangibles +30,706 +12,685 +Other amortizable intangibles +3,263 +2,272 +Cash surrender value of life insurance +22,628 +20,246 +Prepaid pension costs +-- +20,436 +Assets held for exchange +4,719 +5,739 +Notes receivable +2,466 +2,366 +Other +7,593 +6,138 +71,375 +69,882 +Total assets +$ +531,994 +$ +543,678 +Liabilities and Stockholders' Equity +Current liabilities: +Notes payable +$ +-- +$ +90 +Accounts payable +29,542 +28,357 +Salaries, wages and other compensation +12,296 +8,758 +Income taxes +3,575 +6,376 +Taxes, other than income taxes +4,322 +2,908 +Other accrued expenses +15,412 +13,002 +Current maturities of long-term debt +15,030 +15,030 +Total current liabilities +80,177 +74,521 +Long-term debt, less current maturities +57,885 +75,818 +Deferred compensation +4,742 +6,283 +Accrued pension liability +19,870 +-- +Deferred income taxes +80 +12,904 +Minority interest +143 +-- +Stockholders' equity: +Common stock, $1 par value: authorized 80,000,000 shares; issued, +including treasury shares: 2002--45,839,831; 2001--45,413,788 +45,840 +45,414 +Additional paid-in capital +90,994 +86,771 +Retained earnings +339,475 +298,755 +Accumulated other comprehensive loss +(23,522 +) +(4,109 +) +Unearned compensation +(3,833 +) +(4,649 +) +Cost of shares in treasury: 2002--5,869,429 shares; 2001--3,857,988 shares +(79,857 +) +(48,030 +) +Total stockholders' equity +369,097 +374,152 +Total liabilities and stockholders' equity +$ +531,994 +$ +543,678 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +1 +CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME +Fiscal Year +2002 +2001 +2000 +(Thousands of Dollars, Except Per Share Data) +Common Stock +Balance at beginning of the year +$ +45,414 +$ +44,785 +$ +44,426 +Common stock issued under stock incentive plans +(2002--426,543 shares; 2001--628,779 shares; +2000--358,687 shares) +426 +629 +359 +Balance at end of the year +45,840 +45,414 +44,785 +Additional Paid-In Capital +Balance at beginning of the year +86,771 +79,633 +76,752 +Amounts associated with common stock issued +under stock incentive plans: +Proceeds over par value +3,547 +5,617 +2,839 +Income tax benefits +531 +1,521 +42 +Issuance of treasury shares (2002--142,894 shares) +409 +-- +-- +Net change in notes receivable +(264 +) +-- +-- +Balance at end of the year +90,994 +86,771 +79,633 +Retained Earnings +Balance at beginning of the year +298,755 +260,158 +255,265 +Net earnings +47,912 +45,240 +10,690 +Cash dividends (2002--$.18 per share; +2001--$.16 per share; 2000--$.14 per share) +(7,192 +) +(6,643 +) +(5,797 +) +Balance at end of the year +339,475 +298,755 +260,158 +Accumulated Other Comprehensive Income (Loss) +Balance at beginning of the year +(4,109 +) +(2,532 +) +(614 +) +Foreign currency translation adjustments +6,101 +(431 +) +(1,918 +) +Change in fair value of foreign exchange contracts, net of +taxes (2002-- $89) +(244 +) +-- +-- +Minimum pension liability adjustment, net of taxes +(2002-- $13,016; 2001--$591) +(25,270 +) +(1,146 +) +-- +Balance at end of the year +(23,522 +) +(4,109 +) +(2,532 +) +Unearned Compensation +Balance at beginning of the year +(4,649 +) +(5,921 +) +(5,974 +) +Awards under restricted stock incentive plans +(2,037 +) +(2,107 +) +(3,027 +) +Compensation expense +2,853 +3,379 +3,080 +Balance at end of the year +(3,833 +) +(4,649 +) +(5,921 +) +Cost of Shares in Treasury +Balance at beginning of the year +(48,030 +) +(38,885 +) +(37,750 +) +Common stock purchased for treasury +(2002--2,154,335 shares; 2001--625,816 shares; +2000--106,220 shares) +(33,626 +) +(9,145 +) +(1,135 +) +Issuance of treasury shares (2002--142,894 shares) +1,799 +-- +-- +Balance at end of the year +(79,857 +) +(48,030 +) +(38,885 +) +Total stockholders' equity at end of the year +$ +369,097 +$ +374,152 +$ +337,238 +Comprehensive Income +Net earnings +$ +47,912 +$ +45,240 +$ +10,690 +Foreign currency translation adjustments +6,101 +(431 +) +(1,918 +) +Change in fair value of foreign exchange contracts, net of taxes +(244 +) +-- +-- +Minimum pension liability adjustment, net of taxes +(25,270 +) +(1,146 +) +-- +Total comprehensive income +$ +28,499 +$ +43,663 +$ +8,772 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +2 +CONSOLIDATED STATEMENTS OF OPERATIONS +Fiscal Year +2002 +2001 +2000 +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +827,106 +$ +720,066 +$ +701,291 +Cost and expenses: +Cost of products sold +532,878 +463,030 +477,318 +Selling and administrative expenses +217,154 +182,178 +198,953 +Interest expense +6,721 +7,239 +10,281 +Interest income +(255 +) +(497 +) +(372 +) +Other (income) expenses -- net +(1,046 +) +(431 +) +96 +755,452 +651,519 +686,276 +Earnings before income taxes and minority interest +71,654 +68,547 +15,015 +Income taxes +23,599 +23,307 +4,325 +Earnings before minority interest +48,055 +45,240 +10,690 +Minority interest +143 +-- +-- +Net earnings +$ +47,912 +$ +45,240 +$ +10,690 +Net earnings per share: +Basic +$ +1.19 +$ +1.11 +$ +.26 +Diluted +1.15 +1.07 +.26 +See accompanying notes to consolidated financial statements. +3 +CONSOLIDATED STATEMENTS OF CASH FLOWS +Fiscal Year +2002 +2001 +2000 +(Thousands of Dollars) +Operating Activities +Net earnings +$ +47,912 +$ +45,240 +$ +10,690 +Adjustments necessary to reconcile net earnings +to net cash provided by operating activities: +Realignment charges +-- +-- +45,050 +Depreciation +16,633 +15,991 +16,495 +Amortization +227 +1,630 +1,200 +Deferred income taxes (credit) +216 +5,169 +(4,068 +) +Other +2,668 +(2,539 +) +(3,483 +) +Changes in operating assets and liabilities: +Accounts receivable +(5,879) +9,178 +2,175 +Inventories +24,884 +(31,655 +) +11,678 +Other operating assets +(1,076) +2,425 +3,632 +Accounts payable +(656) +7,450 +655 +Other operating liabilities +3,350 +1,046 +(13,055 +) +Net cash provided by operating activities +88,279 +53,935 +70,969 +Investing Activities +Business acquisitions, net of cash acquired +(27,366 +) +(1,410 +) +-- +Additions to property, plant and equipment +(13,875 +) +(11,298 +) +(11,978 +) +Proceeds from the sale of property, plant and equipment +241 +46 +707 +Other +366 +189 +268 +Net cash used in investing activities +(40,634 +) +(12,473 +) +(11,003 +) +Financing Activities +Proceeds from short-term borrowings +-- +6,706 +3,797 +Payments of short-term debt +(90 +) +(7,512 +) +(3,049 +) +Proceeds from long-term borrowings +94,215 +113,972 +120,812 +Payments of long-term debt +(112,226 +) +(115,318 +) +(167,819 +) +Cash dividends +(7,192 +) +(6,643 +) +(5,797 +) +Purchase of common stock for treasury +(33,626 +) +(9,145 +) +(1,135 +) +Proceeds from shares issued under stock incentive plans +2,202 +3,864 +213 +Net cash used in financing activities +(56,717 +) +(14,076 +) +(52,978 +) +Effect of foreign exchange rate changes +330 +-- +-- +Increase (decrease) in cash and cash equivalents +(8,742 +) +27,386 +6,988 +Cash and cash equivalents at beginning of the year +35,820 +8,434 +1,446 +Cash and cash equivalents at end of the year +$ +27,078 +$ +35,820 +$ +8,434 +Other Cash Flow Information +Interest paid +$ +6,633 +$ +7,656 +$ +10,182 +Net income taxes paid +18,201 +7,854 +1,280 +( ) Denotes reduction in cash and cash equivalents. +See accompanying notes to consolidated financial statements. +4 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. Summary of Significant Accounting Policies +PRINCIPLES OF CONSOLIDATION +The consolidated financial statements include the accounts of Wolverine World Wide, Inc. and its wholly and majority owned subsidiaries (collectively, the "Company"). Upon consolidation, all intercompany accounts, transactions and profits have been eliminated. +FISCAL YEAR +The Company's fiscal year is the 52- or 53-week period that ends on the Saturday nearest the end of December. Fiscal years presented herein include the 52-week periods ended December 28, 2002, December 29, 2001 and December 30, 2000. +USE OF ESTIMATES +The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. +REVENUE RECOGNITION +Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped and legal title has passed to the customer. Revenue generated through programs with licensees and distributors involving products utilizing the Company's trademarks and brand names is recognized as earned based on the completion of stated contractual terms. +The Company records provisions against gross revenue for estimated stock returns and cash discounts in the period when the related revenue is recorded. These estimates are based on factors that include, but are not limited to, historical stock returns, historical discounts taken, analysis of credit memorandum activity and customer demand. +SHIPPING AND HANDLING COSTS +Shipping and handling costs that are charged to and reimbursed by the customer are recognized as revenue, while the related expenses incurred by the Company are recorded as cost of products sold in the consolidated statements of operations. +CASH EQUIVALENTS +All short-term investments with a maturity of three months or less when purchased are considered cash equivalents. +ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS +The Company evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. +INVENTORIES +Inventories are valued at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for certain domestic inventories. Foreign, retail and other domestic inventories are valued using methods approximating cost under the first-in, first-out (FIFO) method. +PROPERTY, PLANT AND EQUIPMENT +Property, plant and equipment are stated on the basis of cost and include expenditures for new facilities, major renewals, betterments and software. Normal repairs and maintenance are expensed as incurred. +5 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +Depreciation of plant, equipment and software is computed using the straight-line method. The depreciable lives range from five to forty years for buildings and improvements, from three to ten years for machinery and equipment, and from three to ten years for software. +GOODWILL AND OTHER INTANGIBLES +Goodwill represents the excess of the purchase price over the fair value of net tangible and identifiable intangible assets of acquired businesses. Other intangibles consist primarily of trademarks, brand names and patents. In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, effective for the Company in fiscal 2002. Under the new rules, goodwill and intangible assets deemed to have indefinite lives are no longer amortized but will be subject to impairment tests at least annually in accordance with SFAS No. 142. Other intangible assets are amortized using the straight-line method over their estimated useful life (periods ranging from four to fifteen years). Estimated aggregate amortization expense for such intangibles for each of the five succeeding fiscal years is expected to approximate $200,000 annually. The Company reviews the carrying amounts of goodwill and other non-amortizable intangible assets annually to determine if such assets may be impaired. If the carrying amounts of these assets are not recoverable based upon a discounted cash flow analysis, such assets are reduced by the estimated shortfall of fair value to recorded value. +The Company applied the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002. Application of the non-amortization provisions of SFAS No. 142 in 2001 and 2000 would have resulted in an increase in net earnings of approximately $731,000 ($0.02 per share) and $792,000 ($0.02 per share), respectively. The Company has performed the required impairment tests of goodwill during fiscal 2002 and has determined that there was no impairment indicated for recorded goodwill. +The changes in the net carrying amount of goodwill and other non-amortizable intangibles for the year ended December 28, 2002 is as follows: +2002 +(Thousands of Dollars) +Balance as of December 29, 2001 +$ +12,685 +Goodwill acquired +15,057 +Other non-amortizable intangibles acquired +640 +Foreign currency translation effects +2,324 +Balance as of December 28, 2002 +$ +30,706 +ASSETS HELD FOR EXCHANGE +Assets held for exchange represent barter credits that were acquired in exchange for inventories in December 1997. Such credits are redeemable through December 31, 2005 for a percentage of supplies purchased from certain vendors. The Company evaluates the recoverability of such assets on a quarterly basis and expects to utilize all available credits prior to their expiration. +IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS +In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets , which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of , and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations, for the disposal of a segment of a business. SFAS No. 144 is effective for the Company in fiscal 2002. The Company adopted SFAS No. 144 as of the first +6 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +day of fiscal 2002 and it did not have a significant impact on the Company's financial position or results of operations. +DISPOSAL OBLIGATIONS +In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities , which requires liabilities for costs related to exit or disposal activities to be recognized when the liability is incurred. SFAS No. 146 supersedes EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity , and is effective for the Company in fiscal 2003. The Company will adopt SFAS No. 146 as of the first day of fiscal 2003 and does not expect that the adoption of this statement will have a significant impact on the Company's financial position or results of operations. +GUARANTOR ACCOUNTING +In November 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45). Fin 45 changes current practice in accounting for, and disclosure of, guarantees. FIN 45 will require certain guarantees to be recorded at fair value on the Company's balance sheet, a change from current practice, which is generally to record a liability only when a loss is probable and reasonably estimable, as those terms are defined in SFAS No. 5, Accounting for Contingencies . FIN 45 also requires a guarantor to make significant new disclosures, even when the likelihood of making any payments under the guarantee is remote, which is another change from current practice. The disclosure requirements of FIN 45 are effective immediately and are included in Note 8, "Litigation and Contingencies." The initial recognition and initial measurement provisions are applicable on a prospective basis to guarantees issued or modified after December 28, 2002. The Company expects that the new recognition and measurement provisions will not have a significant impact on the Company's future financial results. +STOCK-BASED COMPENSATION +The Company has elected to follow Accounting Principles Board (APB) Opinion No. 25 , Accounting for Stock Issued to Employees , and related interpretations, in accounting for its stock incentive plans because the alternative fair value accounting provided under SFAS No.123, Accounting for Stock-Based Compensation , requires the use of option valuation models that were not specifically developed for valuing the types of stock incentive plans maintained by the Company. Under APB Opinion No. 25, compensation expense is recognized when the market price of the stock underlying an award on the date of grant exceeds any related exercise price. +Pro forma information regarding net earnings and earnings per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its stock awards using the fair value method. The fair value of these awards was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: risk-free interest rate of 4.2% (4.6% in 2001 and 6.1% in 2000); dividend yield of 1.1% (1.0% in 2001 and .05% in 2000); expected market price volatility factor of 0.420 (0.515 in 2001 and 0.495 in 2000); and an expected option life of four years. +The estimated weighted-average fair value for each option granted was $5.48 in 2002, $6.57 in 2001 and $4.84 in 2000. +The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options that have no vesting provisions and are fully transferable. In addition, the model requires input of highly subjective assumptions. Because the Company's stock options have characteristics significantly different from traded options and the input assumptions can materially affect the estimate of fair value, management believes that the Black-Scholes option model does not necessarily provide a reliable measure of the fair value of the Company's stock options. +For purposes of pro forma disclosures, the estimated fair values of stock options are amortized to expense over the related vesting periods. The Company's pro forma information under SFAS No. 123 is as follows: +7 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +2002 +2001 +2000 +( Thousands of Dollars, Except Per Share Data) +Net earnings, as reported +$ +47,912 +$ +45,240 +$ +10,690 +Deduct: Total stock-based employee compensation +expense determined under fair value based method +for all awards, net of related tax effects +3,229 +5,092 +4,231 +Pro forma net earnings +$ +44,683 +$ +40,148 +$ +6,459 +Net earnings per share: +Basic--as reported +$ +1.19 +$ +1.11 +$ +.26 +Basic--pro forma +1.11 +.99 +.16 +Diluted--as reported +1.15 +1.07 +.26 +Diluted--pro forma +1.08 +.96 +.16 +ADVERTISING COSTS +Advertising costs are expensed as incurred and totaled $33,584,000 in 2002, $29,757,000 in 2001 and $27,514,000 in 2000. +The Company provides sales incentives to retail customers in the form of a cooperative advertising program. Under this program, customers are reimbursed for Company approved advertising-related expenditures where the value to the Company is objectively verifiable. Cooperative advertising dollars are expensed by the Company as earned by customers. +INCOME TAXES +The provision for income taxes is based on the earnings reported in the consolidated financial statements. A deferred income tax asset or liability is determined by applying currently enacted tax laws and rates to the cumulative temporary differences between the carrying values of assets and liabilities for financial statement and income tax purposes. Deferred income tax expense (credit) is measured by the net change in deferred income tax assets and liabilities during the year. +EARNINGS PER SHARE +Basic earnings per share is computed based on weighted average shares of common stock outstanding during each year after adjustment for restricted nonvested common stock issued under restricted stock incentive plans. Diluted earnings per share assumes the exercise of dilutive stock options and the vesting of all common stock under restricted stock programs. +The following table sets forth the reconciliation of weighted average shares used in the computation of basic and diluted earnings per share: +2002 +2001 +2000 +Weighted average shares outstanding during the year +41,016,362 +41,571,272 +41,517,846 +Adjustment for nonvested restricted common stock +(770,749 +) +(832,991 +) +(911,412 +) +Denominator for basic earnings per share +40,245,613 +40,738,281 +40,606,434 +Effect of dilutive stock options +776,864 +877,608 +277,316 +Adjustment for nonvested restricted common stock +770,749 +832,991 +911,412 +Denominator for diluted earnings per share +41,793,226 +42,448,880 +41,795,162 +8 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +Options to purchase 796,487 shares of common stock in 2002, 712,187 shares in 2001 and 2,313,464 shares in 2000 have not been included in the denominator for the computation of diluted earnings per share because the related exercise prices were greater than the average market price for the period and, therefore, they were antidilutive. +FINANCIAL INSTRUMENTS AND RISK MANAGEMENT +The Company's financial instruments consist of cash and cash equivalents, accounts and notes receivable, accounts and notes payable and long-term debt. Except for fixed rate long-term debt at December 28, 2002 with a carrying value of $72,857,000 and a fair value of $77,479,000, the Company's estimate of the fair values of these financial instruments approximates their carrying amounts at December 28, 2002, December 29, 2001 and December 30, 2000. Fair value was determined using discounted cash flow analyses and current interest rates for similar instruments. The Company does not hold or issue financial instruments for trading purposes. +In fiscal 2001, the Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities as amended by SFAS Nos. 137 and 138. The statements require that all derivative instruments be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with foreign currency inventory purchases made by non-U.S. wholesale operations in the normal course of business. At December 28, 2002, foreign exchange contracts with a notional value of $24,000,000 were outstanding to purchase various currencies (principally U.S. dollars) with maturities ranging up to 180 days. These contracts have been designated as cash flow hedges. As of December 28, 2002, a liability of $333,000 has been recognized for the fair value of the foreign exchange contracts. +The fair value of the foreign exchange contracts represents the estimated receipts or payments necessary to terminate the contracts. Hedge effectiveness is evaluated by the hypothetical derivative method. Any hedge ineffectiveness is reported within the other income (expense) caption of the statement of operations. Hedge ineffectiveness was not material to the consolidated financial statements in 2002. If, in the future, the foreign exchange contracts are determined to be ineffective hedges or terminated before their contractual termination dates, the Company would be required to reclassify into earnings all or a portion of the unrealized amounts related to the cash flow hedges that are currently included in accumulated other comprehensive loss within stockholders' equity. +The Company does not require collateral or other security on trade accounts receivable. +COMPREHENSIVE INCOME (LOSS) +Comprehensive income (loss) represents net earnings and any revenues, expenses, gains and losses that, under accounting principles generally accepted in the United States, are excluded from net earnings and recognized directly as a component of stockholders' equity. The ending accumulated other comprehensive loss at December 28, 2002 includes foreign currency translation adjustments of $3,138,000, loss on foreign exchange contracts of $244,000 (net of taxes of $89,000), and a minimum pension liability adjustment of $26,416,000 (net of taxes of $13,607,000). +RECLASSIFICATIONS +Certain amounts previously reported in 2001 and 2000 have been reclassified to conform with the presentation used in 2002. +2. Inventories +Inventories of $95,164,000 at December 28, 2002 and $119,092,000 at December 29, 2001 have been valued using the LIFO method. If the FIFO method had been used, inventories would have been $8,893,000 and $9,633,000 higher than reported at December 28, 2002 and December 29, 2001, respectively. +9 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +3. Debt +Long-term debt consists of the following obligations: +2002 +2001 +( Thousands of Dollars) +6.5% senior notes payable +$ +64,286 +$ +75,000 +7.81% senior notes payable +8,571 +12,857 +Revolving credit obligations +-- +2,903 +Other +58 +88 +72,915 +90,848 +Less current maturities +15,030 +15,030 +$ +57,885 +$ +75,818 +The 6.5% unsecured senior notes payable require annual principal payments of $10,714,000 due through the maturity date of December 8, 2008. In connection with the issuance of these senior notes, the Company entered into an interest rate lock agreement with a bank that was settled in 1998 and resulted in a prepayment of $2,200,000. This prepayment is being amortized over the term of the notes using the effective interest method. +The 7.81% unsecured senior notes payable require a principal payment of $4,285,000 during 2003, with the balance due on August 15, 2004. +The Company has an unsecured revolving credit agreement that allows for borrowings up to $150,000,000, of which $10,000,000 pertains to the Company's Canadian subsidiary. Of the remaining $140,000,000 facility available to the U.S. operations, $35,000,000 may also be utilized by the European subsidiaries. This agreement requires that interest be paid at a variable rate based on LIBOR and expires in May 2006. +The Company had commercial letters of credit outstanding of $8,383,000 and $18,429,000 at December 28, 2002 and December 29, 2001, respectively. +The long-term loan agreements contain restrictive covenants that, among other things, require the Company to maintain certain financial ratios and minimum levels of tangible net worth. At December 28, 2002, unrestricted retained earnings were $41,836,000. The agreements also impose restrictions on securing additional debt, sale and merger transactions and the disposition of significant assets. +Principal maturities of long-term debt during the four years subsequent to 2003 are as follows: 2004--$15,014,000; 2005--$10,728,000; 2006--$10,723,000; 2007--$10,714,000. +Interest costs of $254,000 in 2002, $427,000 in 2001 and $286,000 in 2000 were capitalized in connection with various capital improvement and computer hardware and software installation projects. +4. Leases +The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2018. At December 28, 2002, minimum rental payments due under all noncancelable leases are as follows: 2003--$7,910,000; 2004--$6,723,000; 2005--$5,853,000; 2006--$4,696,000; 2007--$4,074,000; thereafter--$19,098,000. +Rental expense under all operating leases consisted primarily of minimum rentals and totaled $11,011,000 in 2002, $10,105,000 in 2001 and $10,845,000 in 2000. +10 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +5. Capital Stock +The Company has 2,000,000 authorized shares of $1 par value preferred stock, of which none is issued or outstanding. +The Company has a preferred stock rights plan that is designed to protect stockholder interests in the event the Company is confronted with coercive or unfair takeover tactics. One right is associated with each share of common stock currently outstanding. The rights trade with the common stock and become exercisable only upon the occurrence of certain triggering events. Each right, when exercisable, will entitle the holder to purchase one one-hundredth of a share of Series B junior participating preferred stock for $120. The Company has designated 500,000 shares of preferred stock as Series B junior participating preferred stock for possible future issuance under the Company's preferred stock rights plan. Upon issuance for reasons other than liquidation, each share of Series B junior participating preferred stock will have 100 votes and a preferential quarterly dividend equal to the greater of $21 per share or 100 times the dividend declared on common stock. +In the event that the Company is a party to a merger or other business combination, regardless of whether the Company is the surviving corporation, right holders other than the party to the merger will be entitled to receive common stock of the surviving corporation worth twice the exercise price of the rights. The plan also provides for protection against self-dealing transactions by a 15% stockholder or the activities of an adverse person (as defined). The Company may redeem the rights for $.01 each at any time prior to a person being designated as an adverse person or fifteen days after a triggering event. Unless redeemed earlier, all rights expire on May 7, 2007. The Board of Directors can elect to exclude certain transactions from triggering the exercise of preferred stock rights and other actions under the plan. +The Company has stock incentive plans under which options to purchase shares of common stock may be granted to officers, other key employees and non-employee directors. Options granted are exercisable over ten years and vest over various periods. All unexercised options are available for future grant upon their cancellation. +A summary of the transactions under the stock option plans is as follows: +Shares Under +Option +Weighted-Average +Option Price +Outstanding at January 1, 2000 +3,041,001 +$ +13.95 +Granted +857,709 +11.05 +Exercised +(78,394 +) +11.80 +Cancelled +(69,651 +) +13.32 +Outstanding at December 30, 2000 +3,750,665 +13.49 +Granted +900,229 +15.47 +Exercised +(643,035 +) +10.26 +Cancelled +(26,595 +) +16.68 +Outstanding at December 29, 2001 +3,981,264 +14.48 +Granted +797,994 +15.59 +Exercised +(321,869 +) +10.87 +Cancelled +(45,191 +) +15.85 +Outstanding at December 28, 2002 +4,412,198 +$ +14.89 +Shares available for grant under the stock option plans were 1,610,881 at December 28, 2002, 2,036,327 at December 29, 2001 and 825,884 at December 30, 2000. +11 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +The exercise prices of options outstanding at December 28, 2002 range from $1.98 to $30.56. A summary of stock options outstanding at December 28, 2002 by range of option price, is as follows: +Weighted-Average +Number of Options +Option Price +Remaining +Contractual Life +Outstanding +Exercisable +Outstanding +Exercisable +Less than $10 +691,260 +691,260 +$ +8.95 +$ +8.95 +4.8 years +$10 to $20 +3,118,930 +2,210,846 +14.12 +13.91 +7.0 years +Greater than $20 +602,008 +602,008 +25.74 +25.74 +4.1 years +4,412,198 +3,504,114 +$ +14.89 +$ +14.97 +6.2 years +The number of options exercisable at December 29, 2001 and December 30, 2000 totaled 3,075,846 and 2,711,858, respectively. +The Company also has stock award plans for officers and other key employees. Common stock issued under these plans is subject to certain restrictions, including a prohibition against any sale, transfer or other disposition by the officer or employee (except for certain transfers for estate planning purposes for certain officers), and a requirement to forfeit the award upon certain terminations of employment in cases other than death, disability or retirement. These restrictions lapse over a three- to five-year period from the date of the award. Shares aggregating 161,700 in 2002, 156,250 in 2001 and 286,890 in 2000 were awarded under these plans. The weighted-average grant date fair value was $15.47 in 2002, $15.11 in 2001 and $10.95 in 2000 for the shares awarded. Rights to awards were cancelled for 18,224 shares in 2002 and 10,288 shares in 2001 (there were no rights to awards cancelled in 2000). The market value of the shares awarded is recognized as unearned compensation in the consolidated statements of stockholders' equity and is amortized to operations over the vesting period. +6. Retirement Plans +The Company has noncontributory, defined benefit pension plans covering a majority of its domestic employees. The Company's principal defined benefit pension plan provides benefits based on the employees' years of service and final average earnings (as defined), while the other plans provide benefits at a fixed rate per year of service. The Company intends to annually contribute amounts deemed necessary to maintain the plans on a sound actuarial basis. +The Company has a Supplemental Executive Retirement Plan ("SERP") for certain current and former employees that entitles them to receive payments from the Company following retirement based on the employees' years of service and final average earnings (as defined). Under the SERP, the employees are eligible for reduced benefits upon early retirement. The Company also has individual deferred compensation agreements with certain former employees that entitle them to receive payments from the Company for a period of fifteen to eighteen years following retirement. The Company maintains life insurance policies with a cash surrender value of $22,428,000 at December 28, 2002 and $20,062,000 at December 29, 2001 that are intended to fund deferred compensation benefits under the SERP and deferred compensation agreements. +The Company has a defined contribution money accumulation plan covering substantially all employees that provides for Company contributions based on earnings. This plan is combined with the principal defined benefit pension plan for funding purposes. The Company recognized expense for the money accumulation plan of $1,500,000 in 2002, $1,400,000 in 2001 and $1,570,000 in 2000. +The following summarizes the status of and changes in the Company's pension assets and related obligations for its defined benefit pension plans at the end of the plan years: +12 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +September 30 +2002 +2001 +( Thousands of Dollars) +Pension assets at fair value, including assets for underfunded plans of +$6,965 in 2001 +$ +102,486 +$ +114,392 +Projected benefit obligation on services rendered to date for funded +defined benefit plans, including underfunded plan amounts of +$8,787 in 2001 +(120,109 +) +(105,315 +) +Net pension assets (liabilities) of funded defined benefit plans +(17,623 +) +9,077 +Nonqualified trust assets (cash surrender value of life insurance) recorded +in other assets and intended to satisfy the projected benefit obligation of +unfunded supplemental employee retirement plans +17,153 +13,715 +Projected benefit obligation on services rendered to date for unfunded +supplemental employee retirement plans +(12,435 +) +(14,022 +) +Net assets (liabilities) for nonqualified supplemental employee retirement plans +4,718 +(307 +) +Net pension and nonqualified trust assets (liabilities) +$ +(12,905 +) +$ +8,770 +Components of net pension assets (liabilities): +Prepaid pension costs +$ +-- +$ +31,728 +Accrued pension liability +(20,762 +) +(13,589 +) +Intangible asset +4,862 +3,075 +Accumulated other comprehensive income +40,023 +1,737 +Net amounts recognized in balance sheets +24,123 +22,951 +Unrecognized amounts, net of amortization: +Transition assets +-- +27 +Prior service costs +(5,229 +) +(5,619 +) +Net experience losses +(48,952 +) +(22,304 +) +Nonqualified trust assets +17,153 +13,715 +Net pension and nonqualified trust assets (liabilities) +$ +(12,905 +) +$ +8,770 +Change in fair value of pension assets: +Fair value of pension assets at beginning of the year +$ +114,392 +$ +134,815 +Actual net investment loss +(8,140 +) +(13,895 +) +Company contributions +3,099 +1,145 +Benefits paid to plan participants +(6,865 +) +(7,673 +) +Fair value of pension assets at end of the year +$ +102,486 +$ +114,392 +Change in projected benefit obligations: +Projected benefit obligations at beginning of the year +$ +119,337 +$ +104,830 +Service cost pertaining to benefits earned during the year +4,435 +3,753 +Interest cost on projected benefit obligations +8,959 +8,457 +Effect of changes in actuarial assumptions +516 +885 +Actuarial losses +6,162 +8,911 +Special termination benefits +-- +174 +Benefits paid to plan participants +(6,865 +) +(7,673 +) +Projected benefit obligations at end of the year +$ +132,544 +$ +119,337 +13 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +The following is a summary of net pension income (expense) recognized by the Company: +2002 +2001 +2000 +(Thousands of Dollars) +Service cost pertaining to benefits earned during the year +$ +(4,435 +) +$ +(3,753 +) +$ +(4,459 +) +Interest cost on projected benefit obligations +(8,959 +) +(8,457 +) +(7,841 +) +Expected return on pension assets +12,477 +13,310 +12,526 +Net amortization gain (loss) +(1,010 +) +1,427 +1,544 +Curtailment gain +-- +-- +667 +Special termination benefits +-- +(174 +) +(3,201 +) +Net pension income (expense) +$ +(1,927 +) +$ +2,353 +$ +(764 +) +Pension expense for qualified retirement plans was $186,000 in 2002 and pension income, excluding the effect of special termination gains and expenses, was $4,040,000 in 2001 and $4,349,000 in 2000. +In connection with the realignment of its manufacturing operations in 2000 described in Note 11, certain of the Company's pension plans were amended to provide early retirement benefits. Special termination benefit costs of $174,000 and $3,201,000 in 2001 and 2000, respectively, and a curtailment gain of $667,000 in 2000 were recorded as a result of these changes in scheduled benefits. +The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 6.76% and 4.5%, respectively, in 2002 and 7.55% and 4.5%, respectively, in 2001. The expected long-term return on plan assets was 10% in each year. Unrecognized net experience losses exceeding certain corridors are amortized over a five-year period, unless the minimum amortization method based on average remaining service periods produces a higher amortization. +Plan assets were invested in listed equity securities (65%), fixed income funds (24%) and short-term and other investments (11%). Equity securities include 688,512 shares of the Company's common stock with a fair value of $10,328,000 at September 30, 2002. Dividends declared per share of the Company's common stock were $.18 in 2002, $.16 in 2001, and $.14 in 2000. +7. Income Taxes +The provisions for income taxes consist of the following: +2002 +2001 +2000 +(Thousands of Dollars) +Currently payable: +Federal +$ +20,002 +$ +17,147 +$ +7,463 +State and foreign +3,381 +991 +930 +Deferred (credit) +216 +5,169 +(4,068 +) +$ +23,599 +$ +23,307 +$ +4,325 +14 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +A reconciliation of the Company's total income tax expense and the amount computed by applying the statutory federal income tax rate of 35% to earnings before income taxes is as follows: +2002 +2001 +2000 +(Thousands of Dollars) +Income taxes at statutory rate +$ +25,079 +$ +23,991 +$ +5,255 +State income taxes, net of federal income tax reduction +271 +460 +(20 +) +Nontaxable earnings of foreign affiliates +(1,674 +) +(1,518 +) +(1,916 +) +Foreign earnings (losses) taxed at rates differing from +the U.S. statutory rate +121 +(84 +) +163 +Other +(198 +) +458 +843 +$ +23,599 +$ +23,307 +$ +4,325 +Significant components of the Company's deferred income tax assets and liabilities as of the end of 2002 and 2001 are as follows: +2002 +2001 +( Thousands of Dollars) +Deferred income tax assets: +Accounts receivable and inventory valuation allowances +$ +1,611 +$ +1,712 +Deferred compensation accruals +1,475 +1,597 +Future benefit of foreign net operating losses +650 +-- +Accrued pension costs +4,775 +-- +Other amounts not deductible until paid +5,110 +4,446 +Total deferred income tax assets +13,621 +7,755 +Deferred income tax liabilities: +Tax over book depreciation +(9,372 +) +(8,940 +) +Prepaid pension costs +-- +(7,882 +) +Unremitted earnings of Puerto Rican subsidiary +-- +(792 +) +Other +(1,337 +) +(118 +) +Total deferred income tax liabilities +(10,709 +) +(17,732 +) +Net deferred income tax assets (liabilities) +$ +2,912 +$ +(9,977 +) +No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the undistributed earnings ($59,374,000 at December 28, 2002 and $47,889,000 at December 29, 2001) of foreign subsidiaries because it is expected that such earnings will be reinvested overseas indefinitely. Determination of the amount of any unrecognized deferred income tax liability on these unremitted earnings is not practicable. +8. Litigation and Contingencies +The Company is involved in various environmental claims and other legal actions arising in the normal course of business. The environmental claims include sites where the Environmental Protection Agency has notified the Company that it is a potentially responsible party with respect to environmental remediation. These remediation claims are subject to ongoing environmental impact studies, assessment of remediation alternatives, allocation of cost between responsible parties and concurrence by regulatory authorities and have not yet advanced to a stage where the Company's liability is fixed. However, after taking into consideration legal counsel's evaluation of all actions and claims against the Company, management is currently of the opinion that their outcome will not have a significant effect on the Company's consolidated financial position or future results of operations. +15 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +Pursuant to certain of the Company's lease agreements, the Company has provided financial guarantees to third parties in the form of indemnification provisions. These provisions indemnify and reimburse the third parties for costs, including but not limited to adverse judgments in lawsuits and taxes and operating costs. The terms of the guarantees are equal to the terms of the related lease agreements. The Company is not able to calculate the maximum potential amount of future payments it could be required to make under these guarantees, as the potential payment is dependent on the occurrence of future unknown events. +9. Business Segments +The Company has one reportable segment that is engaged in manufacturing and marketing of branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear, to the retail sector. Revenues of this segment are derived from the sale of branded footwear products to external customers and the Company's retail division as well as royalty income from the licensing of the Company's trademarks and brand names to licensees and distributors. The business units comprising the branded footwear segment manufacture or source, market and distribute products in a similar manner. Branded footwear is distributed through wholesale channels and under licensing and distributor arrangements. +The other business units in the following tables consist of the Company's retail, apparel and accessory licensing, tannery and pigskin procurement operations. The Company operated 63 domestic retail stores at December 28, 2002 that sell Company-manufactured and sourced products, as well as footwear manufactured by unaffiliated companies. The other business units distribute products through retail and wholesale channels. +The Company measures segment profits as earnings before income taxes and minority interest. The accounting policies used to determine profitability and total assets of the branded footwear and other business segments are the same as disclosed in Note 1. +Business segment information is as follows: +2002 +Branded +Footwear +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +746,202 +$ +80,904 +$ +-- +$ +827,106 +Intersegment sales +24,814 +3,099 +-- +27,913 +Interest (income) expense -- net +10,841 +1,323 +(5,698 +) +6,466 +Depreciation expense +5,339 +2,407 +8,887 +16,633 +Earnings (loss) before income taxes +and minority interest +78,847 +6,780 +(13,973 +) +71,654 +Assets +384,723 +40,453 +106,818 +531,994 +Additions to property, plant and equipment +8,732 +1,700 +3,443 +13,875 +2001 +Branded +Footwear +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +644,793 +$ +75,273 +$ +-- +$ +720,066 +Intersegment sales +19,599 +4,632 +-- +24,231 +Interest (income) expense -- net +11,939 +1,273 +(6,470 +) +6,742 +Depreciation expense +5,445 +2,295 +8,251 +15,991 +Earnings (loss) before income taxes +68,086 +5,887 +(5,426 +) +68,547 +Assets +355,045 +45,165 +143,468 +543,678 +Additions to property, plant and equipment +2,001 +3,553 +5,744 +11,298 +16 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +2000 +Branded +Footwear +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +622,829 +$ +78,462 +$ +-- +$ +701,291 +Intersegment sales +17,617 +5,503 +-- +23,120 +Interest (income) expense -- net +13,561 +1,296 +(4,948 +) +9,909 +Depreciation expense +7,106 +2,141 +7,248 +16,495 +Realignment charges +45,050 +-- +-- +45,050 +Earnings (loss) before income taxes +9,918 +7,555 +(2,458 +) +15,015 +Assets +346,235 +37,546 +110,787 +494,568 +Additions to property, plant and equipment +3,156 +5,062 +3,760 +11,978 +Geographic information, based on shipping destination, related to revenue included in the consolidated statements of operations is as follows: +2002 +2001 +2000 +(Thousands of Dollars) +United States +$ +644,647 +$ +617,711 +$ +598,115 +Foreign countries: +Europe +127,461 +50,115 +54,555 +Canada +39,363 +34,221 +30,766 +Central and South America +6,417 +7,764 +7,852 +Asia +6,780 +6,356 +7,274 +Middle East and Russia +2,438 +3,899 +2,729 +182,459 +102,355 +103,176 +$ +827,106 +$ +720,066 +$ +701,291 +The Company's long-lived assets (primarily intangible assets and property, plant and equipment) are as follows: +2002 +2001 +2000 +(Thousands of Dollars) +United States +$ +136,644 +$ +155,731 +$ +157,291 +Foreign countries +32,005 +13,144 +12,191 +The Company does not believe that it is dependent upon any single customer, since none accounts for more than 10% of consolidated revenue. +No product groups, other than footwear, account for more than 10% of consolidated revenue. Revenues derived from the sale and licensing of footwear accounted for over 90% of revenue in 2002, 2001 and 2000. +Approximately 17% of the Company's employees are subject to bargaining unit contracts extending through various dates to 2004. +17 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +10. Quarterly Results of Operations (unaudited) +The Company generally reports its quarterly results of operations on the basis of 12-week periods for each of the first three quarters and a 16- or 17-week period for the fourth quarter. +The Company's unaudited quarterly results of operations are as follows: +2002 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +177,277 +$ +169,276 +$ +219,197 +$ +261,356 +Gross margin +62,102 +61,621 +78,018 +92,487 +Net earnings +6,403 +9,099 +15,342 +17,068 +Net earnings per share: +Basic +$ +.16 +$ +.22 +$ +.38 +$ +.43 +Diluted +.15 +.21 +.37 +.42 +2001 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +158,223 +$ +151,699 +$ +186,175 +$ +223,969 +Gross margin +53,326 +55,269 +67,798 +80,643 +Net earnings +5,980 +8,858 +14,364 +16,038 +Net earnings per share: +Basic +$ +.15 +$ +.22 +$ +.35 +$ +.39 +Diluted +.14 +.21 +.34 +.38 +Adjustments in the fourth quarter were immaterial in 2002 and resulted in an increase in net earnings of $1,435,000 ($0.03 per share) in 2001. These adjustments related primarily to inventories. +11. Realignment Charges +On July 12, 2000, the Company announced a strategic realignment of its global sourcing and manufacturing operations. In connection with this realignment, the Company decided to close five of its manufacturing facilities in New York, Missouri, Canada, Puerto Rico and Costa Rica, eliminate certain footwear product offerings and related raw material inventories, reduce administrative support services and incur other expenses. Workforce reductions totaling 1,391 employees occurred in the areas of manufacturing (1,272), general management (28) and administrative support (91). The realignment activities were primarily completed in the third and fourth quarters of 2000 and the first half of 2001. +The following table summarizes the sourcing realignment, impairment and other pre-tax charges recorded in the consolidated statements of operations in 2000 (thousands of dollars): +Sourcing realignment charges: +Severance and related costs +$ +11,723 +Inventories +12,141 +Other exit costs +4,263 +28,127 +Impairment charges: +Property, plant and equipment +8,126 +Goodwill +1,077 +9,203 +Other charges +7,720 +$ +45,050 +18 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +Severance and related costs associated with the sourcing realignment included involuntary and voluntary employee termination expenses. Inventory charges represented the write-down to net realizable value of raw materials that are no longer used in production and certain finished footwear products that were discontinued as part of the realignment plan. Other exit costs primarily represented expenses required under contractual arrangements that have been or are expected to be incurred prior to their estimated disposal dates. +Impairment charges consisted of write-downs of property, plant and equipment to their fair values less costs to sell, costs to close and reconfigure manufacturing facilities, and the write-off of goodwill previously recorded in connection with the purchase of the Company's Costa Rican operation. +Other charges pertained to one-time costs that were expensed as incurred and consisted primarily of the write-off of amounts for customer chargebacks and other deductions that the Company previously expected to collect, but will no longer pursue. +Within the consolidated statements of operations for 2000, cost of products sold, selling and administrative expenses and other expenses included $15,036,000, $29,589,000 and $425,000, respectively, for the sourcing realignment and other charges. These charges resulted in a $0.71 per share reduction of net earnings in 2000. +The following table summarizes the activity and remaining liabilities associated with the sourcing realignment at December 28, 2002, December 29, 2001 and December 30, 2000, and for the fiscal years then ended (thousands of dollars): +Severance and +Related Costs +Inventories +Other Exit +Costs +Total +Amounts recognized as charges in the +consolidated statements of operations +$ +11,723 +$ +12,141 +$ +4,263 +$ +28,127 +Disposal of inventories +-- +(11,024 +) +-- +(11,024 +) +Payments +(5,720 +) +-- +(1,871 +) +(7,591 +) +Balance at December 30, 2000 +6,003 +1,117 +2,392 +9,512 +Changes in amounts recognized +680 +1,114 +15 +1,809 +Disposal of inventories +-- +(2,231 +) +-- +(2,231 +) +Payments +(4,049 +) +-- +(2,209 +) +(6,258 +) +Balance at December 29, 2001 +2,634 +-- +198 +2,832 +Satisfaction of pension benefit obligation +(2,531 +) +-- +-- +(2,531 +) +Payments +(103 +) +-- +(198 +) +(301 +) +Balance at December 28, 2002 +$ +-- +$ +-- +$ +-- +$ +-- +19 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.) +12. Business Acquisitions +On January 16, 2002, the Company established a new subsidiary to operate the CAT® footwear business in the European market. This new entity, Wolverine Europe Limited, purchased assets consisting of accounts receivable, inventory, limited amortizable intangible assets and fixed assets totaling approximately $21,247,000 from Overland Group Limited of London, England and assumed liabilities of approximately $8,514,000. Cash and other consideration of $27,790,000 was remitted for the acquisition, resulting in goodwill of $15,057,000 after allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. The former owner of Overland Group Limited is a 5% minority stockholder in the new subsidiary. The markets served directly by Wolverine Europe Limited include Austria, France, Germany, Ireland, The Netherlands, Switzerland and the United Kingdom. Wolverine Europe Limited also coordinates and supports other European markets served by independently-owned distributors. Based on the information provided by the Overland Group, the Company's consolidated pro forma revenue for 2001, assuming the acquisition occurred at the beginning of 2001, would have included approximately $69.9 million from the acquired business for a total of $784.5 million. Consolidated pro forma revenue for 2002, year-to-date period assuming the transaction occurred at the beginning of the year, would not have been materially different from reported amounts. Consolidated pro forma net earnings for 2002 and 2001, assuming the transaction occurred at the beginning of these years, are not materially different from reported amounts. +In October 2001, the Company expanded its owned Merrell® operations in the United Kingdom to cover the additional countries of Austria, Belgium, France, Germany, Luxembourg, The Netherlands and Spain. A new subsidiary, Merrell® Europe BV, was formed to direct the operations in these additional countries. Assets consisting primarily of inventory and fixed assets totaling $1,272,000 were acquired from certain former Merrell® distributors for cash and the assumption of liabilities totaling $2,552,000. Goodwill of $1,280,000 was recognized as of the purchase date. Consolidated pro forma revenue and net earnings in 2001 and 2000, assuming the transaction occurred at the beginning of these years, are not materially different from reported amounts. +20 +[Ernst & Young LLP Logo] +Ernst & Young LLP +Suite 1000 +171 Monroe Avenue, NW +Grand Rapids, Michigan 49503 +Phone: (616) 774-0710 +Fax: (616) 774-0190 +www.ey.com +Report of Independent Auditors +Board of Directors and Stockholders +Wolverine World Wide, Inc. +We have audited the accompanying consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of December 28, 2002 and December 29, 2001, and the related consolidated statements of stockholders' equity and comprehensive income, operations and cash flows for each of the three fiscal years in the period ended December 28, 2002. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. +We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Wolverine World Wide, Inc. and subsidiaries at December 28, 2002 and December 29, 2001, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended December 28, 2002, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. +As discussed in Note 1 to the Consolidated Financial Statements, in 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets . +/s/ Ernst & Young LLP +Grand Rapids, Michigan +February 5, 2003 +21 +APPENDIX B +Schedule II +Schedule II - Valuation and Qualifying Accounts of Continuing Operations +Wolverine World Wide, Inc. and Subsidiaries +Column A +Column B +Column C +Column D +Column E +Additions +Description +Balance at +Beginning of +Period +(1) +Charged to +Costs and +Expenses +(2) +Charged to +Other Accounts +(Describe) +Deductions +(Describe) +Balance at +End of +Period +Fiscal year ended December 28, 2002 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +6,548,000 +$ +5,717,000 +$ +3,291,000 +(A) +$ +8,974,000 +Allowance for cash discounts +834,000 +11,081,000 +10,698,000 +(B) +1,217,000 +Inventory valuation allowances +5,628,000 +9,195,000 +6,961,000 +(C) +7,862,000 +$ +13,010,000 +$ +25,993,000 +$ +20,950,000 +$ +18,053,000 +Fiscal year ended December 29, 2001 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +5,036,000 +$ +6,819,000 +$ +5,307,000 +(A) +$ +6,548,000 +Allowance for cash discounts +1,111,000 +8,028,000 +8,305,000 +(B) +834,000 +Inventory valuation allowances +6,233,000 +9,409,000 +10,014,000 +(C) +5,628,000 +$ +12,380,000 +$ +24,256,000 +$ +23,626,000 +$ +13,010,000 +Fiscal year ended December 30, 2000 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +6,977,000 +$ +10,864,000 +$ +12,805,000 +(A) +$ +5,036,000 +Allowance for cash discounts +723,000 +6,711,000 +6,323,000 +(B) +1,111,000 +Inventory valuation allowances +8,351,000 +8,503,000 +10,621,000 +(C) +6,233,000 +$ +16,051,000 +$ +26,078,000 +$ +29,749,000 +$ +12,380,000 +(A) Accounts charged off, net of recoveries. +(B) Discounts given to customers. +(C) Adjustment upon disposal of related inventories. +Commission File No. 1-6024 +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +EXHIBITS +TO +FORM 10-K +For the Fiscal Year Ended +December 28, 2002 +Wolverine World Wide, Inc. +9341 Courtland Drive +Rockford, Michigan 49351 +EXHIBIT INDEX +Exhibit +Number +Document +3.1 +Certificate of Incorporation, as amended. Previously filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.1 +Certificate of Incorporation, as amended. See Exhibit 3.1 above. +4.2 +Amended and Restated By-laws. See Exhibit 3.2 above. +4.3 +Rights Agreement dated as of April 17, 1997. Previously filed with the Company's Form 8-A filed April 12, 1997. Here incorporated by reference. +4.4 +Amendment No. 1 dated as of June 30, 2000, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.5 +Second Amendment dated as of February 11, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.6 +Third Amendment dated as of December 10, 2002, to the Rights Agreement dated as of April 17, 1997. +4.7 +Note Purchase Agreement dated as of August 1, 1994, relating to 7.81% Senior Notes. Previously filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.8 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. Previously filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here incorporated by reference. +4.9 +The Registrant has several classes of long-term debt instruments outstanding in addition to those described in Exhibits 4.7, 4.8 and 4.10. The authorized amount of none of these classes of debt exceeds 10% of the Company's total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +4.10 +Credit Agreement dated as of May 29, 2001, with Bank One, Michigan, as agent. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 16, 2001. Here incorporated by reference. +1 +4.11 +First Amendment dated as of February 8, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.12 +Second Amendment dated as of August 30, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.13 +Third Amendment dated as of December 19, 2002, to the Credit Agreement dated as of May 29, 2001. +10.1 +1988 Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed July 21, 1988, Registration No. 33-23196. Here incorporated by reference. +10.2 +1993 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed June 22, 1993, Registration No. 33-64854. Here incorporated by reference. +10.3 +1995 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed October 26, 1995, Registration No. 33-63689. Here incorporated by reference. +10.4 +1997 Stock Incentive Plan.* Previously filed as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2001. Here incorporated by reference. +10.5 +Stock Incentive Plan of 1999.* Previously filed as Appendix A to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 23, 1999. Here incorporated by reference. +10.6 +Stock Incentive Plan of 2001.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 26, 2001. Here incorporated by reference. +10.7 +Amended and Restated Directors Stock Option Plan.* Previously filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.8 +Amended and Restated Directors' Stock Option Plan.* Previously filed as Appendix D to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.9 +Amended and Restated Outside Directors' Deferred Compensation Plan.* Previously filed as Appendix E to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.10 +Supplemental Director's Fee Arrangement dated April 27, 1993, between the Company and Phillip D. Matthews.* (Reflects the grant of a currently oustanding stock option to Mr. Matthews. This agreement is otherwise no longer in effect.) +2 +10.11 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.12 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Appendix C to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.13 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +10.14 +Executive Severance Agreement.* Previously filed as Exhibit 10.10 to the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1998. Here incorporated by reference. An updated participant schedule is attached as Exhibit 10.14. +10.15 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. Previously filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.16 +Benefit Trust Agreement dated May 19, 1987, and Amendments Number 1, 2, 3 and 4 thereto.* Previously filed as Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.17 +Amended and Restated Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. An updated participant schedule is attached as Exhibit 10.17. +10.18 +Employees' Pension Plan (Restated as Amended through December 13, 2001).* Previously filed as Exhibit 10.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2001. Here incorporated by reference. +10.19 +Fiftieth Amendment dated as of July 9, 2002, to the Employees' Pension Plan. +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +99.1 +Certification pursuant to 18 U.S.C. § 1350. This exhibit is furnished, not filed, in accordance with SEC Release Number 33-8212. +____________________________ +*Management contract or compensatory plan or arrangement. +3 \ No newline at end of file diff --git a/raw/filings/0000110471/2002/0000905729-03-000154/filing_metadata.csv b/raw/filings/0000110471/2002/0000905729-03-000154/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..886a9b42455e22be4dbc3ed8350732605c12cc4e --- /dev/null +++ b/raw/filings/0000110471/2002/0000905729-03-000154/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000110471,WWW,WOLVERINE WORLD WIDE INC /DE/,10-K,2003-03-27,2002-12-28,2003-03-27T22:21:12.000Z,0000905729-03-000154,www10k_ye2002.htm,,1207348,0,0,https://www.sec.gov/Archives/edgar/data/110471/000090572903000154/www10k_ye2002.htm,https://www.sec.gov/Archives/edgar/data/110471/000090572903000154/,2002,2002,1 diff --git a/raw/filings/0000110471/2002/0000905729-03-000154/item1.txt b/raw/filings/0000110471/2002/0000905729-03-000154/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..7d865efb353b0b2e7cf63f21f27d314e3f5ab6ab --- /dev/null +++ b/raw/filings/0000110471/2002/0000905729-03-000154/item1.txt @@ -0,0 +1,84 @@ +Item 1. Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The Company, a Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Consumers around the world purchased more than 37 million pairs of Company branded footwear during fiscal 2002, making the Company a global leader among U.S. footwear companies in the marketing of branded casual, work and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort and performance. The products are marketed throughout the world under widely recognized brand names, including Bates ®, CAT ®, Coleman ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Stanley® and Wolverine ®. The Company believes that its primary competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary designs and comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. The Company's footwear products are organized under five operating divisions: (i) the Wolverine Footwear Group, focusing on work, outdoor and lifestyle boots and shoes, (ii) the Merrell Performance Footwear Group, focusing on the Merrell ® product lines of performance and lifestyle footwear, (iii) the CAT Footwear Group, focusing on the CAT ® product lines of work and lifestyle footwear, (iv) the Hush Puppies Company, focusing on Hush Puppies ® brand comfortable casual and dress shoes, and (v) the Wolverine Slipper Group, focusing on moccasins and slippers under the Hush Puppies ® and Karen Neuburger ® brands and other labels for third party retailers. The Company's Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support for the various Company brands. The Company's footwear is distributed domestically through 63 Company-owned retail stores and to numerous accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of the retailers to whom Wolverine distributes operate multiple storefront locations. The Company's products are distributed worldwide in over 130 markets through licensees and distributors. +The Company, through its Wolverine Leathers Division, operates a Company-owned tannery and is one of the premier tanners of quality pigskin leather for the shoe and leather goods industries. Pigskin leather tanned by the Company is used in a significant portion of the footwear marketed by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of shoes. In addition, Wolverine Procurement, Inc., a Company-owned subsidiary, performs skinning operations and purchases raw pigskins which it then cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company, which are attached as Appendix A to this Form 10-K. The Company has one reportable operating segment, Branded Footwear. The Branded Footwear segment is engaged in the manufacture +2 +and marketing of branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear. The Company's Other Businesses category consists of the Company's retail stores, apparel and accessory licensing, tannery and pigskin procurement operations. Financial information regarding the Company's operating segments and financial information about geographic areas is found in Note 9 to the consolidated financial statements of the Company, which are attached as Appendix A to this Form 10-K. +Branded Footwear. +The Company sources and markets a broad range of footwear styles including shoes, boots and sandals under many recognizable brand names including Bates ®, CAT ®, Coleman ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Stanley ® and Wolverine ®. The Company, through its wholly owned subsidiary, Wolverine Slipper Group, Inc., also sources constructed slippers and moccasins and markets them under the Hush Puppies ® and Karen Neuburger ® trademarks and on a private label basis. The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications at both Company-owned and independent manufacturing facilities. +The Company's five branded footwear operating divisions are described below. +1. Wolverine Footwear Group . The Wolverine Footwear Group encompasses footwear under the Wolverine ®, Bates ®, HyTest ®, Harley-Davidson ®, Coleman ® and Stanley ® brands and markets footwear designed with performance and comfort features to serve a variety of work, outdoor and lifestyle functions. +Wolverine ® Work and Industrial Footwear . The Wolverine ® brand has built its reputation by offering high quality work boots and shoes that incorporate innovative technologies to deliver comfort and durability. The Wolverine ® brand, which has been in existence for 120 years, markets work and outdoor footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® technology allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The Wolverine Fusion ®, DuraShocks SR™, SEMC ™ composite safety toe and Wolverine Compressor™ technologies continue the Company's tradition of comfortable work and industrial footwear. The Wolverine® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female industrial and farm workers. The Wolverine ® rugged casual and outdoor sport product lines also incorporate DuraShocks ® technology and other comfort features into products designed for casual and outdoor sport use. The rugged casual line targets active lifestyles and includes walking shoes, rugged casuals and outdoor sandals. The outdoor sport line is designed to meet the demands of hunters, fishermen and other active outdoor sportsmen and women. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® and Thinsulate ® brand fabrics, the Company's performance leathers and patented DuraShocks ® technologies. +3 +Bates ® Uniform Footwear . The Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes DuraShocks ®, DuraShocks SR ™, CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and oxfords including the Bates ®, Enforcer Series ® and Special Ops ™ footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and the militaries of several foreign countries to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial occupations. Bates Uniform Footwear Division products are also distributed through specialty retailers and catalogs. +HyTest ®. The HyTest ® product line consists primarily of high quality work boots and shoes designed to protect male and female industrial workers from foot injuries. HyTest ® footwear incorporates various specialty safety features into its product lines, including steel toe, composite toe, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology and the proprietary SEMC ™ composite toe to provide comfort together with safety for working men and women. HyTest ® footwear is distributed primarily through a network of independently owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company's occupational and work footwear brands to workers at industrial facilities and also through direct sales arrangements with large industrial customers. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson ® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work, military and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a network of independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. +Coleman ® Footgear . The Company has been granted the exclusive rights to manufacture, market, distribute and sell outdoor footwear under the Coleman ® brand in Europe, Asia and the Middle East. Coleman ® brand footwear products include lightweight hiking boots, outdoor sport boots, rubber footgear and outdoor sandals, which are sold primarily at value-oriented prices through specialty retailers and mass merchants. +4 +Stanley ® Footgear . Pursuant to a license arrangement with The Stanley Works, the Company has exclusive rights to manufacture, market, distribute and sell footwear under the Stanley ® brand. The Stanley ® Footgear line is designed primarily for and marketed in the value-priced work footwear market. Stanley ® Footgear is currently sold in Payless ShoeSource, Inc. stores throughout the United States. +2. Merrell Performance Footwear Group . The Merrell Performance Footwear Group was established as a separate division of the Company in October 2002. The Merrell ® product line consists primarily of technical hiking, rugged outdoor and outdoor inspired casual footwear designed for backpacking, day hiking and every day use. The Merrell ® product line also includes the "After-Sport" product line, incorporating Merrell ® footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers™ and other technical materials to create footwear with unique styling, performance and comfort features. Merrell ® products are sold primarily through outdoor specialty retailers, department stores and catalogs. Merrell ® footwear is marketed in over 120 countries worldwide. +3. CAT Footwear Group . The CAT Footwear Group was established as a separate division of the Company in October 2002. Pursuant to a license arrangement with Caterpillar Inc., the Company has exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ®, CAT & Design ®, Walking Machines ® and other trademarks. The Company believes the association with CAT ® equipment enhances the reputation of its boots for quality, ruggedness and durability. CAT ® brand footwear products include work boots and shoes, sport boots, rugged casuals and lifestyle footwear. In addition, the Company also manufactures and markets CAT ® Marine Power footwear, designed for industrial and recreational marine uses. CAT ® footwear products target work and industrial users and active lifestyle users. CAT ® footwear is marketed in over 130 countries worldwide. +4. The Hush Puppies Company . Over its 45-year heritage, the Hush Puppies ® brand has been a pioneer of comfortable casual shoes. The diverse product line includes numerous styles for both dress and casual wear and utilizes comfort features, such as the Comfort Curve ® sole, Float Fx ® , patented Bounce ® technology and lightweight Zero-G ™ constructions. Hush Puppies ® shoes are sold to men, women and children in over 96 countries through department stores, catalogs, and independent retailers. +5. Wolverine Slipper Group, Inc. Through its wholly owned subsidiary, Wolverine Slipper Group, Inc., the Company is one of the leading suppliers of constructed slippers in the United States. The styling of Wolverine Slipper Group's footwear reflects consumer demand for the "rugged indoor" look by using natural leathers such as moosehide, shearling and suede in constructed slipper and indoor and outdoor moccasin designs. The Wolverine Slipper Group designs and manufactures constructed slippers, aftersport footwear, moccasins and children's footwear on a private label basis according to customer specifications. In addition to its traditional line of private label products, the Wolverine Slipper Group also manufactures and markets slipper products under the famous Hush Puppies ® brand and has developed a College Clogs™ program for the sale of licensed collegiate slipper products. In addition, the Wolverine Slipper Group markets Karen Neuburger ® slipper products pursuant to a license arrangement completed in the first quarter of 2002. +5 +Other Businesses. +In addition to the manufacture and marketing of the Company's footwear products that are reported in the Branded Footwear segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly owned subsidiary Wolverine Procurement, Inc., (iii) operates 63 domestic retail footwear stores, and (iv) licenses the Company's brand names for use on non-footwear products. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces pigskin leathers primarily for use in the footwear industry. Wolverine Leathers® brand products are manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes these leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof, stain resistant and washable leathers are featured in many of the Company's domestic footwear lines and many products offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +3. Retail Stores . The Company operates 63 domestic retail shoe stores as of February, 2003, consisting of 61 factory outlet stores under the Hush Puppies and Family name, and two mall-based stores under the Track 'N Trail® name. The Company expects the scope of its retail operations to remain relatively consistent in the foreseeable future. Most of the Company's 61 factory outlet stores carry a large selection of first quality Company branded footwear at discounted retail prices. The Track 'N Trail® stores feature Company brands such as Wolverine® , Merrell® , Hush Puppies® , CAT® and Harley-Davidson® . These stores also carry a selection of branded footwear from other manufacturers. +4. Apparel and Accessory Licensing . The Company's Apparel and Accessory Licensing Division licenses the Company's brands for use on non-footwear products including apparel, eyewear, watches, socks, handbags and plush toys. Current significant licensing programs include Hush Puppies® brand apparel, eyewear, watches and plush toys, and Wolverine® brand apparel, gloves and watches. +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States and international markets to foster a differentiated and consistent image for each of the Company's core footwear brands. Each footwear brand group has its own marketing personnel who develop the marketing strategy for products within that group. Marketing campaigns and strategies vary by brand and may target accounts and/or end users as they strive to increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's footwear. Components of the brand-specific plans vary and may +6 +include print, radio and television advertising, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's footwear brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance that may be provided by the Company to its licensees and distributors are (i) direction on the categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting on retail store layout and design. The Company believes its footwear brand names provide a competitive advantage and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution. +The Company uses a wide variety of distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses three primary distribution strategies. +• +Traditional wholesale distribution is used to service department stores, large footwear chains, specialty retailers, catalogs, independent retailers and uniform outlets. A dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide branded and private label footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchant and government customers. +• +A network of independent Shoemobile ® distribution outlets is used to distribute the Company's work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and enters bids for contracts to supply specific footwear products. +In addition to its wholesale activities, the Company also operates domestic retail shoe stores as described above. The Company is developing various programs both independently and with its retail customers for the distribution of its products over the Internet and operates direct to customer sites at www.upfootgear.com, www.hytest.com, www.wolverinebootsandshoes.com, www.trackandtrail.com, www.hushpuppies.com and www.catfootwear.com. +A broad distribution base insulates the Company from dependence on any one customer . No customer of the Company accounted for more than 10% of the Company's revenue in fiscal 2002. +Footwear sales are seasonal with significant increases in sales experienced during the U.S. fall and spring seasons. Due to this seasonal nature of footwear sales, the Company experiences some fluctuation in its levels of working capital. The Company provides working capital for such fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects the seasonal sales pattern to continue in future years. +7 +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of sales of branded footwear products generated from the Company's owned operations in Canada, the United Kingdom, France, Germany, The Netherlands, Belgium and Luxemburg and from royalty income through a network of independent licensees and distributors. The Company's owned operations include Hush Puppies (UK) Ltd., Merrell Europe B.V., Merrell (Europe) Limited, Hush Puppies Canada Footwear, Ltd., and the Merrell Canada division. In addition, in January 2002, the Company established a new subsidiary to manage the CAT® footwear brand in the European market. This new subsidiary, Wolverine Europe Limited, purchased on-going operations and assets of the European CAT ® footwear business from Overland Group Limited of London, England. The markets served directly by Wolverine Europe Limited include Austria, France, Germany, The Netherlands, the United Kingdom and Switzerland, and it will continue to coordinate and oversee support for other European markets served by independently-owned distributors. The Company's owned operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of Company footwear bearing the Hush Puppies ®, Wolverine ®, Bates ®, HyTest ®, Merrell ® and other trademarks by independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the CAT ®, Coleman ® and Harley-Davidson ® trademarks through foreign distributors. License and distribution arrangements enable the Company to develop sales in international markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. In fiscal 2002, the Company's wholly owned foreign operations, together with the Company's foreign licensees and distributors sold an estimated 17 million pairs of footwear, which is consistent with the level of international sales in fiscal 2001. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent with the global brand position. Independent licensees and distributors purchase goods from either the Company or authorized third-party manufacturers pursuant to distribution agreements or manufacture branded products consistent with Company standards pursuant to license agreements. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and manufacture of approximately 75% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the pairs controlled by the Company, approximately 85% are purchased or sourced from third parties, with the remainder produced at Company-owned facilities. Footwear produced by the Company is manufactured at Company-owned facilities in several domestic and certain affiliated foreign facilities located in Michigan, Arkansas, the Dominican Republic and Mexico. For some of the Company-produced footwear, a "twin plant" concept is utilized whereby a majority of the labor intensive cutting and fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Dominican Republic, Arkansas and Mexico and the technology intensive construction, or "bottoming," is performed at the Company's Michigan facilities. +8 +The Company's factories each have the flexibility to produce a variety of footwear, and depart from the industry's historical practice of dedicating a given facility to production of specific footwear products. This flexibility allows the Company to quickly respond to changes in market preference and demand. The Company primarily produces slippers, work and military footwear in its domestic and Caribbean facilities, allowing the Company to respond to both market and customer-specific demand. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, Central and South America, India and Europe. The Company maintains technical offices in the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In addition, the Company has adopted "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +The Company's domestic manufacturing operations allow the Company to (i) reduce its production lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and (iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (i) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (ii) source the highest quality raw materials from around the world, and (iii) avoid additional capital expenditures necessary for owned factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company maximum flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates a pigskin tannery through its Wolverine Leathers Division, which is one of the premier tanners of quality leather for the footwear industry. The Company and its licensees receive virtually all of their pigskin requirements from the tannery. The Company believes the tannery provides a strategic advantage for the Company by producing leather using proprietary technology at prices below those available from other sources. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of common upper materials and specialty leathers eliminates any reliance by the Company upon a sole supplier. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over 30 years. Alternative sources of pigskin are available; however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas and tariffs, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could have an adverse impact on the Company's operations and financial condition. +9 +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear products. The owned trademarks that are most widely used by the Company include Hush Puppies ®, Wolverine ®, Bates ®, Wolverine Fusion ™, DuraShocks ®, Wolverine Compressor™, Hidden Tracks ®, Bounce ®, Comfort Curve ®, HyTest ®, Merrell ®, Track 'N Trail ® and FootRests ®. The Company has obtained license rights to manufacture, market and distribute footwear throughout most countries of the world under the CAT ® and Harley-Davidson ® trademarks; the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark; the right to manufacture, market and distribute slippers in the United States and certain other countries under the Karen Neuburger® trademark; and the right to manufacture, market and distribute footwear in Europe, Asia and the Middle East under the Coleman ® trademark -- all pursuant to license arrangements with the respective trademark owners. All of the Company's licenses are long term and extend for three or more years with conditional renewal options, with the exception of the Karen Neuburger ® license which expires in 2004. Pigskin leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers ®, Weather Tight ® and All Season Weather Leathers ™. +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of ownership of its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever possible and to vigorously defend its trademarks against infringement or other threats to the greatest extent practicable under the laws of the United States and other countries. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent practicable under applicable laws. +Order Backlog. +At March 22, 2003, the Company had a backlog of footwear orders of approximately $266 million compared with a backlog of approximately $233 million at March 23, 2002. Approximately 60 percent of the backlog is related to orders for products expected to be shipped in the third and fourth quarters of 2003 and the first quarter of 2004 and can be affected by the timing of customer requests for shipment of the ordered products. While orders in backlog are subject to cancellation by customers, the Company has not experienced significant cancellation of orders in the past and the Company expects that substantially all of the orders will be shipped in fiscal 2003. The backlog at a particular time is affected by a number of factors, including seasonality, retail conditions, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments. +10 +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States and Europe. The Company has at least ten major competitors in connection with the sale of its work shoes and boots, at least ten major competitors in connection with the sale of its sport boots, and at least thirty major competitors in connection with the sale of its casual, work and outdoor shoes. Product performance and quality, including technological improvements, product identity, competitive pricing, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing efficiencies, its tannery operations, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and no one company has a dominant market position. +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to new and improved materials for use in its branded footwear and other products and in the development and adaptation of new production techniques. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, such as Bounce ®, DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company uses and generates certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites and other regulatory issues. +Employees. +As of December 28, 2002, the Company had approximately 4,426 domestic and foreign production, office and sales employees. Approximately 767 employees were covered by five union +11 +contracts expiring at various dates through March 31, 2004. The Company has experienced no work stoppages since 1990. The Company presently considers its employee relations to be good. +Available Information. +Information about the Company is available at its website, http://www.wolverineworldwide.com . The Company makes available on or through its website, free of charge, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports (along with certain other Company filings with the Securities and Exchange Commission) as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the Securities and Exchange Commission. These filings are also accessible on the SEC's website at www.sec.gov. \ No newline at end of file diff --git a/raw/filings/0000110471/2002/0000905729-03-000154/item13.txt b/raw/filings/0000110471/2002/0000905729-03-000154/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..3bba61698ff7dcdec1a622bfa92088fb658d2dc0 --- /dev/null +++ b/raw/filings/0000110471/2002/0000905729-03-000154/item13.txt @@ -0,0 +1,3 @@ +Item 13. Certain Relationships and Related Transactions . +The information regarding certain loans following the caption "Executive Compensation," under the subheading "Stock Options," and the information contained under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company dated March 17, 2003, are incorporated herein by reference. +26 \ No newline at end of file diff --git a/raw/filings/0000110471/2002/0000905729-03-000154/item9a.txt b/raw/filings/0000110471/2002/0000905729-03-000154/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000110471/2002/0000905729-03-000154/rp_note.txt b/raw/filings/0000110471/2002/0000905729-03-000154/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000110471/2002/0000905729-03-000154/rpt_disclosure.txt b/raw/filings/0000110471/2002/0000905729-03-000154/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..0ba19dfbda37721f629cfe931c10114e638a6c76 --- /dev/null +++ b/raw/filings/0000110471/2002/0000905729-03-000154/rpt_disclosure.txt @@ -0,0 +1,54 @@ +Certain Relationships and Related +Transactions +During 2002, Wolverine engaged J. Walter +Thompson, an international advertising firm, to perform public +relations and marketing services. Wolverine paid $154,081 in +fees and expenses to J. Walter Thompson. Ms. Joan +Parker, a director of Wolverine, was a Senior Partner with +J. Walter Thompson until April 2002. Wolverine does not +anticipate engaging J. Walter Thompson to provide services +in 2003. +Wolverine has entered into an agreement with +Grimoldi, S.A., an Argentinean corporation of which +Mr. Alberto Grimoldi, a director of Wolverine, is a +significant shareholder, granting to Grimoldi, S.A. the +exclusive rights to distribute and sell footwear products in +Argentina under the Hush Puppies ®, +Caterpillar ® and Merrell ® brand names. +Under this agreement, Grimoldi, S.A., or its subsidiary, pays +Wolverine royalties and certain sublicense fees based on sales +or purchases of footwear products in Argentina. +Under the agreement described above, Grimoldi, +S.A. was obligated to pay to Wolverine royalties, sublicense +fees and service fees in 2002 totaling $341,494. +In the ordinary course of business, Wolverine and +its subsidiaries sell footwear for resale, samples, components +of footwear products (such as leather and shoe soles), +advertising materials and miscellaneous items to licensees, +distributors and customers. In 2002, purchases of such items by +Grimoldi, S.A. totaled $95,202 (including any applicable +sublicense fees for products containing licensed proprietary +technology). +All of the transactions described above occurred +pursuant to continuing contractual arrangements between +Wolverine and Grimoldi, S.A. Wolverine expects similar +transactions to occur between Grimoldi, S.A. and Wolverine and +its subsidiaries during 2003. +During 2002, Wolverine and Grimoldi, S.A. agreed +to payment terms with respect to certain trade accounts owed by +Grimoldi, S.A. to Wolverine. Grimoldi, S.A. executed a +three-year note payable to Wolverine in the face amount of +$635,761 which bears interest at 10 percent per annum. As +of March 3, 2003, the aggregate principal balance of the +note was $605,202. +Compensation Committee Interlocks and Insider +Participation +For 2002, Wolverine’s Compensation Committee +consisted of Donald V. Fites, Phillip D. Matthews, +David P. Mehney and Paul D. Schrage. While +Mr. Matthews was not at any time an employee of Wolverine +or its subsidiaries, he served as Chairman of the Board of +Wolverine from 1993 until 1996. Effective following the +February 2003 meeting of the Board of Directors, +Mr. Matthews resigned from the Compensation Committee and +was appointed to the Audit Committee. \ No newline at end of file diff --git a/raw/filings/0000110471/2003/0000905729-04-000147/filing.txt b/raw/filings/0000110471/2003/0000905729-04-000147/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..50d82b91718178cf5bc631594ec4501bc75cf3d0 --- /dev/null +++ b/raw/filings/0000110471/2003/0000905729-04-000147/filing.txt @@ -0,0 +1,3361 @@ +10-K +1 +wwwform10k_031704.htm +WOLVERINE WORLD WIDE FORM 10-K YE 010304 +Wolverine World Wide, Inc. Form 10-K - 03/17/04 +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +___________________ +Form 10-K +[X] +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended January 3, 2004 +[ ] +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: 1-6024 +WOLVERINE WORLD WIDE, INC. +(Exact name of registrant as specified in its charter) +Delaware +(State or other jurisdiction of +incorporation or organization) +38-1185150 +(I.R.S. Employer Identification No.) +9341 Courtland Drive, Rockford, Michigan +(Address of principal executive offices) +49351 +(Zip Code) +Registrant's telephone number, including area code: (616) 866-5500 +Securities registered pursuant to Section 12(b) of the Securities Exchange Act: +Title of each class +Name of each exchange on which registered +Common Stock, $1 Par Value +New York Stock Exchange/Pacific Exchange, Inc. +Securities registered pursuant to Section 12(g) of the Act: None +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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] +Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). +Yes +X +No +The aggregate market value of the registrant's voting stock held by non-affiliates of the registrant based on the closing price on the New York Stock Exchange on June 13, 2003, the last business day of the registrant's most recently completed second fiscal quarter: $742,712,681. +Number of shares outstanding of the registrant's Common Stock, $1 par value (excluding shares of treasury stock) as of March 12, 2004: 39,423,011. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the definitive proxy statement for the registrant's annual stockholders' meeting to be held April 22, 2004, are incorporated by reference into Part III of this report. +FORWARD-LOOKING STATEMENTS +This Report on Form 10-K contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the footwear business, worldwide economics and the Company itself. Statements, including without limitation, those related to: future revenue, earnings, margins, growth and cash flows; expected timing of shipment of products; expected economic returns; projected 2004 operating results and dividend rates; future strength of the Company; expansion of Merrell® shop-in-shops and Track 'N Trail stores; future marketing investments; the introduction of new lines or categories of products; future growth or success in specific countries, categories or market sectors; continued or expected distribution at specific retailers; liquidity; capital resources and market risk are forward-looking statements. In addition, words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "predicts," "projects," "should," "will," variations of such words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("Risk Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. +Risk Factors include, but are not limited to, uncertainties relating to changes in demand for the Company's products; changes in consumer preferences or spending patterns; the cost and availability of inventories, services, labor and equipment furnished to the Company; the cost and availability of contract manufacturers; the cost and availability of raw materials, including leather; the impact of competition and pricing by the Company's competitors; changes in government and regulatory policies; foreign currency fluctuations; changes in trading policies or import and export regulations; changes in interest rates, tax laws, duties, tariffs, quotas or applicable assessments; technological developments; changes in local, domestic or international economic and market conditions; the size and growth of footwear markets; service interruptions at shipping and receiving ports; changes in the amount or severity of inclement weather; changes due to the growth of Internet commerce; popularity of particular designs and categories of footwear; the ability of the Company to manage and forecast its growth and inventories; the ability to secure and protect trademarks, patents and other intellectual property; integration of operations of newly acquired businesses; changes in business strategy or development plans; the ability to attract and retain qualified personnel; labor strikes or disruptions; the ability to retain rights to brands licensed by the Company; loss, bankruptcy and credit limitations of significant customers; relationships with international distributors and licensees; the Company's ability to meet at-once orders; the exercise of future purchase options by the U.S. Department of Defense on previously awarded contracts; the risk of doing business in developing countries and economically volatile areas; domestic and international terrorism and war; retail buying patterns; consolidation in the retail sector; and the acceptability of U.S. brands in international markets. Additionally, concern regarding acts of terrorism, the war in Iraq and subsequent events have created significant global economic and political uncertainties that may have material and adverse effects on consumer demand, foreign sourcing of footwear, shipping and transportation, product imports and exports and the sale of products in foreign markets. These matters are representative of the Risk Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement. Historical operating results are not necessarily indicative of the results that may be expected in the future. The Risk Factors included here are not exhaustive. Other Risk Factors exist, and new Risk Factors emerge from time-to-time, that may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. Furthermore, the Company undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. +2 +PART 1 +Item 1. Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The Company, a Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Consumers around the world purchased more than 41 million pairs of Company branded footwear during fiscal 2003, making the Company a global leader among footwear companies in the marketing of branded casual, work and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort and performance. The products are marketed throughout the world under widely recognized brand names, including Bates ®, CAT ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Sebago ®, Stanley ® and Wolverine ®. The Company believes that its primary competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary designs and comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. The Company's footwear products are organized under five operating units: (i) the Wolverine Footwear Group, focusing on the Bates®, Harley-Davidson®, HyTest®, Stanley® and Wolverine® product lines of work, outdoor and lifestyle boots and shoes, (ii) the Outdoor Group, focusing on the Sebago ® and Merrell ® product lines of performance and lifestyle footwear, (iii) Caterpillar Footwear, focusing on the CAT® product lines of work and lifestyle footwear, (iv) The Hush Puppies Company, focusing on the Hush Puppies ® brand of comfortable casual and dress footwear and slippers, and (v) Other Branded Footwear, focusing on the design and manufacture of private label footwear. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, gloves, handbags and plush toys. +The Company's Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support for the various Company brands. The Company's footwear is distributed domestically through 64 Company-owned retail stores and to numerous accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of the retailers to whom Wolverine distributes operate multiple storefront locations. The Company's products are distributed worldwide in over 140 markets through licensees and distributors. +The Company, through its Wolverine Leathers Division, operates a tannery which is one of the premier tanners of quality pigskin leather for the shoe and leather goods industries. Pigskin leather tanned by the Company is used in a significant portion of the footwear marketed by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of shoes. In addition, Wolverine Procurement, Inc., a Company-owned subsidiary, performs skinning operations and purchases raw pigskins which it then cures and sells to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company that are attached as Appendix A to this Form 10-K. The Company has one reportable segment, +3 +Branded Footwear. The Branded Footwear segment is engaged in manufacturing, sourcing, marketing and distributing branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear. The Company's Other Business units consist of its retail stores, apparel and accessory licensing, tannery and pigskin procurement operations. Financial information regarding the Company's business segments and financial information about geographic areas is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Form 10-K. +Branded Footwear. +The Company sources and markets a broad range of footwear styles including shoes, boots, slippers, moccasins and sandals under many recognizable brand names including Bates ®, CAT ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Sebago ®, Stanley ® and Wolverine ®. The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications at both Company-owned and independent manufacturing facilities. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, handbags and plush toys. Current significant licensing programs include Hush Puppies ® apparel, eyewear, watches and plush toys, and Wolverine ® brand apparel, gloves, watches and eyewear. +The Company's five branded footwear operating units are described below. +1. Wolverine Footwear Group . The Wolverine Footwear Group encompasses footwear primarily under the Wolverine ®, Bates ®, HyTest ®, Harley-Davidson ®, and Stanley ® brands and markets footwear designed with performance and comfort features to serve a variety of work, outdoor and lifestyle functions. +Wolverine ® Work and Industrial Footwear . The Wolverine ® brand has built its reputation by offering high quality work boots and shoes that incorporate innovative technologies to deliver comfort and durability. The Wolverine ® brand, which has been in existence for 120 years, markets work and outdoor footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® technology has allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The Wolverine Fusion® , DuraShocks SR™ and Wolverine Compressor™ technologies continue the Company's tradition of comfortable work and industrial footwear. The Wolverine® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female industrial and farm workers. The Wolverine ® rugged casual and outdoor sport product lines also incorporate DuraShocks ® technology and other comfort features into products designed for casual and outdoor sport use. The rugged casual line targets active lifestyles and includes walking shoes, rugged casuals and outdoor sandals. The outdoor sport line is designed to meet the demands of hunters, fishermen and other active outdoor sportsmen and women. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® and Thinsulate ® brand fabrics, the Company's performance leathers and patented DuraShocks ® technologies. In addition, the Wolverine ® brand is licensed for use on apparel, eyewear, watches and gloves. +Bates ® Uniform Footwear . The Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes DuraShocks ®, DuraShocks SR ™, CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and +4 +oxfords including the Bates ®, Enforcer Series ® and Special Ops ™ footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and the militaries of several foreign countries to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial occupations. Bates Uniform Footwear Division's products are also distributed through specialty retailers and catalogs. +HyTest ®. The HyTest ® product line consists primarily of high-quality work boots and shoes designed to protect male and female industrial workers from foot injuries. HyTest ® footwear incorporates various specialty safety features into its product lines, including steel toe, composite toe, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology to provide comfort together with safety for working men and women. HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company's occupational and work footwear brands to workers at industrial facilities and also through direct sales arrangements with large industrial customers. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson ® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work, military and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a network of independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. +Stanley ® Footgear . Pursuant to a license arrangement with The Stanley Works, the Company has exclusive rights to manufacture, market, distribute and sell footwear under the Stanley® brand. The Stanley® Footgear line is designed primarily for and marketed in the value-priced work footwear market. Stanley® Footgear is currently sold in Payless ShoeSource, Inc. stores throughout the United States. +2. The Outdoor Group . The Outdoor Group, which includes Merrell ® and Sebago ® footwear, was established as a separate operating unit of the Company in November 2003, following the Company's acquisition of Sebago, Inc. The Merrell ® product line consists primarily of technical hiking, rugged outdoor and outdoor-inspired casual footwear designed for backpacking, day hiking and everyday use. The Merrell ® product line also includes the "After-Sport" category, incorporating Merrell ® footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers™ and other technical materials to create footwear with unique styling, performance and comfort features. Merrell ® products are sold primarily through outdoor specialty retailers, department stores and catalogs. Merrell ® footwear is marketed in over 120 countries worldwide. +The Sebago ® product line consists primarily of performance nautical and American-inspired casual footwear. Sebago ® brand classic American footwear for men and women such as handsewn loafers and boat shoes have been manufactured and distributed since 1946. Highly recognized Sebago ® line extensions include Docksides , Drysides and Campsides. The Sebago ® product line is distributed in over 85 countries worldwide. The Sebago ® manufacturing and design tradition of quality componentry, durability, comfort and "Americana" heritage is further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. +5 +3. Caterpillar Footwear . Caterpillar Footwear was established as a separate operating unit of the Company in October 2002. Pursuant to a license arrangement with Caterpillar Inc., the Company has exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ®, CAT & Design ®, Walking Machines ® and other trademarks. The Company believes the association with CAT ® equipment enhances the reputation of its boots for quality, ruggedness and durability. CAT ® brand footwear products include work boots and shoes, sport boots, rugged casuals and lifestyle footwear. In addition, the Company also manufactures and markets CAT ® and Marine Power ® footwear, designed for industrial and recreational marine uses. CAT ® footwear products target work and industrial users and active lifestyle users. CAT® footwear is marketed in over 120 countries worldwide. +4. The Hush Puppies Company . Over its 46-year heritage, the Hush Puppies ® brand has been a pioneer of comfortable casual footwear. The diverse product line includes numerous styles for both dress and casual wear and utilizes comfort features, such as the Comfort Curve ® sole, Float Fx ®, patented Bounce ® technology and lightweight Zero-g ™ constructions. Hush Puppies ® shoes and slippers are marketed to men, women and children in over 100 countries through department stores, catalogs, and independent retailers. In addition, the Hush Puppies ® brand is licensed for use on apparel, eyewear, watches and plush toys. +5. Other Branded Footwear . The Company designs and manufactures constructed slippers, aftersport footwear, moccasins and children's footwear on a private label basis according to customer specifications. The styling of the Company's footwear reflects consumer demand for the "rugged indoor" look by using natural leathers such as moosehide, shearling and suede in constructed slipper and indoor and outdoor moccasin designs. In addition to its traditional line of private label products, the Company has developed a College Clogs™ program for the sale of licensed collegiate slipper products. +Other Businesses. +In addition to manufacturing, sourcing, marketing and distributing the Company's footwear products as reported in the Branded Footwear segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly-owned subsidiary Wolverine Procurement, Inc., and (iii) operates 64 domestic retail footwear stores. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces pigskin leathers primarily for use in the footwear industry. Wolverine Leathers® brand products are primarily manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes these leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof and stain resistant leathers are featured in many of the Company's domestic footwear lines and many products offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +6 +3. Wolverine Retail . The Company operates 64 domestic retail shoe stores as of February 2004, consisting of 60 factory outlet stores under the Hush Puppies and Family SM name, and four specialty stores under the Track 'N Trail® name. The Company expects to open at least six new Track 'N Trail® stores in 2004. With the exception of the possible expansion of the Track 'N Trail® concept, the Company expects the scope of its retail operations to remain relatively consistent in the foreseeable future. Most of the Company's 60 factory outlet stores carry a large selection of first quality Company branded footwear at discounted retail prices. The Track 'N Trail® stores feature Company brands such as Wolverine® , Merrell® , Hush Puppies® , CAT® , Sebago® and Harley-Davidson® . These stores also carry a selection of branded footwear from other manufacturers. The Company also operates the direct-to-customer retail websites described below. +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States and international markets to foster a differentiated and consistent image for each of the Company's core footwear brands. Each footwear brand group has its own marketing personnel who develop the marketing strategy for products within that group. Marketing campaigns and strategies vary by brand and may target accounts and/or end users as they strive to increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's footwear. Components of the brand-specific plans vary and may include print, radio and television advertising, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's footwear brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance that may be provided by the Company to its licensees and distributors are (i) direction on the categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting on retail store layout and design. The Company believes its footwear brand names provide a competitive advantage and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution. +The Company uses a wide variety of distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses the following distribution strategies. +• +Traditional wholesale distribution is used to service department stores, large footwear chains, specialty retailers, catalogs, independent retailers and uniform outlets. A dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide branded and private label footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchant and government customers. +7 +• +A network of independent Shoemobile ® distribution outlets is used to distribute the Company's work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and enters bids for contracts to supply specific footwear products. +In addition to its wholesale activities, the Company also operates domestic retail shoe stores as described above. The Company is developing various programs, both independently and with its retail customers, for the distribution of its products over the Internet and operates direct-to-customer sites at www.upfootgear.com, www.hytest.com, www.wolverinebootsandshoes.com, www.wolverine.com, www.trackandtrail.com, www.hushpuppies.com and www.catfootwear.com. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's revenue in fiscal 2003. +Footwear sales are seasonal with significant increases in sales experienced during the U.S. fall and spring seasons. Due to this seasonal nature of footwear sales, the Company experiences some fluctuation in its levels of working capital. The Company provides working capital for such fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects the seasonal sales pattern to continue in future years. +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of sales of branded footwear products generated from the Company's owned operations in Canada, the United Kingdom, Austria, France, Germany, the Netherlands, Belgium, Luxemburg, Spain and Switzerland and from royalty income through a network of independent licensees and distributors. The Company's owned operations include Hush Puppies (UK) Ltd., Merrell Europe B.V., Merrell (Europe) Limited, Hush Puppies Canada Footwear, Ltd., and the Merrell Canada division. In addition, in January 2002, the Company established a new subsidiary to manage the CAT ® footwear brand in the European market. This new subsidiary, Wolverine Europe Limited, purchased ongoing operations and assets of the European CAT® footwear business from Overland Group Limited of London, England. Wolverine Europe Limited will continue to coordinate and oversee support for other European markets served by independently-owned distributors. The Company's owned operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of Company footwear bearing the Hush Puppies ®, Wolverine ®, Bates ®, HyTest ®, Merrell ® and other trademarks by independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the CAT ®, and Harley-Davidson ® trademarks through foreign distributors. License and distribution arrangements enable the Company to develop sales in international markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. In fiscal 2003, the Company's wholly-owned foreign operations, together with the Company's foreign licensees and distributors, sold an estimated 19.6 million pairs of footwear. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent with the global brand position. Independent licensees and distributors purchase goods from either the Company or authorized third-party manufacturers pursuant to distribution agreements or manufacture branded products consistent with Company standards pursuant to license agreements. +8 +Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and manufacture of approximately 73% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the pairs controlled by the Company, approximately 88% are purchased or sourced from third parties, with the remainder produced at Company-owned facilities. Footwear produced by the Company is manufactured at Company-owned facilities in several domestic and certain affiliated foreign facilities located in Michigan, Arkansas, and the Dominican Republic. For some of the Company-produced footwear, a "twin plant" concept is utilized whereby a majority of the labor intensive cutting and fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Dominican Republic and Arkansas, and the technology intensive construction, or "bottoming," is performed at the Company's Michigan facilities. +The Company's factories each have the flexibility to produce a variety of footwear, which departs from the industry's historical practice of dedicating a given facility to production of specific footwear products. This flexibility allows the Company to quickly respond to changes in market preference and demand. The Company currently produces slippers, military footwear and work, casual and dress casual footwear in its domestic and/or Dominican Republic facilities. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, Central and South America, India and Europe. The Company maintains technical offices in the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In addition, the Company has adopted "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +The Company's domestic manufacturing operations allow the Company to (i) reduce its production lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and (iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (i) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (ii) source the highest quality raw materials from around the world, and (iii) avoid additional capital expenditures necessary for owned factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company maximum flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates a pigskin tannery through its Wolverine Leathers Division, which is one of the premier tanners of quality leather for the footwear industry. The Company and its licensees receive virtually all of their pigskin requirements from the tannery. The Company believes the tannery provides a strategic advantage for the Company by producing pigskin leather using proprietary technology at prices below those available from other sources. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of common upper materials and specialty leathers eliminates any reliance by the Company +9 +upon a sole supplier. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over 30 years. Alternative sources of pigskin are available; however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas and tariffs, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could have an adverse impact on the Company's operations and financial condition. +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear products. The owned trademarks that are most widely used by the Company include Hush Puppies ®, Wolverine ®, Bates ®, Wolverine Fusion ®, DuraShocks ®, Wolverine Compressor™, Hidden Tracks ®, Bounce ®, Comfort Curve ®, HyTest ®, Merrell ®, Sebago ®, and Track 'N Trail ®. The Company has obtained license rights to manufacture, market and distribute footwear throughout the world under the CAT ® and Harley-Davidson ® trademarks, and the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark, all pursuant to license arrangements with the respective trademark owners. The CAT ®, Harley-Davidson ®, and Stanley® licenses are long-term and extend for five or more years with conditional renewal options and are subject to early termination for breach. Pigskin leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers ®, Weather Tight ® and All Season Weather Leathers ™. +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of ownership of its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever possible and to vigorously defend its trademarks against infringement or other threats to the greatest extent practicable under the laws of the United States and other countries. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent practicable under applicable laws. +Order Backlog. +At March 13, 2004, the Company had a backlog of footwear orders of approximately $274 million compared with a backlog of approximately $233 million at March 8, 2003. Substantially all of the backlog relates to orders for products expected to be shipped in 2004. While orders in backlog are subject to cancellation by customers, the Company has not experienced significant cancellation of orders in the past. The backlog at a particular time is affected by a number of factors, including seasonality, retail conditions, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments. +10 +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States and Europe. The Company has at least ten major competitors in connection with the sale of its work shoes and boots, at least ten major competitors in connection with the sale of its sport boots, and at least thirty major competitors in connection with the sale of its casual, work and outdoor shoes. Product performance and quality, including technological improvements, product identity, competitive pricing, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing efficiencies, its tannery operations, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and no one company has a dominant market position. +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to the development of new production techniques and to improving the function, performance, reliability and quality of its branded footwear and other products. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, such as Bounce ®, DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company uses and generates certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites and other regulatory issues. +Employees. +As of January 3, 2004, the Company had approximately 4,784 domestic and foreign production, office and sales employees. Approximately 634 employees were covered by four union contracts expiring at various dates through May 1, 2006. The Company presently considers its employee relations to be good. +11 +Available Information. +Information about the Company, including the Company's Code of Conduct & Compliance, Corporate Governance Guidelines, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, Executive Committee Charter and Governance Committee Charter, is available at its website, http://www.wolverineworldwide.com . Printed copies of the documents listed above are available by writing to the Company at 9341 Courtland Drive, N.E., Rockford, MI 49351, Attention: Director of Investor Relations. +The Company also makes available on or through its website, free of charge, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports (along with certain other Company filings with the Securities and Exchange Commission ("SEC")) as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These filings are also accessible on the SEC's website at www.sec.gov. +Item 2. Properties . +The Company operates its domestic administration, sales and marketing operations primarily from an owned facility of approximately 225,000 square feet in Rockford, Michigan. The Company's manufacturing operations are primarily conducted at its owned pigskin tannery in Rockford, Michigan, and a combination of leased and owned footwear manufacturing facilities in Arkansas, Michigan and the Dominican Republic. The Company operates its warehousing operations primarily through owned warehouses in Rockford, Michigan, totaling approximately 475,000 square feet, a leased warehouse in Cedar Springs, Michigan, of approximately 362,000 square feet and a leased warehouse in Howard City, Michigan, of approximately 350,000 square feet. +The Company also leases and owns various other offices and warehouses in the United States to meet its operational requirements. In addition, the Company's subsidiary, Hush Puppies Retail, Inc., operates retail stores through leases with various third-party landlords. International operations are conducted in Canada, the United Kingdom, and Europe through leased warehouses, offices and showrooms. The Company believes that its current facilities are suitable and adequate for its current needs. +Item 3. Legal Proceedings . +The Company is involved in litigation and various legal matters arising in the normal course of business, including certain environmental compliance activities. The Company has considered facts related to legal and regulatory matters and opinions of counsel handling these matters, and does not believe the ultimate resolution of such proceedings will have a material adverse effect on the Company's financial condition or future results of operations. +Item 4. Submission of Matters to a Vote of Security Holders . +No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report. +Supplemental Item. Executive Officers of the Registrant . +The following table lists the names and ages of the Executive Officers of the Company as of January 3, 2004, and the positions presently held with the Company. The information provided below the +12 +table lists the business experience of each such Executive Officer during the past five years. All Executive Officers serve at the pleasure of the Board of Directors of the Company, or if not appointed by the Board of Directors, they serve at the pleasure of management. +Name +Age +Positions held with the Company +Steven M. Duffy +51 +Executive Vice President and President, +Global Operations Group +V. Dean Estes +54 +Vice President and President, +Wolverine Footwear Group +Stephen L. Gulis, Jr. +46 +Executive Vice President, Chief Financial +Officer and Treasurer +Blake W. Krueger +50 +Executive Vice President, Secretary, and +President, Caterpillar Footwear +Timothy J. O'Donovan +58 +Chief Executive Officer and President +Nicholas P. Ottenwess +41 +Vice President of Finance and Corporate +Controller +Robert J. Sedrowski +54 +Vice President of Human Resources +James D. Zwiers +36 +General Counsel and Assistant +Secretary +Steven M. Duffy has served the Company as Executive Vice President since April 1996 and is President of the Company's Global Operations Group. From 1993 to 1996 he served as Vice President. From 1989 to 1993 he served in various senior manufacturing positions. +V. Dean Estes has served the Company as Vice President since 1995. Mr. Estes is also President of the Wolverine Footwear Group. Since he joined the Company in 1975, Mr. Estes has served in various positions relating to the sales, marketing and product development functions of the Company's work boot and shoe related businesses. +Stephen L. Gulis, Jr., has served the Company as Executive Vice President, Chief Financial Officer and Treasurer since April 1996. From 1994 to April 1996 he served as Vice President and Chief Financial Officer. From 1993 to 1994 he served as Vice President of Finance and Corporate Controller and from 1986 to 1993 he was the Vice President of Administration and Controller for The Hush Puppies Company. +Blake W. Krueger has served the Company as Executive Vice President, Secretary and President of Caterpillar Footwear since November 2003. From April 1996 to November 2003 he served the Company as Executive Vice President, General Counsel and Secretary. From 1993 to April 1996 he served as General Counsel and Secretary. From 1985 to 1996 he was a partner with the law firm of Warner Norcross & Judd LLP. +Timothy J. O'Donovan has served the Company as Chief Executive Officer and President since April 2000. From 1996 to April 2000 he served as Chief Operating Officer and President. From 1982 to April 1996 he served as Executive Vice President. +Nicholas P. Ottenwess has served the Company as Vice President of Finance and Corporate Controller since June 2001. From September 1997 to June 2001 he served as Corporate Controller. From 1993 to September 1997 he served as Vice President of Finance and Administration for The Hush Puppies Company. +13 +Robert J. Sedrowski has served the Company as Vice President of Human Resources since October 1993. From 1990 to 1993 he served as Director of Human Resources. +James D. Zwiers has served the Company as General Counsel and Assistant Secretary since December 2003. From January 1998 to December 2003 he served the Company as Associate General Counsel and Assistant Secretary. From 1995 to 1998 he was an attorney with the law firm of Warner Norcross & Judd LLP. +PART II +Item 5. +Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +The Company's common stock is traded on the New York Stock Exchange and the Pacific Exchange under the symbol "WWW." The following table shows the high and low sales prices on the New York Stock Exchange and dividends declared by calendar quarter for 2003 and 2002. The number of stockholders of record on March 1, 2004, was 1,597. +2003 +2002 +Stock price +High +Low +High +Low +First quarter +$ +17.58 +$ +14.29 +$ +18.23 +$ +14.00 +Second quarter +19.30 +16.05 +19.25 +15.80 +Third quarter +21.00 +18.52 +17.72 +12.55 +Fourth quarter +21.59 +19.50 +17.24 +13.42 +Cash Dividends Declared Per Share: +2003 +2002 +First quarter +$ +.055 +$ +.045 +Second quarter +.055 +.045 +Third quarter +.055 +.045 +Fourth quarter +.055 +.045 +A quarterly dividend of $.065 per share was declared during the first quarter of fiscal 2004. +See Item 12 for information with respect to the Company's equity compensation plans. +14 +Item 6. Selected Financial Data . +Five-Year Operating and Financial Summary (1) +2003 +2002 +2001 +2000 +1999 +(Thousands of Dollars, Except Per Share Data) +Summary of Operations +Revenue +$ +888,926 +$ +827,106 +$ +720,066 +$ +701,291 +$ +665,576 +Net earnings +51,716 +47,912 +45,240 +10,690 +32,380 +Per share of common stock: +Basic net earnings (2) +$ +1.32 +$ +1.19 +$ +1.11 +$ +.26 +$ +.80 +Diluted net earnings (2) +1.27 +1.15 +1.07 +.26 +.78 +Cash dividends declared +.22 +.18 +.16 +.14 +.12 +Financial Position at Year End +Total assets +$ +578,881 +$ +531,994 +$ +543,678 +$ +494,568 +$ +534,395 +Long-term debt +59,923 +72,915 +90,848 +92,194 +139,201 +Notes to Five-Year Operating and Financial Summary +1. +This summary should be read in conjunction with the consolidated financial statements and the notes thereto, which are attached as Appendix A to this Form 10-K. In particular, see the discussions of the fiscal 2000 $45.0 million realignment charge as discussed in the Company's 2000 Form 10-K filed with the Securities and Exchange Commission ("SEC"), the $14.0 million realignment charge to exit the Company's Russian wholesale footwear operation as discussed in the Company's 1999 Form 10-K filed with the SEC and Note 11 - Business Acquisitions. +2. +Basic earnings per share are based on the weighted average number of shares of common stock outstanding during the year after adjustment for nonvested common stock. Diluted earnings per share assume the exercise of dilutive stock options and the vesting of all outstanding common stock. +15 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. +OVERVIEW +During 2003, Wolverine World Wide, Inc. (the "Company") achieved record revenue and earnings. Revenue grew 7.5% to $888.9 million, marking a fourth consecutive year of record performance. Earnings per share growth extended for a third consecutive year, improving 10.4% to $1.27 per share. The Company ended 2003 with $55.4 million in cash on hand and a debt balance at a seven-year low. It was also the fifth consecutive year of positive cash generation with cash from operations exceeding $102 million for 2003. Asset management programs contributed to reductions in year-end accounts receivable and inventory balances of 6.0% and 2.4%, respectively. +These results are being driven by the Company's strategic growth plan unveiled several years ago. This plan is focused on transforming Wolverine World Wide into the premier company in the non-athletic segment of the global footwear market. The key growth strategies of this plan include: +• +Establishing a stronger presence in Europe - European-based wholesale operations represented over 16% of the Company's 2003 revenue and accounted for nearly one-third of the year-over-year revenue increase. +• +Achieving product excellence from design through execution - The Company's product development process allows for more frequent introductions of tightly focused product collections to attract new customers by maintaining a fresh appearance at retail. This strategy also contributed to lower inventory levels and fewer overall style and size requirements. Improvements in the global supply chain have shortened lead times and improved product quality. +• +Securing new sources of growth - In November 2003, the Company strengthened its brand portfolio with the acquisition of Sebago ® , which together with its Docksides ® line, is recognized globally as a leader in performance marine and American-inspired handcrafted footwear. A stronger consumer-direct business is being built to showcase the Company's brands, including the rollout of 60 Merrell shop-in-shops in select, upper-tier retailers in the U.S. The Company is also testing a new retail concept for the outdoor enthusiast, Track 'N Trail ® , in several Midwest locations. +• +Providing "Best in Class" service to our customers - Investments in business systems are helping to leverage customer service into a competitive advantage. +• +Building a strong team and company culture - The Company strengthened its global branded sales and marketing teams through the recruitment of several highly-skilled top managers and executives with solid industry track records. +Looking ahead, the Company is pursuing this strategic growth plan built on a foundation of the rigorous pursuit of product, marketing and service excellence with the goal of fueling the growth of the Company's portfolio of global brands. This plan is focused on creating stockholder value through the delivery of consistent revenue and earnings growth, improved operating leverage, effective asset utilization and strong cash generation. The three-year growth goals include: +• +Producing revenue growth averaging mid- to upper-single digits annually - The Company expects this growth to be generated through global expansion and market share gains from branded operations. +• +Generating earnings growth at approximately 1.5 times the rate of revenue growth - The Company expects to achieve this through gross margin expansion while controlling selling, general and administrative costs. +• +Driving the global growth of the Company's brands through investments in marketing and product development - Over the next three years, the Company plans to increase its investment in marketing at a rate faster than revenue growth by reinvesting a portion of margin gains into brand building activities. +16 +The following is a discussion of the Company's results of operations and liquidity and capital resources. This section should be read in conjunction with the consolidated financial statements and notes. +RESULTS OF OPERATIONS - FISCAL 2003 COMPARED TO FISCAL 2002 +Financial Summary - 2003 versus 2002 +2003 +2002 +Change +$ +% +$ +% +$ +% +(Millions of Dollars, Except Per Share Data) +Revenue +Branded Footwear +$ +809.7 +91.1 +% +$ +746.2 +90.2 +% +$ +63.5 +8.5 +% +Other business units +79.2 +8.9 +% +80.9 +9.8 +% +(1.7 +) +(2.1 +%) +Total revenue +$ +888.9 +100.0 +% +$ +827.1 +100.0 +% +$ +61.8 +7.5 +% +Gross margin +Branded Footwear +$ +297.2 +36.7 +% +$ +262.5 +35.2 +% +$ +34.7 +13.2 +% +Other business units +29.4 +37.1 +% +31.7 +39.2 +% +2.3 +(7.3 +%) +Total gross margin +$ +326.6 +36.7 +% +$ +294.2 +35.6 +% +$ +32.4 +11.0 +% +Selling and administrative expenses +$ +246.7 +27.7 +% +$ +217.2 +26.3 +% +$ +29.5 +13.6 +% +Interest expense +5.5 +0.6 +% +6.5 +0.8 +% +(1.0 +) +(15.3 +%) +Other income-net +0.7 +0.1 +% +1.0 +0.1 +% +(0.3 +) +(34.4 +%) +Earnings before income taxes and +minority interest +75.1 +8.5 +% +71.7 +8.7 +% +3.4 +4.9 +% +Net earnings +51.7 +5.8 +% +47.9 +5.8 +% +3.8 +7.9 +% +Diluted earnings per share +$ +1.27 +$ +1.15 +$ +0.12 +10.4 +% +The Company has one reportable segment that is engaged in manufacturing, sourcing, marketing and distributing branded footwear. Within the Branded Footwear segment, the Company has identified five branded footwear operating units, consisting of the Wolverine Footwear Group (comprised of the Bates®, Hytest®, Harley-Davidson®, Stanley® and Wolverine® brands), the Outdoor Group (comprised of the Merrell® and Sebago® brands), CAT Footwear, The Hush Puppies Company, and Other Branded Footwear. The Company's other business units consist of Hush Puppies Retail, Apparel and Accessory Licensing, Wolverine Leathers and Wolverine Procurement. The following is supplemental information on revenue by the Branded Footwear operating units: +Revenue - Branded Footwear Operating Units +2003 +2002 +Change +$ +% +$ +% +$ +% +(Millions of Dollars) +Wolverine Footwear Group +$ +299.6 +33.7 +% +$ +283.5 +34.3 +% +$ +16.1 +5.7 +% +Outdoor Group +223.2 +25.1 +% +180.0 +21.8 +% +43.2 +24.0 +% +CAT Footwear +106.9 +12.0 +% +109.2 +13.2 +% +(2.3 +) +(2.1 +%) +The Hush Puppies Company +137.9 +15.5 +% +131.9 +15.9 +% +6.0 +4.6 +% +Other Branded Footwear +42.1 +4.8 +% +41.6 +5.0 +% +0.5 +1.2 +% +Total Branded Footwear revenue +$ +809.7 +91.1 +% +$ +746.2 +90.2 +% +$ +63.5 +8.5 +% +17 +REVENUE +Revenue for 2003 increased $61.8 million over 2002. Increases in unit volume, changes in product mix and changes in selling price for the Branded Footwear operations as discussed below, contributed $44.8 million of the revenue increase. The impact of translating foreign denominated revenue to U.S. dollars improved revenue by $15.6 million. The acquisition of Sebago added $3.1 million to revenue. These increases were offset by a $1.7 million decrease in other business units. Both domestic and international revenue increased, with international revenue accounting for 24.1% of total revenue. +The Wolverine Footwear Group's revenue increase was largely due to the success of the Bates and Harley-Davidson divisions. The Bates® brand improvements were driven by increased shipments of technical boot products to the U.S. Military and tactical ultra-light uniform footwear for the civilian uniform market. Revenue from Harley-Davidson® footwear improved due to expanded product offerings in the existing Harley-Davidson® dealerships, as well as new distribution channels. Wolverine® Boots and Shoes (including Hytest® and Stanley®) recognized an increase in units sold, but experienced a slight decline in revenue dollars per unit sold reflecting a continued shift in the marketplace to more moderately priced footwear. +The Outdoor Group reported its sixth consecutive year of double-digit revenue growth. The Merrell U.S. footwear business accounted for approximately half of the increase, with growth coming from the outdoor/sporting goods and department store distribution channels. The Merrell® European and Canadian wholesale businesses also contributed to the increase, due to the expansion of multi-sport and casual footwear product sales. Revenue from the Merrell International business increased with Italy, Japan, Argentina and Sweden/Finland each recognizing over a 100,000 pair increase from the prior year. Sebago®, which was purchased in November 2003, also contributed to the revenue increase for the Outdoor Group. +CAT Footwear's revenue decrease was due to lower sales in the CAT U.S. wholesale business primarily caused by a reduction in shipments of work and industrial product resulting from cautious inventory reorders by large national chain retailers. The CAT® international distributor business reported improved revenues, reflecting an increase in pairs sold in Canada, South Africa, Saudi Arabia, Mexico and the Pacific Rim. The CAT European business recognized an increase in revenue reflecting the impact of translating foreign denominated revenue to U.S. dollars. +The Hush Puppies Company's increase was generated primarily from the international divisions as a result of expanded retail distribution and higher royalty income from international licensees in the Pacific Rim and Europe. Within The Hush Puppies Company's foreign wholesale operations, Hush Puppies U.K. reported strong increases in revenue as a result of expanded distribution of its better grade products while Hush Puppies Canada revenue was up slightly for the year. Hush Puppies U.S. experienced a slight decrease in revenue as it continued to transition from lower priced, more mature products in favor of higher priced, better grade footwear aimed at a younger, more contemporary consumer. +Revenue for other branded footwear increased slightly due to higher shipments of slippers and other footwear to a key U.S. catalog retailer. +Within the Company's other business units, Hush Puppies Retail reported an increase in revenue as a result of same store revenue increases of 2.3% and new store openings. Wolverine Leathers and Wolverine Procurement recorded decreases in revenue due to reduced market demand for sueded leather used for footwear. Revenue for Apparel and Accessory Licensing increased due primarily to the expansion of Wolverine® branded rugged apparel. +18 +As a result of increases in customer orders for future delivery, the Company ended 2003 with unshipped orders 19% above 2002 year-end levels. The purchase of Sebago® contributed 4% of the increase in unshipped orders. +GROSS MARGIN +The gross margin dollar and percentage increases for the Branded Footwear segment relate to the increased sales mix of the Company's lifestyle product offerings, fewer required markdowns on slow moving inventories and favorable foreign exchange rate changes. The gross margin percentage for the other business units decreased as a result of inefficiencies and overhead absorption losses experienced in the Wolverine Leathers operation due to reduced production levels. Hush Puppies Retail, Wolverine Procurement and Apparel and Accessory Licensing gross margin levels remained flat. +SELLING AND ADMINISTRATIVE EXPENSES +The increase in selling and administrative expenses includes planned increases of $7.3 million in pension expense, due to reductions in the market value of assets and interest rates used in the actuarial valuation, and $2.3 million in employee benefit costs. The impact of translating foreign denominated operating expense to U.S. dollars increased total expenses by $6.6 million (0.2%) in 2003. The remaining increase relates primarily to selling and distribution costs which are directly variable to the increase in revenue. +INTEREST, OTHER & TAXES +The decrease in interest expense reflects lower average outstanding amounts on senior notes and minimal borrowing under the revolving credit facility. +The change in other income primarily relates to the change in realized gains or losses on foreign currency transactions. +The Company's 2003 effective income tax rate was 31.0% compared to 32.9% for 2002. This reduced effective tax rate reflects the overall profit mix from the Company's foreign entities and the impact of research and development tax credits recorded in 2003. The Company expects the research and development tax credit will have an ongoing positive benefit. The estimated annualized effective tax rate for fiscal 2004 is 32.0%. +Net earnings improved as a result of the changes discussed above. All of the Company's major Branded Footwear operations contributed to record results for the year and the Company's strategy of building a strong portfolio of global footwear brands continues to gain momentum. +19 +RESULTS OF OPERATIONS - FISCAL 2002 COMPARED TO FISCAL 2001 +Financial Summary - 2002 versus 2001 +2002 +2001 +Change +$ +% +$ +% +$ +% +(Millions of Dollars, Except Per Share Data) +Revenue +Branded Footwear +$ +746.2 +90.2 +% +$ +644.8 +89.5 +% +$ +101.4 +15.7 +% +Other business units +80.9 +9.8 +% +75.3 +10.5 +% +5.6 +7.5 +% +Total revenue +$ +827.1 +100.0 +% +$ +720.1 +100.0 +% +$ +107.0 +14.9 +% +Gross margin +Branded Footwear +$ +262.5 +35.2 +% +$ +229.5 +35.6 +% +$ +33.0 +14.4 +% +Other business units +31.7 +39.2 +% +27.5 +36.6 +% +4.2 +15.1 +% +Total gross margin +$ +294.2 +35.6 +% +$ +257.0 +35.7 +% +$ +37.2 +14.5 +% +Selling and administrative expenses +$ +217.2 +26.3 +% +$ +182.2 +25.3 +% +$ +35.0 +19.2 +% +Interest expense +6.5 +0.8 +% +6.7 +0.9 +% +(0.2 +) +(4.1 +%) +Other income-net +1.0 +0.1 +% +0.4 +0.1 +% +(0.6 +) +142.7 +% +Earnings before income taxes +and minority interest +71.7 +8.7 +% +68.5 +9.5 +% +3.2 +4.5 +% +Net earnings +47.9 +5.8 +% +45.2 +6.3 +% +2.7 +5.9 +% +Diluted earnings per share +$ +1.15 +$ +1.07 +$ +0.08 +7.5 +% +The European acquisitions discussed in Note 11 to the consolidated financial statements increased 2002 revenue by 10%. Revenue for the Company's Branded Footwear businesses increased in 2002, of which 11.2% related to the European acquisitions. The Company's other business units also reported an increase in revenue in 2002. The following is supplemental information on revenue by the Branded Footwear operating units: +Revenue - Branded Footwear Operating Units +2002 +2001 +Change +$ +% +$ +% +$ +% +(Millions of Dollars) +Wolverine Footwear Group +$ +283.5 +34.3 +% +$ +286.0 +39.7 +% +$ +(2.5 +) +(0.9 +%) +Outdoor Group +180.0 +21.8 +% +135.0 +18.7 +% +45.0 +33.3 +% +CAT Footwear +109.2 +13.2 +% +47.3 +6.6 +% +61.9 +130.8 +% +The Hush Puppies Company +131.9 +15.9 +% +129.7 +18.0 +% +2.2 +1.7 +% +Other Branded Footwear +41.6 +5.0 +% +46.8 +6.5 +% +(5.2 +) +(11.1 +%) +Total Branded Footwear revenue +$ +746.2 +90.2 +% +$ +644.8 +89.5 +% +$ +101.4 +15.7 +% +REVENUE +Within the Wolverine Footwear Group, Harley-Davidson Footwear reported double-digit revenue gains due to increased product demand from the Harley-Davidson® specialty retailer network and expanded distribution in the department store channel. Bates® also generated a double-digit increase in revenue as a result of fulfilling contractual orders from the Department of Defense and increased demand in the civilian sector. Wolverine® Boots and Shoes (including Hytest®) experienced a decline in revenue resulting from a planned exit and refocusing of underperforming product lines, a general softness in the +20 +industrial work boot market and a shift in product mix toward lower price point products. Stanley® Footgear reported a small reduction in revenue reflecting cautious inventory purchases made by its primary retail customer during the first three quarters of 2002. +In the Outdoor Group, Merrell Performance Footwear reported the fifth consecutive year of double-digit revenue growth. The Merrell U.S. footwear business accounted for approximately 70% of the increase as a result of strong consumer demand and the expansion of product offerings with existing footwear retailers. The Merrell international businesses accounted for the remaining increase, benefiting from the full year results of the 2001 Merrell Europe acquisition. +The CAT European business, which was acquired in January 2002, accounted for the increase in CAT Footwear. The CAT® Footwear wholesale business in the U.S. reported a decrease in revenue for the full year 2002. However, the CAT® U.S. business experienced a double-digit revenue increase in the second half of 2002 resulting from a new strategic brand plan focused on a younger lifestyle consumer. The CAT international distribution business reported decreased revenue, reflecting a reduction of pairs sold in Mexico, South America and the Pacific Rim. +The Hush Puppies Company reported an increase in revenue generated primarily from the Hush Puppies U.K. and Hush Puppies Canada wholesale operations as a result of expanded product distribution and heightened consumer demand. Hush Puppies International recorded an increase in revenue reflecting strong licensing results in Germany, Mexico and Australia. Hush Puppies U.S. reported a decline in revenue, as management continued to execute the repositioning of the brand's product line, distribution channels and identity. Management believes these initiatives are taking hold as Hush Puppies U.S. reported an increase in revenue for the second half of 2002 as compared to 2001. +Within other branded footwear, Wolverine Slippers' 2002 revenue decreased as a result of reduced retailer demand. +Within the Company's other business units, Hush Puppies Retail reported a slight increase in revenue. Wolverine Leathers recorded an increase in revenue related to improved demand for Wolverine Performance Leathers™ from both external branded footwear companies and third party contract manufacturers that produce footwear under the Company's branded labels. Wolverine Procurement reported a reduction in revenue. Revenue for Apparel and Accessory Licensing also increased slightly. +GROSS MARGIN +The overall margin decline in 2002 was primarily due to liquidating excess inventories as the Company refocused the product lines of its newly acquired European businesses. Excluding the European acquisitions, 2002 gross margins were 36.2% compared to 35.7% for 2001, a 50 basis point improvement, reflecting an improved mix of higher margin lifestyle products and improved margins from the Company's other business units. The gross margin percentage for the Branded Footwear businesses decreased primarily from the actions taken to liquidate excess inventory in the Company's newly acquired European businesses, as noted above. Excluding the European acquisitions, 2002 gross margins for the Branded Footwear businesses were 35.9% compared to 35.6% for 2001, a 30 basis point improvement, reflecting increased shipments of higher margin lifestyle products under the Merrell® and Harley-Davidson® brands. The gross margin percentage for the other business units improved primarily from increased volume and improved efficiencies from the Wolverine Leathers operations and improvements reported by the Apparel and Accessory Licensing division. +21 +SELLING AND ADMINISTRATIVE EXPENSES +The dollar change in selling and administrative expenses includes increases of $19.8 million related to the acquired European entities, $2.8 million related to increased employee benefit costs and $4.0 million in additional pension expense. The remaining $8.4 million relates to variable costs associated with the revenue increase. +INTEREST, OTHER & TAXES +The decrease in interest expense reflects a reduction in senior notes outstanding due to principal payments made during the year and lower average borrowings and interest rates under the Company's revolving credit facility. +The change in other income primarily relates to the change in realized gains or losses on foreign currency transactions. +The Company's 2002 effective income tax rate of 32.9% compared to 34.0% for 2001. The decrease in the 2002 effective tax rate from 2001 relates to a higher percentage of income being generated in foreign jurisdictions with lower tax rates. +Net earnings of $47.9 million for 2002 compares to $45.2 million for 2001. Diluted earnings per share of $1.15 for 2002 compares to $1.07 for 2001. The non-amortization provisions of Statement of Financial Accounting Standard (SFAS) No. 142 apply to 2002 results and application of the non-amortization provisions to results for 2001 would have resulted in an increase in 2001 net earnings of $731,000 ($0.02 per share). +LIQUIDITY AND CAPITAL RESOURCES +January 3, +December 28, +Change +2004 +2002 +$ +% +(Millions of Dollars) +Cash +$ +55.4 +$ +27.1 +$ +28.3 +104.4 +% +Accounts receivable +146.9 +156.3 +(9.4 +) +(6.0 +%) +Inventories +164.9 +169.0 +(4.1 +) +(2.4 +%) +Accounts payable +26.3 +29.5 +(3.2 +) +(10.9 +%) +Other accrued liabilities +43.4 +35.6 +7.8 +21.9 +% +Debt +59.9 +72.9 +(13.0 +) +(17.8 +%) +Cash provided by operating activities +102.2 +88.3 +13.9 +15.3 +% +Additions to property, plant and +equipment +16.0 +13.9 +2.1 +15.4 +% +Depreciation and amortization +17.9 +16.9 +1.0 +6.4 +% +The Company generated a record $102.2 million of cash from operating activities for the year. The number of days' sales outstanding was reduced by 7.6% and SKU (stock keeping unit) levels were reduced by 13.0%. These actions contributed to a $25.0 million reduction in accounts receivable and inventory excluding the $11.5 million of accounts receivable and inventory acquired with the Sebago business. Cash of $35.0 million was generated from working capital improvements in 2003. +The decrease in accounts payable was a result of reduced liabilities for sourced inventories due to inventory management programs. The increase in other accrued liabilities was primarily attributable to liabilities assumed in the Sebago® footwear acquisition in 2003, adjustments made for foreign currency forward exchange contracts, timing of various tax payments and increases in employee benefit accruals. +22 +The majority of capital expenditures were for information system enhancements, consumer-direct initiatives, distribution equipment and building improvements. The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2018. +The Company has a long-term revolving credit agreement that expires in May 2006 and allows for borrowings up to $150.0 million, of which $10.0 million is allocated to the Company's Canadian subsidiary. Of the remaining $140.0 million facility, $35.0 million can be utilized by the Company's European subsidiaries. The revolving credit facility is used to support working capital requirements. No amounts were outstanding under revolving credit facilities at January 3, 2004 or December 28, 2002. Proceeds from existing credit facilities and anticipated renewals, along with cash flows from operations, are expected to be sufficient to meet capital needs in the foreseeable future. Any excess cash flows from operating activities are expected to be used to purchase property, plant and equipment, pay down existing debt, fund internal and external growth initiatives, pay dividends or repurchase the Company's common stock. +The decrease in debt was the result of annual principal payments on the Company's senior notes and lower borrowings made on the revolving credit facility to fund working capital investments. The Company had commercial letter-of-credit facilities outstanding of $2.4 million and $8.4 million at the end of 2003 and 2002, respectively. The decrease in letters of credit is due to the elimination of letter-of-credit requirements in favor of open account terms for a majority of the Company's footwear suppliers. The total debt to total capital ratio for the Company was 12.2% in 2003 and 16.5% in 2002. +Assets held for exchange in the amount of $3.5 million represent barter credits that were acquired in exchange for inventories in December 1997. Such credits are redeemable for a percentage of supplies purchased from certain vendors through 2005 with an option for a two-year extension. The Company evaluates the recoverability of such assets on a quarterly basis and expects to utilize all available credits prior to their expiration. Barter credits of $4.4 million have been utilized through January 3, 2004. +The Company's pension benefit costs and credits are based upon actuarial valuations. Inherent in these valuations are key assumptions, including discount rates and expected returns on plan assets. The Company is required to consider market conditions, including changes in interest rates, in selecting these assumptions. Pre-tax charges resulting from the Company's qualified defined benefit pension plans increased $7.3 million ($0.12 per share) for 2003 when compared to 2002 due to market conditions and declining interest rates that adversely affected asset values of plan investments and the Company's estimated projected benefit obligation. The Company also recorded a net change of $22.5 million within the accumulated component of other comprehensive income in stockholders' equity in 2003 which reduced a portion of the previously recorded minimum pension liability. This adjustment had no impact on the net earnings or cash flows of the Company. +Applying the provisions of SFAS No. 87 and SFAS No. 132, the Company's qualified pension plans were underfunded by $2.4 million in 2003 and underfunded by $17.6 million in 2002. Under the Employee Retirement Income Security Act of 1974 (ERISA), the Wolverine Employees' Pension Plan (representing 91% of the Company's pension benefit obligation) had no minimum funding requirements. Discretionary cash contributions were made to the Wolverine Employees' Pension Plan totaling $8.9 million in 2003 and $2.1 million in 2002 to provide long-term stability to the plan. The Company also maintains three separate defined benefit pension plans for certain bargaining units and hourly employees (representing 9% of the Company's projected benefit obligation) which required funding of $0.6 million in 2003 and $0.1 million in 2002 under ERISA. +23 +The Company's Board of Directors has approved three common stock repurchase programs each authorizing the repurchase of 2.0 million shares of common stock over a 24-month period commencing on the effective dates listed below. The primary purpose of these stock repurchase programs is to increase stockholder value. The Company intends to continue to repurchase shares of its common stock in open market or privately negotiated transactions, from time to time, depending upon market conditions and other factors. +Effective date +Shares +repurchased +in 2003 +Market price +of shares +repurchased +Shares +repurchased +in 2002 +Market price +of shares +repurchased +Cumulative +shares +repurchased +Market price +of cumulative +shares +December 9, 2003 +- +$ +- +- +$ +- +- +$ +- +August 19, 2002 +1,289,200 +24,296,000 +569,800 +9,014,000 +1,859,000 +33,310,000 +October 3, 2000 +- +- +1,476,300 +22,790,000 +1,971,800 +29,613,000 +The Company declared dividends of $8.6 million in 2003, or $0.22 per share, which was a 22.2% increase over the $7.2 million, or $0.18 per share, declared in 2002. On February 19, 2004, the Company declared a quarterly cash dividend of $0.065 per share of common stock, an increase of 18.2% as compared to the same period of 2003. The quarterly dividend is payable on May 3, 2004, to stockholders of record on April 1, 2004. +On November 3, 2003, the Company acquired significant operating assets of Sebago, Inc., an international distributor of performance nautical and American-inspired footwear, consisting of accounts receivable, inventory, fixed assets, trademarks and other amortizable intangible assets totaling approximately $18.1 million and assumed liabilities of approximately $2.0 million. Subject to certain post-closing adjustments, the total purchase price of Sebago, Inc., was $16.8 million, which consisted of $14.8 million paid in cash and a note payable for $2.0 million ($1.0 million due in both 2004 and 2005), resulting in goodwill of $0.7 million. +On January 16, 2002, the Company acquired, through a newly formed subsidiary, Wolverine Europe Limited, certain assets totaling $21.2 million and assumed certain liabilities of $8.5 million of the CAT European business from Overland Group Limited of London, England. Cash and other consideration paid totaled $27.8 million, resulting in goodwill of $15.1 million. On October 17, 2001, the Company acquired, through a newly formed subsidiary, Merrell Europe B.V., assets from certain European distributors for cash and other consideration of $2.2 million. +These acquisitions are discussed further in Note 11 to the consolidated financial statements. +CRITICAL ACCOUNTING POLICIES +The preparation of the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an on-going basis, management evaluates these estimates. Estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Historically, actual results have not been materially different from the Company's estimates. However, actual results may differ from these estimates under different assumptions or conditions. +The Company has identified the following critical accounting policies used in determining estimates and assumptions in the amounts reported. Management believes that an understanding of these policies is important to an overall understanding of the consolidated financial statements. +24 +REVENUE RECOGNITION +The Company's revenue consists of sales to customers, license fees and royalties. Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped and legal title has passed to the customer. Revenue generated through programs with licensees and distributors involving products utilizing the Company's trademarks and brand names is recognized as earned based on the completion of stated contractual terms. +The Company records provisions against gross revenue for estimated stock returns and cash discounts in the period when the related revenue is recorded. These estimates are based on factors that include, but are not limited to, historical stock returns, historical discounts taken and analysis of credit memorandum activity. The actual amount of customer returns or allowances, which is uncertain, may differ from the Company's estimates. The Company would record either an increase or decrease to net sales in the period in which it determined an adjustment to be appropriate. +ACCOUNTS RECEIVABLE +The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from its customers' inability to make required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. Historically, losses have been within the Company's expectations. Adjustments to these estimates may be required if the financial condition of the Company's customers were to change. If the Company were to determine that increases or decreases to the allowance for uncollectible accounts were appropriate, the Company would record either an increase or decrease to general and administrative expenses in the period the Company made such a determination. At January 3, 2004 and December 28, 2002, management believes that it has provided sufficient reserves to address future collection uncertainties. +INVENTORY +The Company values its inventory using actual costs on a last-in, first-out (LIFO) basis for the majority of its inventory and a first-in, first-out (FIFO) basis for foreign, retail and certain other domestic inventories, less allowances to reflect the lower of cost or market. The Company reduces the value of its inventories to the lower of cost or market for excess or obsolete inventories based upon assumptions about future demand and market conditions. If the Company were to determine that the estimated market value of its inventory is less than the carrying value of such inventory, the Company would provide a reserve for such difference as a charge to cost of sales. If actual market conditions are different from those projected, adjustments to those inventory reserves may be required. The adjustments would increase or decrease the Company's cost of sales and net income in the period in which they were realized or recorded. Inventory quantities are verified at various times throughout the year by performing physical and perpetual inventory cycle count procedures. If the Company determines that adjustments to the inventory quantities are appropriate, an increase or decrease to the Company's cost of sales and inventory would be recorded in the period in which such determination was made. +GOODWILL AND OTHER NON-AMORTIZABLE INTANGIBLES +Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually. The first step of the goodwill impairment test requires that the fair value of the applicable reporting unit be compared with its recorded value. The Company establishes fair value by calculating the present value of the future cash flows of the reporting unit. The Company uses assumptions about expected future operating performance in determining estimates of those cash flows, which may differ from actual cash flows. If the recorded values of these assets are not recoverable, based on this discounted cash flow analysis, management performs the next step which compares the fair value of the reporting unit calculated in step one to the fair value of the tangible and intangible assets of the +25 +reporting unit, which results in an implied fair value of goodwill. Goodwill is reduced by any shortfall of implied goodwill to its carrying value. Impairment tests for other non-amortizable intangibles require the determination of the fair value of the intangible asset. The carrying value is reduced by any excess over fair value. The Company reviewed the carrying amounts of goodwill and other non-amortizable intangible assets and there was no impairment indicated for 2003 or 2002. +INCOME TAXES +The Company operates in multiple tax jurisdictions both inside and outside the United States. Accordingly, management must determine the appropriate allocation of income in accordance with local law for each of these jurisdictions. The Company believes its tax accruals are adequate to cover exposures related to changes in income allocation between tax jurisdictions. The carrying value of the Company's deferred tax assets assumes that the Company will be able to generate sufficient taxable income in future years to utilize these deferred tax assets. If these assumptions change, the Company may be required to record valuation allowances against its gross deferred tax assets in future years, which would result in additional income tax expense in the Company's consolidated statements of operations. Management evaluates the potential for realizing gross deferred tax assets and assesses the need for valuation allowances on a quarterly basis. The Company did not record a valuation allowance in 2003 or 2002. +On a periodic basis, the Company estimates what the effective tax rate will be for the full fiscal year and records a quarterly income tax provision in accordance with the anticipated annual rate. As the fiscal year progresses, that estimate is refined based upon actual events and earnings by tax jurisdictions during the year. This continual estimation process periodically results in a change to the expected effective tax rate of the fiscal year. When this occurs, the Company adjusts the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date provision equals the expected annual rate. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +The Company faces market risk to the extent that changes in foreign currency exchange rates affect the Company's foreign assets, liabilities and inventory purchase commitments and to the extent that its long-term debt requirements are affected by changes in interest rates. The Company manages these risks by attempting to denominate contractual and other foreign arrangements in U.S. dollars and by maintaining a significant percentage of fixed-rate debt. The Company does not believe that there has been a material change in the nature of the Company's primary market risk exposures, including the categories of market risk to which the Company is exposed and the particular markets that present the primary risk of loss to the Company. As of the date of this Annual Report, the Company does not know of or expect there to be any material change in the general nature of its primary market risk exposure in the near term. +Under the provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS Nos. 137 and 138, the Company is required to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings or recognized in accumulated other comprehensive gain (loss) until the hedged item is recognized in earnings. +The Company conducts wholesale operations outside of the United States in Europe and Canada where the functional currencies are primarily the British pound, Canadian dollar and euro. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with foreign currency inventory purchases made by non-U.S. wholesale operations in the normal course of business. At January 3, 2004 and December 28, 2002, the Company had outstanding forward currency exchange +26 +contracts to purchase $37.9 million and $24.0 million, respectively, of various currencies (principally U. S. dollars) with maturities ranging up to 280 days. +The Company also has production facilities in the Dominican Republic where financial statements are prepared in U.S. dollars as the functional currency; however, operating costs are paid in the local currencies. Royalty revenue generated by the Company from third party foreign licensees is calculated in the licensees' local currencies, but paid in U.S. dollars. Accordingly, the Company could be subject to related foreign currency remeasurement gains and losses in 2004 and beyond. +Assets and liabilities outside the United States are primarily located in the United Kingdom, Canada and the Netherlands. The Company's investments in foreign subsidiaries with a functional currency other than the U.S. dollar are generally considered long-term. Accordingly, the Company does not hedge these net investments. For the years ended January 3, 2004 and December 28, 2002, the strengthening of foreign currencies increased the value of these investments in net assets by $10.9 million and $6.1 million, respectively. This gain resulted in cumulative foreign currency translation adjustments at January 3, 2004 and December 28, 2002 of $14.1 million and $3.1 million, respectively, that are deferred and recorded as a component of accumulated other comprehensive income (loss) in stockholders' equity. +Because the Company markets, sells and licenses its products throughout the world, it could be affected by weak economic conditions in foreign markets that could reduce demand for its products. +The Company is exposed to changes in interest rates primarily as a result of its long-term debt requirements. The Company's interest rate risk management objectives are to limit the effect of interest rate changes on earnings and cash flows and to effectively manage overall borrowing costs. To achieve its objectives, the Company maintains substantially all fixed-rate debt to take advantage of lower relative interest rates currently available and finances seasonal working capital needs with variable-rate debt. The Company has not historically utilized interest rate swaps or similar hedging arrangements to fix interest rates; however, in 1998 the Company entered into an interest rate lock agreement to fix the interest rate prior to the issuance of 6.5% senior notes in the amount of $75 million. The contract was settled in 1998 and resulted in a prepayment of interest of $2.2 million that is being amortized over the term of the senior notes. The amortization of the prepayment creates an effective interest rate of 6.78% on the senior notes. +The Company does not enter into contracts for speculative or trading purposes, nor is it a party to any leveraged derivative instruments. +The following table lists required principal payments and related interest rates for the Company's short- and long-term debt by fiscal year of maturity. For foreign currency-denominated debt, the information is presented in U.S. dollar equivalents. Variable interest rates are based on the weighted average rates of the portfolio at the respective consolidated balance sheet dates. +2003 +2002 +2004 +2005 +2006 +2007 +2008 +There- +after +Total +Fair +Value +Total +Fair +Value +(Millions of Dollars, Except Percentages) +Denominated in U.S. Dollars: +Fixed rate +$16.0 +$11.8 +$10.7 +$10.7 +$10.7 +- +$59.9 +$65.5 +$72.9 +$77.5 +Average interest rate +6.8 +% +6.4 +% +6.5 +% +6.5 +% +6.5 +% +- +6.5 +% +- +6.7 +% +- +27 +The Company has the following payments under contractual obligations due by period: +Total +Less than +1 year +1-3 years +4-5 years +More than +5 years +(Thousands of Dollars) +Long-term debt +$ +59,857 +$ +16,000 +$ +22,429 +$ +21,428 +$ +- +Capital leases +66 +20 +36 +10 +- +Operating leases +48,651 +9,007 +14,642 +9,458 +15,544 +Purchase obligations (1) +85,100 +85,100 +- +- +- +Deferred compensation +2,693 +329 +639 +610 +1,115 +Pension (2) +1,009 +1,009 +- +- +- +SERP +11,665 +579 +1,158 +1,158 +8,770 +Dividends declared +4,727 +4,727 +- +- +- +Minimum royalties +4,455 +1,012 +1,722 +1,721 +- +Minimum advertising +8,981 +1,388 +2,903 +3,080 +1,610 +Total +$ +227,204 +$ +119,171 +$ +43,529 +$ +37,465 +$ +27,039 +(1) Purchase obligations primarily relate to inventory and capital expenditure commitments. +(2) Pension obligations represent required funding obligations under government regulations. +Should additional funds be required, the Company had $174.4 million of additional borrowing capacity available under all of its existing credit facilities at January 3, 2004. The Company's additional borrowing capacity is summarized as follows: +Expiration of Availability +Total Commitments +Available +Less than +1 Year +1 Year or +Greater +(Millions of Dollars) +Revolving credit +$ 150.0 +$ - +$ 150.0 +Commercial letters of credit +20.8 +20.8 +- +Standby letters of credit +3.6 +3.6 +- +Item 7A. Quantitative and Qualitative Disclosures About Market Risk. +The response to this Item is set forth under the caption " Quantitative and Qualitative Disclosures About Market Risk " in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and is incorporated herein by reference. +Item 8. Financial Statements and Supplementary Data . +The response to this Item is set forth in Appendix A of this Annual Report on Form 10-K and is incorporated herein by reference. +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . +None. +Item 9A. Controls and Procedures . +An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of +28 +the design and operation of the Company's disclosure controls and procedures. Based on and as of the time of such evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filings with the SEC. There was no change in the Company's internal control over financial reporting that occurred during the seventeen-week period ended January 3, 2004 that has materially affected, or that is reasonably likely to materially affect, the Company's internal control over financial reporting. +PART III +Item 10. Directors and Executive Officers of the Registrant . +The Company's Audit Committee is comprised of four Board members who are independent under applicable regulations of the SEC and the New York Stock Exchange. The Audit Committee members each have financial and business experience with companies of substantial size and complexity and have a significant understanding of generally accepted accounting principles, financial statements, internal controls and audit committee functions. The Company's Board of Directors has determined that Mr. Kollat, Mr. Matthews and Mr. Parini are audit committee financial experts as defined by the SEC. +The Company has adopted an Accounting and Finance Code of Ethics that applies to the Company's principal executive officer, principal financial officer and principal accounting officer. The Accounting and Finance Code of Ethics is available on the Company's website, www.wolverineworldwide.com . Any waiver from or amendment to the Accounting and Finance Code of Ethics will be disclosed on the Company's website. +The information regarding directors of the Company contained under the caption "Election of Directors" and under the caption "Wolverine's Board of Directors" under the subheadings "Nominees for Terms Expiring in 2007," "Continuing Directors - Terms Expiring in 2006," "Continuing Directors - Terms Expiring in 2005," and "Board Committees and Meetings-Audit Committee" in the definitive Proxy Statement of the Company dated March 12, 2004, is incorporated herein by reference. +In addition to the directors discussed in the definitive Proxy Statement, the Company's Board of Directors currently includes Joseph Parini (age 72), who will retire at this year's annual meeting. His term was scheduled to expire at the annual meeting in 2006. Mr. Parini is retiring after 17 years of service as a director. Mr. Parini is Chairman of the Board and an officer of EFW, Inc., a designer and manufacturer of avionics systems for global markets, and has held that position since January 1997. He is also President and Chief Executive Officer of Intermet Systems, Inc., a manufacturer of weather instrumentation systems, and has held that position since January 1997. Mr. Parini was previously President and Chief Executive Officer of Elbit Systems, Inc., a designer, manufacturer and marketer of infrared, telecommunications and medical instrumentation, as well as defense products, from 1990 until 1996. +The information regarding directors and executive officers of the Company under the caption "Related Matters" under the subheading "Section 16(a) Beneficial Ownership Reporting Compliance" in the definitive Proxy Statement of the Company dated March 12, 2004, is incorporated herein by reference. Additional information regarding Executive Officers is provided in the Supplemental Item following Item 4 of Part I above. +29 +Item 11. +Executive Compensation . +The information contained under the caption "Wolverine's Board of Directors" under the subheadings "Compensation of Directors" and "Board Committees and Meetings-Compensation Committee," under the caption "Related Matters" under the subheading "Compensation Committee Interlocks and Insider Participation," and under the captions "Executive Compensation" and "Employment Agreements and Termination of Employment and Change in Control Arrangements" in the definitive Proxy Statement of the Company dated March 12, 2004, is incorporated herein by reference. +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters . +The information contained under the caption "Ownership of Wolverine Stock" contained in the definitive Proxy Statement of the Company dated March 12, 2004, is incorporated herein by reference. +The following table provides information about the Company's equity compensation plans as of January 3, 2004: +Equity Compensation Plan Information +Plan Category (1) +Number of +Securities to be +Issued Upon +Exercise of +Outstanding +Options, Warrants +and Rights +(a) +Weighted Average +Exercise Price of +Outstanding +Options, +Warrants and +Rights +(b) +Number of Securities +Remaining Available for +Future Issuance Under +Equity Compensation +Plans (Excluding +Securities Reflected in +Column (a)) +(c) +Equity compensation +plans approved by +security holders +4,421,976 +(2)(3) +$ +15.61 +2,489,481 +(4) +Equity compensation +plans not approved by +security holders +--- +n/a +--- +Total +4,421,976 +$ +15.61 +2,489,481 +Notes to Equity Compensation Plan Information +1. +Each plan for which aggregated information is provided contains customary anti-dilution provisions that are applicable in the event of a stock split, stock dividend or certain other changes in the Company's capitalization. +2. +Includes 3,150,130 stock options awarded to employees under the 1988 Stock Option Plan, the 1993 Stock Incentive Plan, the 1995 Stock Incentive Plan, the 1997 Stock Incentive Plan, the Stock Incentive Plan of 1999 and the Stock Incentive Plan of 2001, and 1,271,846 stock options awarded to non-employee directors under the currently effective Amended and Restated Directors' Stock Option Plan and the previous Amended and Restated Directors' Stock Option Plan initially adopted in 1988. Column (a) does not include stock units credited to outside directors' fee +30 +accounts or retirement accounts under the Outside Directors' Deferred Compensation Plan. Stock units do not have an exercise price. Each stock unit credited to a director's fee account and retirement account under the Outside Directors' Deferred Compensation Plan will be converted into one share of common stock upon distribution. Column (a) also does not include shares of restricted or unrestricted common stock previously issued under the Company's equity compensation plans. +3. +Of this amount, 906,392 options were not exercisable as of January 3, 2004, due to vesting restrictions. +4. +Comprised of: (i) 390,099 shares available for issuance to non-employee directors under the Amended and Restated Directors' Stock Option Plan, which only authorizes the award of stock option grants at pre-established limited levels as described in the plan (this number of shares is expected to be sufficient to make awards to directors for approximately six years); (ii) 391,138 shares available for issuance under the Outside Directors' Deferred Compensation Plan upon the retirement of the current directors or upon a change in control; and (iii) 1,708,244 shares issuable under the various employee stock incentive plans. Of these total amounts available, the number of shares with respect to the following plans may be issued other than upon the exercise of an option, warrant or right as of January 3, 2004: +• +Outside Directors' Deferred Compensation Plan: 391,138 +• +1995 Stock Incentive Plan: 4,999 +• +1997 Stock Incentive Plan: 2,583 +• +Stock Incentive Plan of 1999: 39,934 +• +Stock Incentive Plan of 2001: 360,728 +• +Stock Incentive Plan of 2003: 195,000 +The Outside Directors' Deferred Compensation Plan is a supplemental, unfunded, nonqualified deferred compensation plan for non-employee directors. Participation in the plan is voluntary. The plan allows participating directors to receive, in lieu of some or all directors' fees, a number of stock units equal to the amount of the deferred directors' fees divided by the fair market value of the Company's common stock on the date of payment of the next cash dividend on the Company's common stock. These stock units are increased by a dividend equivalent based on dividends paid by the Company and the amount of stock units credited to the participating director's fee account and retirement account. Upon distribution, the participating directors receive a number of shares of the Company's common stock equal to the number of stock units to be distributed at that time. Distribution is triggered by termination of service as a director or by a change in control of the Company and can occur in a lump sum, in installments or on another deferred basis. Of the 391,138 shares issuable under the Outside Directors' Deferred Compensation Plan, 146,731 shares have been issued to a trust to satisfy the Company's obligations and are included in shares reported as issued and outstanding as of the record date. +The employee stock incentive plans listed above are equity-based incentive plans for officers and key employees. Those plans authorize awards of stock options, restricted common stock, common stock and, under certain plans, tax benefit rights. The Stock Incentive Plans of 2001 and 2003 specifically limit the number of shares that can be awarded as restricted or unrestricted common stock to 40% and 15%, respectively, of the shares authorized under the plan. The numbers provided in this footnote and in column (c) will increase to the extent that options relating to the number of shares listed in column (a) of the table or outstanding shares of restricted or unrestricted stock previously issued under a plan are canceled, surrendered, modified, exchanged for +31 +substitutes or expire or terminate prior to exercise or vesting because any such number of shares will again become available for issuance under the plan under which the option or stock was granted. +Item 13. Certain Relationships and Related Transactions . +The information regarding certain loans under the caption "Executive Compensation," under the subheading "Stock Options," and the information contained under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company dated March 12, 2004, are incorporated herein by reference. +Item 14. Principal Accountant Fees and Services . +The information contained under the caption "Selection of Auditors" in the definitive Proxy Statement of the Company dated March 12, 2004, is incorporated herein by reference. +PART IV +Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K . +Item 15(a)(1). Financial Statements . Attached as Appendix A. +The following consolidated financial statements of Wolverine World Wide, Inc. and subsidiaries are filed as a part of this report: +• +Consolidated Balance Sheets as of January 3, 2004 and December 28, 2002. +• +Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Fiscal Years Ended January 3, 2004, December 28, 2002, and December 29, 2001. +• +Consolidated Statements of Operations for the Fiscal Years Ended January 3, 2004, December 28, 2002, and December 29, 2001. +• +Consolidated Statements of Cash Flows for the Fiscal Years Ended January 3, 2004, December 28, 2002, and December 29, 2001. +• +Notes to Consolidated Financial Statements as of January 3, 2004. +• +Report of Independent Auditors. +Item 15(a)(2). Financial Statement Schedules . Attached as Appendix B. +The following consolidated financial statement schedule of Wolverine World Wide, Inc. and subsidiaries is filed as a part of this report: +• +Schedule II--Valuation and Qualifying Accounts of Continuing Operations. +All other schedules (I, III, IV, and V) for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and, therefore, have been omitted. +32 +Item 15(a)(3). Exhibits . +The following exhibits are filed as part of this report: +Exhibit +Number +Document +3.1 +Certificate of Incorporation, as amended. Previously filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.1 +Certificate of Incorporation, as amended. See Exhibit 3.1 above. +4.2 +Amended and Restated By-laws. See Exhibit 3.2 above. +4.3 +Rights Agreement dated as of April 17, 1997. Previously filed with the Company's Form 8-A filed April 12, 1997. Here incorporated by reference. +4.4 +Amendment No. 1 dated as of June 30, 2000, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.5 +Second Amendment dated as of February 11, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.6 +Third Amendment dated as of December 10, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2002. Here incorporated by reference. +4.7 +Note Purchase Agreement dated as of August 1, 1994, relating to 7.81% Senior Notes. Previously filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.8 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. Previously filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here incorporated by reference. +4.9 +The Registrant has several classes of long-term debt instruments outstanding in addition to those described in Exhibits 4.7, 4.8 and 4.10. The authorized amount of none of these classes of debt exceeds 10% of the Company's total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +33 +4.10 +Credit Agreement dated as of May 29, 2001, with Bank One, Michigan, as agent. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 16, 2001. Here incorporated by reference. +4.11 +First Amendment dated as of February 8, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.12 +Second Amendment dated as of August 30, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.13 +Third Amendment dated as of December 19, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.13 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2002. Here incorporated by reference. +10.1 +1988 Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed July 21, 1988, Registration No. 33-23196. Here incorporated by reference. +10.2 +1993 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed June 22, 1993, Registration No. 33-64854. Here incorporated by reference. +10.3 +1995 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed October 26, 1995, Registration No. 33-63689. Here incorporated by reference. +10.4 +1997 Stock Incentive Plan.* Previously filed as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2001. Here incorporated by reference. +10.5 +Stock Incentive Plan of 1999.* Previously filed as Appendix A to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 23, 1999. Here incorporated by reference. +10.6 +Stock Incentive Plan of 2001.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 26, 2001. Here incorporated by reference. +10.7 +Stock Incentive Plan of 2003.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 24, 2003. Here incorporated by reference. +10.8 +Amended and Restated Directors Stock Option Plan.* Previously filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +34 +10.9 +Amended and Restated Directors' Stock Option Plan.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 14, 2003. Here incorporated by reference. +10.10 +Amended and Restated Outside Directors' Deferred Compensation Plan.* Previously filed as Appendix E to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.11 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.12 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Appendix C to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.13 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +10.14 +Executive Severance Agreement.* Previously filed as Exhibit 10.10 to the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1998. Here incorporated by reference. An updated participant schedule is attached as Exhibit 10.14. +10.15 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. Previously filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.16 +Benefit Trust Agreement dated May 19, 1987, and Amendments Number 1, 2, 3 and 4 thereto.* Previously filed as Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.17 +Amended and Restated Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. An updated participant schedule is attached as Exhibit 10.17. +10.18 +Employees' Pension Plan (Restated as amended through December 19, 2003).* +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +35 +31.1 +Certification of President and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Executive Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +____________________________ +*Management contract or compensatory plan or arrangement. +The Company will furnish a copy of any exhibit listed above to any stockholder without charge upon written request to Mr. Blake W. Krueger, Executive Vice President and Secretary, 9341 Courtland Drive, Rockford, Michigan 49351. +Item 15(b). Reports on Form 8-K . +The following reports on Form 8-K were filed during the period covered by this report: +Date +Items Reported +Financial Statements +October 1, 2003 +Items 7, 12 +None +November 4, 2003 +Items 7, 9 +None +December 12, 2003 +Items 7, 9 +None +36 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +WOLVERINE WORLD WIDE, INC. +Dated March 16, 2004 +By: +/s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, +Chief Financial Officer and Treasurer +(Principal Financial Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. +Signature +Title +Date +*/s/ Geoffrey B. Bloom +Geoffrey B. Bloom +Chairman of the Board +of Directors +March 16, 2004 +/s/ Timothy J. O'Donovan +Timothy J. O'Donovan +Chief Executive Officer, +President (Principal Executive Officer) +and Director +March 16, 2004 +/s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, Chief +Financial Officer and Treasurer +(Principal Financial Officer) +March 16, 2004 +/s/ Nicholas P. Ottenwess +Nicholas P. Ottenwess +Vice President of Finance and +Corporate Controller (Principal +Accounting Officer) +March 16, 2004 +*/s/ Donald V. Fites +Donald V. Fites +Director +March 16, 2004 +*/s/ Alberto L. Grimoldi +Alberto L. Grimoldi +Director +March 16, 2004 +37 +*/s/ David T. Kollat +David T. Kollat +Director +March 16, 2004 +*/s/ Brenda J. Lauderback +Brenda J. Lauderback +Director +March 16, 2004 +*/s/ Phillip D. Matthews +Phillip D. Matthews +Director +March 16, 2004 +*/s/ David P. Mehney +David P. Mehney +Director +March 16, 2004 +*/s/ Joseph A. Parini +Joseph A. Parini +Director +March 16, 2004 +*/s/ Elizabeth A. Sanders +Elizabeth A. Sanders +Director +March 16, 2004 +*/s/ Paul D. Schrage +Paul D. Schrage +Director +March 16, 2004 +*by /s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Attorney-in-Fact +Executive Vice President, Chief +Financial Officer and Treasurer +(Principal Financial Officer) +March 16, 2004 +38 +APPENDIX A +Financial Statements +1 +Consolidated Balance Sheets +As of Fiscal Year End +2003 +2002 +(Thousands of Dollars) +Assets +Current assets: +Cash and cash equivalents +$ +55,356 +$ +27,078 +Accounts receivable, less allowances (2003-$10,462; 2002-$10,191) +146,879 +156,285 +Inventories: +Finished products +143,127 +146,229 +Raw materials and work-in-process +21,777 +22,769 +164,904 +168,998 +Deferred income taxes +6,528 +2,992 +Other current assets +12,969 +9,290 +Total current assets +386,636 +364,643 +Property, plant and equipment: +Land +1,080 +1,104 +Buildings and improvements +64,235 +62,982 +Machinery and equipment +128,954 +123,499 +Software +44,081 +38,389 +238,350 +225,974 +Less accumulated depreciation +142,343 +128,700 +96,007 +97,274 +Other assets: +Goodwill and other non-amortizable intangibles +42,130 +33,288 +Cash surrender value of life insurance +24,880 +22,628 +Prepaid pension costs +19,451 +- +Assets held for exchange +3,539 +4,719 +Other +6,238 +9,442 +96,238 +70,077 +Total assets +$ +578,881 +$ +531,994 +Liabilities and Stockholders' Equity +Current liabilities +Accounts payable +$ +26,328 +$ +29,542 +Salaries, wages and other compensation +16,696 +12,296 +Income taxes +1,513 +3,575 +Taxes, other than income taxes +3,416 +4,322 +Other accrued expenses +21,793 +15,412 +Current maturities of long-term debt +16,020 +15,030 +Total current liabilities +85,766 +80,177 +Long-term debt, less current maturities +43,903 +57,885 +Deferred compensation +5,736 +4,742 +Accrued pension liability +- +19,870 +Deferred income taxes +13,068 +80 +Minority interest +314 +143 +Stockholders' equity: +Common stock, $1 par value: authorized 80,000,000 shares; issued, +including treasury shares: 2003 - 46,662,593; 2002 - 45,839,831 +46,663 +45,840 +Additional paid-in capital +101,706 +90,994 +Retained earnings +382,603 +339,475 +Accumulated other comprehensive income (loss) +8,540 +(23,522 +) +Unearned compensation +(4,138 +) +(3,833 +) +Cost of shares in treasury: 2003 - 7,209,313 shares; 2002 - 5,869,429 shares +(105,280 +) +(79,857 +) +Total stockholders' equity +430,094 +369,097 +Total liabilities and stockholders' equity +$ +578,881 +$ +531,994 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +2 +Consolidated Statements of Stockholders' Equity and Comprehensive Income +Fiscal Year +2003 +2002 +2001 +(Thousands of Dollars, Except Per Share Data) +Common Stock +Balance at beginning of the year +$ +45,840 +$ +45,414 +$ +44,785 +Common stock issued under stock incentive plans +(2003-823,262 shares; 2002-426,543 shares; +2001-628,779 shares) +823 +426 +629 +Balance at end of the year +46,663 +45,840 +45,414 +Additional Paid-In Capital +Balance at beginning of the year +90,994 +86,771 +79,633 +Amounts associated with common stock issued +under stock incentive plans: +Proceeds over par value +8,693 +3,547 +5,617 +Income tax benefits +1,710 +531 +1,521 +Issuance of treasury shares (2003-27,886 shares; +2002-142,894 shares) +51 +409 +- +Net change in employee notes receivable +258 +(264 +) +- +Balance at end of the year +101,706 +90,994 +86,771 +Retained Earnings +Balance at beginning of the year +339,475 +298,755 +260,158 +Net earnings +51,716 +47,912 +45,240 +Cash dividends (2003-$.22 per share; +2002-$.18 per share; 2001-$.16 per share) +(8,588 +) +(7,192 +) +(6,643 +) +Balance at end of the year +382,603 +339,475 +298,755 +Accumulated Other Comprehensive Income (Loss) +Balance at beginning of the year +(23,522 +) +(4,109 +) +(2,532 +) +Foreign currency translation adjustments +10,922 +6,101 +(431 +) +Change in fair value of foreign exchange contracts, net of +taxes (2003-$730; 2002- $89) +(1,393 +) +(244 +) +- +Minimum pension liability adjustment, net of taxes +(2003- $11,608; 2002-$13,016; 2001-$592) +22,533 +(25,270 +) +(1,146 +) +Balance at end of the year +8,540 +(23,522 +) +(4,109 +) +Unearned Compensation +Balance at beginning of the year +(3,833 +) +(4,649 +) +(5,921 +) +Awards under restricted stock incentive plans +(2,488 +) +(2,037 +) +(2,107 +) +Compensation expense +2,183 +2,853 +3,379 +Balance at end of the year +(4,138 +) +(3,833 +) +(4,649 +) +Cost of Shares in Treasury +Balance at beginning of the year +(79,857 +) +(48,030 +) +(38,885 +) +Common stock purchased for treasury +(2003-1,367,770 shares; 2002-2,154,335 shares; +2001-625,816 shares) +(25,656 +) +(33,626 +) +(9,145 +) +Issuance of treasury shares (2003-27,886; +2002-142,894 shares) +233 +1,799 +- +Balance at end of the year +(105,280 +) +(79,857 +) +(48,030 +) +Total stockholders' equity at end of the year +$ +430,094 +$ +369,097 +$ +374,152 +Comprehensive Income +Net earnings +$ +51,716 +$ +47,912 +$ +45,240 +Foreign currency translation adjustments +10,922 +6,101 +(431 +) +Change in fair value of foreign exchange contracts, net of taxes +(1,393 +) +(244 +) +- +Minimum pension liability adjustment, net of taxes +22,533 +(25,270 +) +(1,146 +) +Total comprehensive income +$ +83,778 +$ +28,499 +$ +43,663 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +3 +Consolidated Statements of Operations +Fiscal Year +2003 +2002 +2001 +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +888,926 +$ +827,106 +$ +720,066 +Cost and expenses: +Cost of products sold +562,338 +532,878 +463,030 +Selling and administrative expenses +246,652 +217,154 +182,178 +Interest expense +5,896 +6,721 +7,239 +Interest income +(422 +) +(255 +) +(497 +) +Other income - net +(686 +) +(1,046 +) +(431 +) +813,778 +755,452 +651,519 +Earnings before income taxes and minority interest +75,148 +71,654 +68,547 +Income taxes +23,262 +23,599 +23,307 +Earnings before minority interest +51,886 +48,055 +45,240 +Minority interest +170 +143 +- +Net earnings +$ +51,716 +$ +47,912 +$ +45,240 +Net earnings per share: +Basic +$ +1.32 +$ +1.19 +$ +1.11 +Diluted +1.27 +1.15 +1.07 +See accompanying notes to consolidated financial statements. +4 +Consolidated Statements of Cash Flows +Fiscal Year +2003 +2002 +2001 +(Thousands of Dollars, Except Per Share Data) +Operating Activities +Net earnings +$ +51,716 +$ +47,912 +$ +45,240 +Adjustments necessary to reconcile net earnings +to net cash provided by operating activities: +Depreciation +17,664 +16,633 +15,991 +Amortization +283 +227 +1,630 +Deferred income taxes (credit) +(902 +) +216 +5,169 +Other +(1,538 +) +2,668 +(2,539 +) +Changes in operating assets and liabilities: +Accounts receivable +15,534 +(5,879 +) +9,178 +Inventories +17,069 +24,884 +(31,655 +) +Other operating assets +529 +(1,076 +) +2,425 +Accounts payable +(5,820 +) +(656 +) +7,450 +Other operating liabilities +7,668 +3,350 +1,046 +Net cash provided by operating activities +102,203 +88,279 +53,935 +Investing Activities +Business acquisitions, net of cash acquired +(14,780 +) +(27,366 +) +(1,410 +) +Additions to property, plant and equipment +(16,015 +) +(13,875 +) +(11,298 +) +Other +58 +607 +235 +Net cash used in investing activities +(30,737 +) +(40,634 +) +(12,473 +) +Financing Activities +Proceeds from short-term borrowings +- +- +6,706 +Payments of short-term debt +- +(90 +) +(7,512 +) +Proceeds from long-term borrowings +66,194 +94,215 +113,972 +Payments of long-term debt +(81,176 +) +(112,226 +) +(115,318 +) +Cash dividends +(8,588 +) +(7,192 +) +(6,643 +) +Purchase of common stock for treasury +(25,656 +) +(33,626 +) +(9,145 +) +Proceeds from shares issued under stock incentive plans +7,570 +2,202 +3,864 +Net cash used in financing activities +(41,656 +) +(56,717 +) +(14,076 +) +Effect of foreign exchange rate changes +(1,532 +) +330 +- +Increase (decrease) in cash and cash equivalents +28,278 +(8,742 +) +27,386 +Cash and cash equivalents at beginning of the year +27,078 +35,820 +8,434 +Cash and cash equivalents at end of the year +$ +55,356 +$ +27,078 +$ +35,820 +Other Cash Flow Information +Interest paid +$ +5,461 +$ +6,633 +$ +7,656 +Net income taxes paid +22,725 +18,201 +7,854 +( ) Denotes reduction in cash and cash equivalents. +See accompanying notes to consolidated financial statements. +5 +Notes to the Consolidated Financial Statements +1. Summary of Significant Accounting Policies +NATURE OF OPERATIONS +Wolverine World Wide, Inc. (NYSE: WWW) is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The Company's global portfolio of owned and licensed brands includes: Bates®, CAT®, Harley-Davidson®, Hush Puppies®, HyTest®, Merrell®, Sebago®, Stanley® and Wolverine®. The Company also operates a retail division to showcase its brands and branded footwear from other manufacturers, a tannery that produces Wolverine Performance Leathers™ and an apparel and accessory licensing division to extend its owned brands into product categories beyond footwear. +PRINCIPLES OF CONSOLIDATION +The consolidated financial statements include the accounts of Wolverine World Wide, Inc. and its wholly and majority owned subsidiaries (collectively, the "Company"). All intercompany transactions have been eliminated in consolidation. +FISCAL YEAR +The Company's fiscal year is the 52- or 53-week period that ends on the Saturday nearest to December 31. Fiscal years presented in this report include the 53-week period ended January 3, 2004 and the 52-week periods ended December 28, 2002 and December 29, 2001. +USE OF ESTIMATES +The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. +REVENUE RECOGNITION +Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped and legal title has passed to the customer. Revenue generated through programs with licensees and distributors involving products utilizing the Company's trademarks and brand names is recognized as earned based on the completion of stated contractual terms. +The Company records provisions against gross revenue for estimated stock returns and cash discounts in the period when the related revenue is recorded. These estimates are based on factors that include, but are not limited to, historical stock returns, historical discounts taken and analysis of credit memorandum activity. +SHIPPING AND HANDLING COSTS +Shipping and handling costs that are charged to and reimbursed by the customer are recognized as revenue, while the related expenses incurred by the Company are recorded as cost of products sold in the consolidated statements of operations. +CASH EQUIVALENTS +All short-term investments with a maturity of three months or less when purchased are considered cash equivalents. +ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS +The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from its customers' inability to make required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. Adjustments to these estimates may be required if the financial condition of the +6 +Notes to the Consolidated Financial Statements +Company's customers were to change. The Company does not require collateral or other security on trade accounts receivable. +INVENTORIES +Inventories are valued at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for certain domestic inventories. Foreign, retail and other domestic inventories are valued using methods approximating cost under the first-in, first-out (FIFO) method. +PROPERTY, PLANT AND EQUIPMENT +Property, plant and equipment are stated on the basis of cost and include expenditures for new facilities, major renewals, betterments and software. Normal repairs and maintenance are expensed as incurred. +Depreciation of plant, equipment and software is computed using the straight-line method. The depreciable lives range from five to forty years for buildings and improvements and from three to ten years for machinery and equipment and software. +GOODWILL AND OTHER INTANGIBLES +Goodwill represents the excess of the purchase price over the fair value of net tangible and identifiable intangible assets of acquired businesses. Other intangibles consist primarily of trademarks, brand names, patents and customer lists. Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets , The Company reviews the carrying amounts of goodwill and other non-amortizable intangible assets annually to determine if such assets may be impaired. If the carrying amounts of these assets are not recoverable based upon a discounted cash flow analysis, such assets are reduced by the estimated shortfall of fair value to recorded value. Other amortizable intangible assets (principally patents) are amortized using the straight-line method over their estimated useful life (periods ranging from two to fifteen years). Other amortizable intangible assets are included in other assets on the consolidated balance sheets and have net carrying amounts of $986,000 and $681,000 for 2003 and 2002, respectively and accumulated amortization of $694,000 and $417,000 for 2003 and 2002, respectively. Estimated aggregate amortization expense for such intangibles for each of the five fiscal years succeeding 2003 is expected to approximate $200,000 annually. +The Company applied the rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002. Application of the non-amortization provisions of SFAS No. 142 in 2001 would have resulted in an increase in net earnings of approximately $731,000 ($0.02 per share). The Company has performed the required impairment tests of goodwill during fiscal 2003 and 2002 and has determined that there was no impairment indicated for recorded goodwill and other non-amortizable intangibles. +The changes in the net carrying amount of goodwill and other non-amortizable intangibles for the years ended January 3, 2004 and December 28, 2002 are as follows: +2003 +2002 +(Thousands of Dollars) +Balance at beginning of year +$ +33,288 +$ +15,267 +Goodwill acquired +720 +15,057 +Other non-amortizable intangibles acquired +5,257 +640 +Purchase accounting adjustments +(614 +) +- +Foreign currency translation effects +3,479 +2,324 +Balance at end of the year +$ +42,130 +$ +33,288 +7 +Notes to the Consolidated Financial Statements +ASSETS HELD FOR EXCHANGE +Assets held for exchange represent barter credits that were acquired in exchange for inventories in December 1997. Such credits are redeemable for a percentage of supplies purchased from certain vendors through December 31, 2005 (with an option for a two year extension). The Company evaluates the recoverability of such assets on a quarterly basis and expects to utilize all available credits prior to their expiration. +IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS +The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Each impairment test is based on a comparison of the carrying amount of the assets to the future undiscounted net cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment amount to be recognized is the amount by which the carrying value of the assets exceeds the fair value of the assets. +CONSOLIDATION OF VARIABLE INTEREST ENTITIES +In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). This standard clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements , and addresses consolidation by business enterprises of variable interest entities. FIN 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risk among the parties involved. FIN 46 also enhances the disclosure requirements related to variable interest entities. This statement is effective for any variable interest entities entered into by the Company as of the end of the first quarter of fiscal 2004. The adoption of FIN 46 is not expected to have a material impact on the Company's financial position or results of operations. +STOCK-BASED COMPENSATION +The Company has elected to follow Accounting Principles Board (APB) Opinion No. 25 , Accounting for Stock Issued to Employees , and related interpretations, in accounting for its stock incentive plans because the alternative fair value accounting provided under SFAS No.123, Accounting for Stock-Based Compensation , requires the use of option valuation models that were not specifically developed for valuing the types of stock incentive plans maintained by the Company. Under APB Opinion No. 25, compensation expense is recognized when the market price of the stock underlying an award on the date of grant exceeds any related exercise price. +Pro forma information regarding net earnings and earnings per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its stock awards using the fair value method. The fair value of these awards was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: risk-free interest rate of 2.9% (4.2% in 2002 and 4.6% in 2001); dividend yield of 1.3% (1.1% in 2002 and 1.0% in 2001); expected market price volatility factor of 0.386 (0.420 in 2002 and 0.515 in 2001); and an expected option life of four years. +The estimated weighted-average fair value for each option granted was $4.95 in 2003, $5.48 in 2002 and $6.57 in 2001. +8 +Notes to the Consolidated Financial Statements +For purposes of pro forma disclosures, the estimated fair values of stock options are amortized to expense over the related vesting periods. The Company's pro forma information under SFAS No. 123 is as follows: +2003 +2002 +2001 +( Thousands of Dollars, Except Per Share Data) +Net earnings, as reported +$ +51,716 +$ +47,912 +$ +45,240 +Add: Total stock-based compensation expense included +in reported net income, net of related tax effects +143 +9 +166 +Deduct: Total stock-based employee compensation +expense determined under fair value based method +for all awards, net of related tax effects +3,273 +3,020 +5,092 +Pro forma net earnings +$ +48,586 +$ +44,901 +$ +40,314 +Net earnings per share: +Basic-as reported +$ +1.32 +$ +1.19 +$ +1.11 +Basic-pro forma +1.24 +1.12 +.99 +Diluted-as reported +1.27 +1.15 +1.07 +Diluted-pro forma +1.19 +1.08 +.96 +ADVERTISING COSTS +Advertising costs are expensed as incurred and totaled $35,254,000 in 2003, $33,584,000 in 2002 and $29,757,000 in 2001. +The Company provides sales incentives to retail customers in the form of a cooperative advertising program. Under this program, customers are reimbursed for Company approved advertising-related expenditures where the value to the Company is objectively verifiable. Cooperative advertising dollars are expensed by the Company as earned by customers These expenses are recorded within selling and administrative expenses. +INCOME TAXES +The provision for income taxes is based on the earnings reported in the consolidated financial statements. A deferred income tax asset or liability is determined by applying currently enacted tax laws and rates to the cumulative temporary differences between the carrying values of assets and liabilities for financial statement and income tax purposes. +EARNINGS PER SHARE +Basic earnings per share is computed based on weighted average shares of common stock outstanding during each year after adjustment for restricted nonvested common stock issued under restricted stock incentive plans. Diluted earnings per share assumes the exercise of dilutive stock options and the vesting of all common stock under restricted stock programs. +The following table sets forth the reconciliation of weighted average shares used in the computation of basic and diluted earnings per share: +2003 +2002 +2001 +Weighted average shares outstanding during the year +39,897,434 +41,016,362 +41,571,272 +Adjustment for nonvested restricted common stock +(721,246 +) +(770,749 +) +(832,991 +) +Denominator for basic earnings per share +39,176,188 +40,245,613 +40,738,281 +Effect of dilutive stock options +1,047,188 +776,864 +877,608 +Adjustment for nonvested restricted common stock +497,562 +533,130 +543,117 +Denominator for diluted earnings per share +40,720,938 +41,555,607 +42,159,006 +Options to purchase 659,067 shares of common stock in 2003, 796,487 shares in 2002 and 712,187 shares in 2001 have not been included in the denominator for the computation of diluted earnings per share because the related exercise prices were greater than the average market price for the period and, therefore, they were antidilutive. +9 +Notes to the Consolidated Financial Statements +FOREIGN CURRENCY +For the Company's international subsidiaries, the local currency is the functional currency. Assets and liabilities of these subsidiaries are translated into U.S. dollars at the year-end exchange rate. Operating statement amounts are translated at average exchange rates for the period. The cumulative translation adjustments resulting from changes in exchange rates are included in the consolidated balance sheet as a component of accumulated other comprehensive income (loss) in stockholders' equity. Transaction gains and losses are included in the consolidated statements of operations and were not material. +FINANCIAL INSTRUMENTS AND RISK MANAGEMENT +The Company's financial instruments consist of cash and cash equivalents, accounts and notes receivable, accounts and notes payable and long-term debt. Except for fixed rate long-term debt with a carrying value of $59,857,000 and a fair value of $65,465,000 at January 3, 2004 and a carrying value of $72,857,000 and a fair value of $77,479,000 at December 28, 2002, the Company's estimate of the fair values of these financial instruments approximates their carrying amounts for the respective years. Fair value was determined using discounted cash flow analyses and current interest rates for similar instruments. The Company does not hold or issue financial instruments for trading purposes. +The Company follows SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS Nos. 137 and 138, which requires that all derivative instruments be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with foreign currency inventory purchases made by non-U.S. wholesale operations in the normal course of business. At January 3, 2004 and December 28, 2002, foreign exchange contracts with a notional value of $37,902,000 and $24,000,000, respectively, were outstanding to purchase various currencies (principally U.S. dollars) with maturities ranging up to 280 days. These contracts have been designated as cash flow hedges. As of January 3, 2004 and December 28, 2002, a liability of $2,270,000 and $333,000, respectively, has been recognized for the fair value of the foreign currency forward exchange contracts. +The fair value of the foreign currency forward exchange contracts represents the estimated receipts or payments necessary to terminate the contracts. Hedge effectiveness is evaluated by the hypothetical derivative method. Any hedge ineffectiveness is reported within the cost of products sold caption of the consolidated statements of operations. Hedge ineffectiveness was not material in 2003 or 2002. If, in the future, the foreign exchange contracts are determined to be ineffective hedges or terminated before their contractual termination dates, the Company would be required to reclassify into earnings all or a portion of the unrealized amounts related to the cash flow hedges that are currently included in accumulated other comprehensive income (loss) within stockholders' equity. +COMPREHENSIVE INCOME (LOSS) +Comprehensive income (loss) represents net earnings and any revenues, expenses, gains and losses that, under accounting principles generally accepted in the United States, are excluded from net earnings and recognized directly as a component of stockholders' equity. +Ending accumulated other comprehensive income (loss) is as follows: +2003 +2002 +(Thousands of Dollars) +Foreign currency translation adjustments +$ +14,060 +$ +3,138 +Foreign currency cash flow hedge adjustments, net of taxes +(2003 - $819; 2002 - $89) +(1,637 +) +(244 +) +Minimum pension liability adjustments, net of taxes +(2003 - $2,000; 2002 - $13,016) +(3,883 +) +(26,416 +) +Accumulated other comprehensive income (loss) +$ +8,540 +$ +(23,522 +) +10 +Notes to the Consolidated Financial Statements +RECLASSIFICATIONS +Certain amounts previously reported in 2002 and 2001 have been reclassified to conform with the presentation used in 2003. +2. Inventories +Inventories of $90,368,000 at January 3, 2004 and $85,509,000 at December 28, 2002 have been valued using the LIFO method. If the FIFO method had been used, inventories would have been $8,817,000 and $8,893,000 higher than reported at January 3, 2004 and December 28, 2002, respectively. +3. Debt +Long-term debt consists of the following obligations: +2003 +2002 +(Thousands of Dollars) +6.5% senior notes payable +$ +53,571 +$ +64,286 +7.81% senior notes payable +4,286 +8,571 +Revolving credit obligations +- +- +Other +2,066 +58 +59,923 +72,915 +Less current maturities +16,020 +15,030 +$ +43,903 +$ +57,885 +The 6.5% unsecured senior notes payable require annual principal payments of $10,714,000 due through the maturity date of December 8, 2008. In connection with the issuance of these senior notes, the Company entered into an interest rate lock agreement with a bank that was settled in 1998 and resulted in a prepayment of interest of $2,200,000. This prepayment is being amortized over the remaining term of the notes using the effective interest method. +The 7.81% unsecured senior notes payable balance is due on August 15, 2004. +The Company has an unsecured revolving credit agreement that allows for borrowings up to $150,000,000, of which $10,000,000 pertains to the Company's Canadian subsidiary. Of the remaining $140,000,000 facility available to the U.S. operations, $35,000,000 may also be utilized by the European subsidiaries. This agreement requires that interest be paid at a variable rate based on LIBOR and expires in May 2006. +The Company had commercial letters of credit outstanding of $2,380,000 and $8,383,000 at January 3, 2004 and December 28, 2002, respectively. +The long-term loan agreements contain restrictive covenants that, among other things, require the Company to maintain certain financial ratios and minimum levels of tangible net worth. At January 3, 2004, unrestricted retained earnings were $82,147,000. The agreements also impose restrictions on securing additional debt, sale and merger transactions and the disposition of significant assets. +Principal maturities of long-term debt during the four years subsequent to 2004 are as follows: 2005-$11,734,000; 2006-$10,730,000; 2007-$10,721,000; 2008-$10,718,000. +Interest costs of $235,000 in 2003, $254,000 in 2002 and $427,000 in 2001 were capitalized in connection with various capital improvement and computer hardware and software installation projects. +4. Leases +The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2018. At January 3, 2004, minimum rental payments due under all noncancelable leases are as follows: 2004-$9,007,000; 2005-$8,088,000; 2006-$6,554,000; 2007-$5,436,000; 2008-$4,022,000; thereafter-$15,544,000. +11 +Notes to the Consolidated Financial Statements +Rental expense under all operating leases consisted primarily of minimum rentals and totaled $11,614,000 in 2003, $11,011,000 in 2002 and $10,105,000 in 2001. +5. Capital Stock +The Company has 2,000,000 authorized shares of $1 par value preferred stock, of which none is issued or outstanding. +The Company has a preferred stock rights plan that is designed to protect stockholder interests in the event the Company is confronted with coercive or unfair takeover tactics. One right is associated with each share of common stock currently outstanding. The rights trade with the common stock and become exercisable only upon the occurrence of certain triggering events. Each right, when exercisable, will entitle the holder to purchase one one-hundredth of a share of Series B junior participating preferred stock for $120. The Company has designated 500,000 shares of preferred stock as Series B junior participating preferred stock for possible future issuance under the Company's preferred stock rights plan. Upon issuance for reasons other than liquidation, each share of Series B junior participating preferred stock will have 100 votes and a preferential quarterly dividend equal to the greater of $21 per share or 100 times the dividend declared on common stock. +In the event that the Company is a party to a merger or other business combination, regardless of whether the Company is the surviving corporation, right holders other than the party to the merger will be entitled to receive common stock of the surviving corporation worth twice the exercise price of the rights. The plan also provides for protection against self-dealing transactions by certain 15% stockholders or the activities of an adverse person (as defined in the plan). The Company may redeem the rights for $.01 each at any time prior to a person being designated as an adverse person or fifteen days after a triggering event. Unless redeemed earlier, all rights expire on May 7, 2007. The Board of Directors can elect to exclude certain transactions from triggering the exercise of preferred stock rights and other actions under the plan. +The Company has stock incentive plans under which options to purchase shares of common stock may be granted to officers, other key employees and non-employee directors. Options granted are exercisable over no more than ten years and vest over various periods. All unexercised options are available for future grant upon their cancellation. +A summary of the transactions under the stock option plans is as follows: +Shares Under +Option +Weighted-Average +Option Price +Outstanding at December 30, 2000 +3,750,665 +$ +13.49 +Granted +900,229 +15.47 +Exercised +(643,035 +) +10.26 +Cancelled +(26,595 +) +16.68 +Outstanding at December 29, 2001 +3,981,264 +14.48 +Granted +797,994 +15.59 +Exercised +(321,869 +) +10.87 +Cancelled +(45,191 +) +15.85 +Outstanding at December 28, 2002 +4,412,198 +14.89 +Granted +805,334 +16.21 +Exercised +(751,500 +) +11.94 +Cancelled +(44,056 +) +20.18 +Outstanding at January 3, 2004 +4,421,976 +$ +15.61 +Shares available for grant under the stock option plans were 2,098,343 at January 3, 2004, 1,610,881 at December 28, 2002 and 2,036,327 at December 29, 2001. +12 +Notes to the Consolidated Financial Statements +The exercise prices of options outstanding at January 3, 2004 range from $1.73 to $30.56. A summary of stock options outstanding at January 3, 2004 by range of option price is as follows: +Weighted-Average +Number of Options +Option Price +Remaining +Outstanding +Exercisable +Outstanding +Exercisable +Contractual Life +Less than $10 +481,091 +481,091 +$ +9.03 +$ +9.03 +3.7 years +$10 to $20 +3,324,121 +2,428,904 +14.73 +14.42 +6.6 years +Greater than $20 +616,764 +605,589 +25.46 +25.58 +3.3 years +4,421,976 +3,515,584 +$ +15.61 +$ +15.60 +5.9 years +The number of options exercisable at December 28, 2002 and December 29, 2001 totaled 3,504,114 and 3,075,846, respectively. +The Company also has stock award plans for officers and other key employees. Common stock issued under these plans is subject to certain restrictions, including a prohibition against any sale, transfer or other disposition by the officer or employee (except for certain transfers for estate planning purposes for certain officers), and a requirement to forfeit the award upon certain terminations of employment in cases other than death, disability, retirement or consensual severance. These restrictions lapse over a three- to five-year period from the date of the award. Shares aggregating 162,400 in 2003, 161,700 in 2002 and 156,250 in 2001 were awarded under these plans. The weighted-average grant date fair value was $15.85 in 2003, $15.47 in 2002 and $15.11 in 2001 for the shares awarded. There were no awards cancelled in 2003, 18,224 awards cancelled in 2002 and 10,288 awards cancelled in 2001. The market value of the shares awarded is recognized as unearned compensation in the consolidated statements of stockholders' equity and is amortized to operations over the vesting period. +6. Retirement Plans +The Company has noncontributory, defined benefit pension plans covering a majority of its domestic employees. The Company's principal defined benefit pension plan provides benefits based on the employees' years of service and final average earnings (as defined in the plan), while the other plans provide benefits at a fixed rate per year of service. The Company intends to annually contribute amounts deemed necessary to maintain the plans on a sound actuarial basis. +The Company has a Supplemental Executive Retirement Plan ("SERP") for certain current and former employees that entitles them to receive payments from the Company following retirement based on the employees' years of service and final average earnings (as defined in the SERP). Under the SERP, the employees can elect early retirement with a corresponding reduction in benefits. The Company also has individual deferred compensation agreements with certain former employees that entitle them to receive payments from the Company for a period of fifteen to eighteen years following retirement. The Company maintains life insurance policies with a cash surrender value of $24,648,000 at January 3, 2004 and $22,428,000 at December 28, 2002 that are intended to fund deferred compensation benefits under the SERP and deferred compensation agreements. +The Company has a defined contribution money accumulation plan covering substantially all domestic employees that provides for Company contributions based on earnings. This plan is combined with the principal defined benefit pension plan for funding purposes to the extent allowable under applicable regulations. The Company recognized expense for the money accumulation plan of $1,620,000 in 2003, $1,500,000 in 2002 and $1,400,000 in 2001. The Company also has certain defined contribution plans at foreign subsidiaries. Contributions to these plans were $662,000 in 2003, $506,000 in 2002 and $278,000 in 2001. +The Company uses a September 30 measurement date for its defined benefit plans. +13 +Notes to the Consolidated Financial Statements +The following summarizes the status of and changes in the Company's pension assets and related obligations for its pension plans (which include the Company's defined benefit pension plans and the SERP) as of: +September 30 +2003 +2002 +(Thousands of Dollars) +Change in projected benefit obligations: +Projected benefit obligations at beginning of the year +$ +132,544 +$ +119,337 +Service cost pertaining to benefits earned during the year +3,243 +4,435 +Interest cost on projected benefit obligations +8,634 +8,959 +Effect of changes in actuarial assumptions +(401 +) +516 +Actuarial losses +9,027 +6,162 +Benefits paid to plan participants +(6,561 +) +(6,865 +) +Projected benefit obligations at end of the year +$ +146,486 +$ +132,544 +Change in fair value of pension assets: +Fair value of pension assets at beginning of the year +$ +102,486 +$ +114,392 +Actual net investment gain (loss) +22,195 +(8,140 +) +Company contributions +9,734 +3,099 +Benefits paid to plan participants +(6,561 +) +(6,865 +) +Fair value of pension assets at end of the year +$ +127,854 +$ +102,486 +Funded status +$ +(18,632 +) +$ +(30,058 +) +Unrecognized prior service costs +3,879 +5,229 +Unrecognized net actuarial losses +41,465 +48,952 +Net amount recognized +$ +26,712 +$ +24,123 +Amounts recognized in the consolidated balance sheets: +Prepaid benefit cost +$ +37,578 +$ +- +Accrued benefit cost +(18,887 +) +(20,762 +) +Intangible assets +2,138 +4,862 +Accumulated other comprehensive loss +5,883 +40,023 +Net amount recognized +$ +26,712 +$ +24,123 +Funded status of pension plans and SERP (supplemental): +Funded status of qualified defined benefit plans and SERP +$ +(18,632 +) +$ +(30,058 +) +Nonqualified trust assets (cash surrender value of life insurance) recorded +in other assets and intended to satisfy the projected benefit obligation +of unfunded supplemental employee retirement plans +19,140 +17,153 +Net funded status of pension plans and SERP (supplemental) +$ +508 +$ +(12,905 +) +The Company made contributions of $194,000 and $271,000 subsequent to the measurement date and before the fiscal year ended 2003 and 2002, respectively. +Information for pension plans with an accumulated benefit obligation in excess of plan assets: +September 30 +2003 +2002 +(Thousands of Dollars) +Projected benefit obligations +$ +27,805 +$ +132,544 +Accumulated benefit obligations +26,502 +123,248 +Fair value of plan assets +7,615 +102,486 +The accumulated benefit obligations for all defined benefit pension plans and the SERP were $138,419,000 and $123,248,000 at September 30, 2003, and 2002, respectively. +14 +Notes to the Consolidated Financial Statements +The following is a summary of net pension and SERP income (expense) recognized by the Company: +2003 +2002 +2001 +(Thousands of Dollars) +Service cost pertaining to benefits earned during the year +$ +(3,243 +) +$ +(4,435 +) +$ +(3,753 +) +Interest cost on projected benefit obligations +(8,634 +) +(8,959 +) +(8,457 +) +Expected return on pension assets +10,175 +12,477 +13,310 +Net amortization gain (loss) +(5,491 +) +(1,010 +) +1,427 +Special termination benefits +- +- +(174 +) +Net pension income (expense) +$ +(7,193 +) +$ +(1,927 +) +$ +2,353 +Expense for qualified defined benefit pension plans was $6,014,000 in 2003, and pension income was $1,314,000 in 2002 and $5,440,000 in 2001. +2003 +2002 +Weighted average assumptions used to determine benefit obligations at September 30: +Discount rate +6.11% +6.76% +Rate of compensation increase +3.50% +4.50% +Weighted average assumptions used to determine net periodic benefit cost for the years ended: +Discount rate +6.76% +7.55% +Expected long-term rate of return on plan assets +8.90% +10.00% +Rate of compensation increase-qualified plans +3.50% +4.50% +Rate of compensation increase-SERP +3.85% +4.50% +Unrecognized net experience losses exceeding certain corridors are amortized over a five-year period, unless the minimum amortization method based on average remaining service periods produces a higher amortization. +The long-term rate of return is based on overall market expectations for a balanced portfolio with an asset mix similar to the Company's, utilizing historic returns for broad market and fixed income indices. +2003 +2002 +Weighted average asset allocations at September 30 by asset category are as follows: +Equity securities +72.0% +65.0% +Debt instruments +23.0% +24.0% +Cash and money market investments +5.0% +11.0% +100.0% +100.0% +The Company's investment policy for plan assets uses a blended approach of U.S. and foreign equities combined with U.S. fixed income investments. Policy guidelines indicate that total equities should not exceed 80% and fixed income securities should not exceed 50%. Within the equity and fixed income classifications, the investments are diversified. +Equity securities include shares of the Company's common stock in the amounts of $9,477,000 and $10,328,000 at September 30, 2003 and 2002, respectively. Dividends received on Company stock holdings were $134,000 in 2003, $120,000 in 2002 and $114,000 in 2001. +The Company expects to contribute $5,000,000 to its qualified defined benefit pension plans and $626,000 to the SERP in 2004. +15 +Notes to the Consolidated Financial Statements +7. Income Taxes +The provisions for income taxes consist of the following: +2003 +2002 +2001 +(Thousands of Dollars) +Currently payable: +Federal +$ +19,818 +$ +20,002 +$ +17,147 +State and foreign +4,346 +3,381 +991 +Deferred (credit) expense +(902 +) +216 +5,169 +$ +23,262 +$ +23,599 +$ +23,307 +A reconciliation of the Company's total income tax expense and the amount computed by applying the statutory federal income tax rate of 35% to earnings before income taxes is as follows: +2003 +2002 +2001 +(Thousands of Dollars) +Income taxes at statutory rate +$ +26,302 +$ +25,079 +$ +23,991 +State income taxes, net of federal income tax reduction +183 +271 +460 +Nontaxable earnings of foreign affiliates +(1,605 +) +(1,674 +) +(1,518 +) +Research and development credits +(1,870 +) +- +- +Foreign earnings (losses) taxed at rates differing from +the U.S. statutory rate +718 +121 +(84 +) +Other +(466 +) +(198 +) +458 +$ +23,262 +$ +23,599 +$ +23,307 +Significant components of the Company's deferred income tax assets and liabilities as of the end of 2003 and 2002 are as follows: +2003 +2002 +(Thousands of Dollars) +Deferred income tax assets: +Accounts receivable and inventory valuation allowances +$ +3,086 +$ +1,611 +Deferred compensation accruals +2,187 +1,475 +Future benefit of foreign net operating losses +254 +650 +Accrued pension costs +2,000 +13,608 +Other amounts not deductible until paid +5,906 +5,110 +Total deferred income tax assets +13,433 +22,454 +Deferred income tax liabilities: +Tax over book depreciation +(9,256 +) +(9,372 +) +Prepaid pension costs +(9,738 +) +(8,833 +) +Other +(979 +) +(1,337 +) +Total deferred income tax liabilities +(19,973 +) +(19,542 +) +Net deferred income tax assets (liabilities) +$ +(6,540 +) +$ +2,912 +No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the undistributed earnings ($69,558,000 at January 3, 2004 and $59,374,000 at December 28, 2002) of foreign subsidiaries because it is expected that such earnings will be reinvested overseas indefinitely. Determination of the amount of any unrecognized deferred income tax liability on these unremitted earnings is not practicable. +8. Litigation and Contingencies +The Company is involved in various environmental claims and other legal actions arising in the normal course of business. The environmental claims include sites where the Environmental Protection Agency has notified the Company that it is a potentially responsible party with respect to environmental +16 +Notes to the Consolidated Financial Statements +remediation. These remediation claims are subject to ongoing environmental impact studies, assessment of remediation alternatives, allocation of costs between responsible parties and concurrence by regulatory authorities and have not yet advanced to a stage where the Company's liability is fixed. However, after taking into consideration legal counsel's evaluation of all actions and claims against the Company, management is currently of the opinion that their outcome will not have a material effect on the Company's consolidated financial position or future results of operations. +Pursuant to certain of the Company's lease agreements, the Company has provided financial guarantees to third parties in the form of indemnification provisions. These provisions indemnify and reimburse the third parties for costs, including but not limited to adverse judgments in lawsuits and taxes and operating costs. The terms of the guarantees are equal to the terms of the related lease agreements. The Company is not able to calculate the maximum potential amount of future payments it could be required to make under these guarantees, as the potential payment is dependent on the occurrence of future unknown events. +On July 17, 2003, the Company's 153 union tannery employees voted to strike as their existing contract expired. The strike ended on September 10, 2003, and on January 23, 2004, all complaints and suits related to the strike were settled by mutual agreement. +9. Business Segments +The Company has one reportable segment that is engaged in manufacturing, sourcing, marketing and distribution of branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear, to the retail sector. Revenues of this segment are derived from the sale of branded footwear products to external customers as well as royalty income from the licensing of the Company's trademarks and brand names to licensees and distributors. The business units comprising the branded footwear segment manufacture or source, market and distribute products in a similar manner. Branded footwear is distributed through wholesale channels and under licensing and distributor arrangements. +The other business units in the following tables consist of the Company's retail, apparel and accessory licensing, tannery and pigskin procurement operations. The Company operated 64 domestic retail stores at January 3, 2004 that sell Company-manufactured and sourced products, as well as footwear manufactured by unaffiliated companies. The other business units distribute products through retail and wholesale channels. +The Company measures segment profits as earnings before income taxes and minority interest. The accounting policies used to determine profitability and total assets of the branded footwear and other business segments are the same as disclosed in Note 1. +Business segment information is as follows: +2003 +Branded +Footwear +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +809,690 +$ +79,236 +$ +- +$ +888,926 +Intersegment sales +27,288 +2,471 +- +29,759 +Interest (income) expense - net +9,285 +1,088 +(4,899 +) +5,474 +Depreciation expense +5,665 +2,589 +9,410 +17,664 +Earnings (loss) before income taxes +and minority interest +83,089 +3,562 +(11,503 +) +75,148 +Assets +399,276 +36,594 +143,011 +578,881 +Additions to property, plant and equipment +6,225 +3,359 +6,431 +16,015 +17 +Notes to the Consolidated Financial Statements +2002 +Branded +Footwear +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +746,202 +$ +80,904 +$ +- +$ +827,106 +Intersegment sales +24,814 +3,099 +- +27,913 +Interest (income) expense - net +10,841 +1,323 +(5,698 +) +6,466 +Depreciation expense +5,339 +2,407 +8,887 +16,633 +Earnings (loss) before income taxes +and minority interest +78,847 +6,780 +(13,973 +) +71,654 +Assets +384,723 +40,453 +106,818 +531,994 +Additions to property, plant and equipment +8,732 +1,700 +3,443 +13,875 +2001 +Branded +Footwear +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +644,793 +$ +75,273 +$ +- +$ +720,066 +Intersegment sales +19,599 +4,632 +- +24,231 +Interest (income) expense - net +11,939 +1,273 +(6,470 +) +6,742 +Depreciation expense +5,455 +2,295 +8,251 +15,991 +Earnings (loss) before income taxes +68,086 +5,887 +(5,426 +) +68,547 +Assets +355,045 +45,165 +143,468 +543,678 +Additions to property, plant and equipment +2,001 +3,553 +5,744 +11,298 +Geographic information, based on shipping destination, related to revenue included in the consolidated statements of operations is as follows: +2003 +2002 +2001 +(Thousands of Dollars) +United States +$ +674,794 +$ +644,647 +$ +617,711 +Foreign countries: +Europe +150,643 +127,461 +50,115 +Canada +45,422 +39,363 +34,221 +Central and South America +6,639 +6,417 +7,764 +Asia +8,132 +6,780 +6,356 +Middle East and Russia +3,296 +2,438 +3,899 +214,132 +182,459 +102,355 +$ +888,926 +$ +827,106 +$ +720,066 +The Company's long-lived assets (primarily property, plant and equipment and intangible assets) are as follows: +2003 +2002 +2001 +(Thousands of Dollars) +United States +$ +155,365 +$ +136,644 +$ +155,731 +Foreign countries: +36,880 +32,005 +13,144 +The Company does not believe that it is dependent upon any single customer, since none accounts for more than 10% of consolidated revenue. +No product groups, other than footwear, account for more than 10% of consolidated revenue. Revenues derived from the sale and licensing of footwear accounted for 96% of revenue in 2003, 2002 and 2001. +18 +Notes to the Consolidated Financial Statements +Approximately 13% of the Company's employees are subject to bargaining unit contracts extending through various dates to 2006. +10. Quarterly Results of Operations (unaudited) +The Company reports its quarterly results of operations on the basis of 12-week periods for each of the first three quarters and a 16- or 17-week period for the fourth quarter. The fourth quarter of 2003 includes 17 weeks and the fourth quarter of 2002 includes 16 weeks. +The Company's unaudited quarterly results of operations are as follows: +2003 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +191,485 +$ +184,040 +$ +230,571 +$ +282,830 +Gross margin +69,196 +65,724 +86,714 +104,954 +Net earnings +7,414 +9,281 +16,414 +18,607 +Net earnings per share: +Basic +$ +.19 +$ +.24 +$ +.42 +$ +.47 +Diluted +.18 +.23 +.40 +.46 +2002 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +177,277 +$ +169,276 +$ +219,197 +$ +261,356 +Gross margin +62,102 +61,621 +78,018 +92,487 +Net earnings +6,403 +9,099 +15,342 +17,068 +Net earnings per share: +Basic +$ +.16 +$ +.22 +$ +.38 +$ +.43 +Diluted +.15 +.21 +.37 +.42 +Adjustments in the fourth quarter resulted in an increase in net earnings of $579,000 ($0.01 per share) in 2003 and were immaterial in 2002. These adjustments related primarily to inventories. +11. Business Acquisitions +On November 3, 2003, the Company acquired significant operating assets of Sebago, Inc., an international distributor of performance nautical and American-inspired footwear, consisting of accounts receivable, inventory, fixed assets, trademarks and other amortizable intangible assets totaling approximately $18,046,000 and assumed liabilities of approximately $1,986,000. Subject to certain post-closing adjustments, the total purchase price of Sebago, Inc., was $16,780,000, which consisted of $14,780,000 paid in cash and a note payable for $2,000,000 ($1,000,000 due in both 2004 and 2005), resulting in goodwill of $720,000 after allocation of the preliminary purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. Future adjustments to the preliminary purchase price allocation will result in a corresponding adjustment to goodwill. The acquisition has been accounted for using the purchase method of accounting and, accordingly, the results of operations since November 3, 2003 are included in the Company's consolidated statements of operations. +An independent valuation of the Sebago trademarks was performed as of the date of the acquisition which totaled $4,904,000. Pursuant to SFAS No. 142, goodwill and indefinite-lived intangibles will not be amortized, but will be evaluated for impairment annually. Goodwill was assigned to the Company's +19 +Notes to the Consolidated Financial Statements +Branded Footwear segment. The majority of the goodwill is expected to be deductible for tax purposes. The other intangible assets have a weighted average useful life of approximately nine years. +The following table sets forth the unaudited pro forma information for the Company as if the Sebago acquisition had occurred as of the beginning of each year utilizing the Company's effective tax rate. The unaudited pro forma financial information is provided for informational purposes only and does not purport to be indicative of the Company's results of operations that would actually have been achieved had the acquisition been completed at the beginning of the periods presented or that may be achieved in the future. The unaudited pro forma financial information was derived from the annual financial statements of the acquired company and does not give effect to any operational synergies or integration costs that may occur as a result of or following the acquisition. +2003 +2002 +( Thousands of Dollars, Except Per Share Data) +Revenue +$ +921,944 +$ +865,469 +Net earnings +53,460 +49,732 +Basic earnings per share +$ +1.36 +$ +1.24 +Diluted earnings per share +1.31 +1.20 +Immediately after the acquisition was consummated, management of the Company began to implement an integration plan for the Sebago acquisition. In conjunction with the integration plan, the Company recorded additional liabilities of approximately $1,792,000, which were included in the acquisition cost allocation in accordance with Emerging Issues Task Force Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination . The additional liabilities include approximately $1,496,000 for severance and related costs for approximately 100 manufacturing and administrative employees in Maine, and $296,000 related to exit costs for specific product lines of Sebago, Inc. At January 3, 2004, substantially all of the liabilities remained on the consolidated balance sheets. +On January 16, 2002, the Company established a new subsidiary to operate the CAT® footwear business in the European market. This new entity, Wolverine Europe Limited, purchased assets consisting of accounts receivable, inventory, limited amortizable intangible assets and fixed assets totaling approximately $21,247,000 from Overland Group Limited of London, England and assumed liabilities of approximately $8,514,000. Cash and other consideration of $27,790,000 was remitted for the acquisition, resulting in goodwill of $15,057,000 after allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. The former owner of Overland Group Limited is a 5% minority stockholder in the new subsidiary. The markets served directly by Wolverine Europe Limited include Austria, France, Germany, Ireland, the Netherlands, Switzerland and the United Kingdom. Wolverine Europe Limited also coordinates and supports other European markets served by independently-owned distributors. Based on the information provided by Overland Group Limited, the Company's consolidated pro forma revenue for 2001, assuming the acquisition occurred at the beginning of 2001, would have included approximately $69.9 million from the acquired business for a total of $784.5 million. Consolidated pro forma revenue for 2002, assuming the transaction occurred at the beginning of the year, would not have been materially different from reported amounts. Consolidated pro forma net earnings for 2002 and 2001, assuming the transaction occurred at the beginning of these years, are not materially different from reported amounts. +In October 2001, the Company expanded its owned Merrell® operations in the United Kingdom to cover the additional countries of Austria, Belgium, France, Germany, Luxembourg, the Netherlands and Spain. A new subsidiary, Merrell® Europe BV, was formed to direct the operations in these additional countries. Assets consisting primarily of inventory and fixed assets totaling $1,272,000 were acquired from certain former Merrell® distributors for cash and the assumption of liabilities totaling $2,552,000. Goodwill of $1,280,000 was recognized as of the purchase date. Consolidated pro forma revenue and net earnings in 2001, assuming the transaction occurred at the beginning of that year, are not materially different from reported amounts. +20 +Report of Independent Auditors +Board of Directors and Stockholders +Wolverine World Wide, Inc. +We have audited the accompanying consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of January 3, 2004 and December 28, 2002, and the related consolidated statements of stockholders' equity and comprehensive income, operations and cash flows for each of the three fiscal years in the period ended January 3, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. +We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Wolverine World Wide, Inc. and subsidiaries at January 3, 2004 and December 28, 2002, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended January 3, 2004, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +February 4, 2004 +APPENDIX B +Schedule II +Valuation and Qualifying Accounts of Continuing Operations +Wolverine World Wide, Inc. and Subsidiaries +Column A +Column B +Column C +Column D +Column E +Additions +Description +Balance at +Beginning of +Period +(1) +Charged to +Costs and +Expenses +(2) +Charged to +Other Accounts +(Describe) +Deductions +(Describe) +Balance at +End of +Period +Fiscal year ended January 3, 2004 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +8,974,000 +$ +4,962,000 +$ +4,604,000 +(A) +$ +9,332,000 +Allowance for cash discounts +1,217,000 +12,632,000 +12,719,000 +(B) +1,130,000 +Inventory valuation allowances +4,751,000 +12,011,000 +10,407,000 +(C) +6,355,000 +$ +14,942,000 +$ +29,605,000 +$ +27,730,000 +$ +16,817,000 +Fiscal year ended December 28, 2002 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +6,548,000 +$ +5,717,000 +$ +3,291,000 +(A) +$ +8,974,000 +Allowance for cash discounts +834,000 +11,081,000 +10,698,000 +(B) +1,217,000 +Inventory valuation allowances +4,014,000 +7,698,000 +6,961,000 +(C) +4,751,000 +$ +11,396,000 +$ +24,496,000 +$ +20,950,000 +$ +14,942,000 +Fiscal year ended December 29, 2001 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +5,036,000 +$ +6,819,000 +$ +5,307,000 +(A) +$ +6,548,000 +Allowance for cash discounts +1,111,000 +8,028,000 +8,305,000 +(B) +834,000 +Inventory valuation allowances +4,385,000 +9,409,000 +9,780,000 +(C) +4,014,000 +$ +10,532,000 +$ +24,256,000 +$ +23,392,000 +$ +11,396,000 +(A) Accounts charged off, net of recoveries. +(B) Discounts given to customers. +(C) Adjustment upon disposal of related inventories. +Commission File No. 1-6024 +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +EXHIBITS +TO +FORM 10-K +For the Fiscal Year Ended +January 3, 2004 +Wolverine World Wide, Inc. +9341 Courtland Drive +Rockford, Michigan 49351 +EXHIBIT INDEX +Exhibit +Number +Document +3.1 +Certificate of Incorporation, as amended. Previously filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.1 +Certificate of Incorporation, as amended. See Exhibit 3.1 above. +4.2 +Amended and Restated By-laws. See Exhibit 3.2 above. +4.3 +Rights Agreement dated as of April 17, 1997. Previously filed with the Company's Form 8-A filed April 12, 1997. Here incorporated by reference. +4.4 +Amendment No. 1 dated as of June 30, 2000, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.5 +Second Amendment dated as of February 11, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.6 +Third Amendment dated as of December 10, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2002. Here incorporated by reference. +4.7 +Note Purchase Agreement dated as of August 1, 1994, relating to 7.81% Senior Notes. Previously filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.8 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. Previously filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. Here incorporated by reference. +4.9 +The Registrant has several classes of long-term debt instruments outstanding in addition to those described in Exhibits 4.7, 4.8 and 4.10. The authorized amount of none of these classes of debt exceeds 10% of the Company's total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +4.10 +Credit Agreement dated as of May 29, 2001, with Bank One, Michigan, as agent. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 16, 2001. Here incorporated by reference. +4.11 +First Amendment dated as of February 8, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.12 +Second Amendment dated as of August 30, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.13 +Third Amendment dated as of December 19, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.13 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2002. Here incorporated by reference. +10.1 +1988 Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed July 21, 1988, Registration No. 33-23196. Here incorporated by reference. +10.2 +1993 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed June 22, 1993, Registration No. 33-64854. Here incorporated by reference. +10.3 +1995 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed October 26, 1995, Registration No. 33-63689. Here incorporated by reference. +10.4 +1997 Stock Incentive Plan.* Previously filed as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2001. Here incorporated by reference. +10.5 +Stock Incentive Plan of 1999.* Previously filed as Appendix A to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 23, 1999. Here incorporated by reference. +10.6 +Stock Incentive Plan of 2001.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 26, 2001. Here incorporated by reference. +10.7 +Stock Incentive Plan of 2003.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 24, 2003. Here incorporated by reference. +10.8 +Amended and Restated Directors Stock Option Plan.* Previously filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.9 +Amended and Restated Directors' Stock Option Plan.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 14, 2003. Here incorporated by reference. +10.10 +Amended and Restated Outside Directors' Deferred Compensation Plan.* Previously filed as Appendix E to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.11 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.12 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Appendix C to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.13 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +10.14 +Executive Severance Agreement.* Previously filed as Exhibit 10.10 to the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1998. Here incorporated by reference. An updated participant schedule is attached as Exhibit 10.14. +10.15 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. Previously filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.16 +Benefit Trust Agreement dated May 19, 1987, and Amendments Number 1, 2, 3 and 4 thereto.* Previously filed as Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.17 +Amended and Restated Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. An updated participant schedule is attached as Exhibit 10.17. +10.18 +Employees' Pension Plan (Restated as amended through December 19, 2003).* +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31.1 +Certification of President and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Executive Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +____________________________ +*Management contract or compensatory plan or arrangement. \ No newline at end of file diff --git a/raw/filings/0000110471/2003/0000905729-04-000147/filing_metadata.csv b/raw/filings/0000110471/2003/0000905729-04-000147/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..73d5ad26d5d609133a649261fc07ab6095f8a19d --- /dev/null +++ b/raw/filings/0000110471/2003/0000905729-04-000147/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000110471,WWW,WOLVERINE WORLD WIDE INC /DE/,10-K,2004-03-17,2004-01-03,2004-03-17T20:33:20.000Z,0000905729-04-000147,wwwform10k_031704.htm,WOLVERINE WORLD WIDE FORM 10-K YE 010304,1141830,0,0,https://www.sec.gov/Archives/edgar/data/110471/000090572904000147/wwwform10k_031704.htm,https://www.sec.gov/Archives/edgar/data/110471/000090572904000147/,2003,2003,1 diff --git a/raw/filings/0000110471/2003/0000905729-04-000147/item1.txt b/raw/filings/0000110471/2003/0000905729-04-000147/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..6717302cae75bca7192549e716a2d856739ed8ac --- /dev/null +++ b/raw/filings/0000110471/2003/0000905729-04-000147/item1.txt @@ -0,0 +1,85 @@ +Item 1. Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The Company, a Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Consumers around the world purchased more than 41 million pairs of Company branded footwear during fiscal 2003, making the Company a global leader among footwear companies in the marketing of branded casual, work and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort and performance. The products are marketed throughout the world under widely recognized brand names, including Bates ®, CAT ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Sebago ®, Stanley ® and Wolverine ®. The Company believes that its primary competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary designs and comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. The Company's footwear products are organized under five operating units: (i) the Wolverine Footwear Group, focusing on the Bates®, Harley-Davidson®, HyTest®, Stanley® and Wolverine® product lines of work, outdoor and lifestyle boots and shoes, (ii) the Outdoor Group, focusing on the Sebago ® and Merrell ® product lines of performance and lifestyle footwear, (iii) Caterpillar Footwear, focusing on the CAT® product lines of work and lifestyle footwear, (iv) The Hush Puppies Company, focusing on the Hush Puppies ® brand of comfortable casual and dress footwear and slippers, and (v) Other Branded Footwear, focusing on the design and manufacture of private label footwear. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, gloves, handbags and plush toys. +The Company's Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support for the various Company brands. The Company's footwear is distributed domestically through 64 Company-owned retail stores and to numerous accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of the retailers to whom Wolverine distributes operate multiple storefront locations. The Company's products are distributed worldwide in over 140 markets through licensees and distributors. +The Company, through its Wolverine Leathers Division, operates a tannery which is one of the premier tanners of quality pigskin leather for the shoe and leather goods industries. Pigskin leather tanned by the Company is used in a significant portion of the footwear marketed by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of shoes. In addition, Wolverine Procurement, Inc., a Company-owned subsidiary, performs skinning operations and purchases raw pigskins which it then cures and sells to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company that are attached as Appendix A to this Form 10-K. The Company has one reportable segment, +3 +Branded Footwear. The Branded Footwear segment is engaged in manufacturing, sourcing, marketing and distributing branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear. The Company's Other Business units consist of its retail stores, apparel and accessory licensing, tannery and pigskin procurement operations. Financial information regarding the Company's business segments and financial information about geographic areas is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Form 10-K. +Branded Footwear. +The Company sources and markets a broad range of footwear styles including shoes, boots, slippers, moccasins and sandals under many recognizable brand names including Bates ®, CAT ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Sebago ®, Stanley ® and Wolverine ®. The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications at both Company-owned and independent manufacturing facilities. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, handbags and plush toys. Current significant licensing programs include Hush Puppies ® apparel, eyewear, watches and plush toys, and Wolverine ® brand apparel, gloves, watches and eyewear. +The Company's five branded footwear operating units are described below. +1. Wolverine Footwear Group . The Wolverine Footwear Group encompasses footwear primarily under the Wolverine ®, Bates ®, HyTest ®, Harley-Davidson ®, and Stanley ® brands and markets footwear designed with performance and comfort features to serve a variety of work, outdoor and lifestyle functions. +Wolverine ® Work and Industrial Footwear . The Wolverine ® brand has built its reputation by offering high quality work boots and shoes that incorporate innovative technologies to deliver comfort and durability. The Wolverine ® brand, which has been in existence for 120 years, markets work and outdoor footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® technology has allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The Wolverine Fusion® , DuraShocks SR™ and Wolverine Compressor™ technologies continue the Company's tradition of comfortable work and industrial footwear. The Wolverine® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female industrial and farm workers. The Wolverine ® rugged casual and outdoor sport product lines also incorporate DuraShocks ® technology and other comfort features into products designed for casual and outdoor sport use. The rugged casual line targets active lifestyles and includes walking shoes, rugged casuals and outdoor sandals. The outdoor sport line is designed to meet the demands of hunters, fishermen and other active outdoor sportsmen and women. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® and Thinsulate ® brand fabrics, the Company's performance leathers and patented DuraShocks ® technologies. In addition, the Wolverine ® brand is licensed for use on apparel, eyewear, watches and gloves. +Bates ® Uniform Footwear . The Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes DuraShocks ®, DuraShocks SR ™, CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and +4 +oxfords including the Bates ®, Enforcer Series ® and Special Ops ™ footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and the militaries of several foreign countries to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial occupations. Bates Uniform Footwear Division's products are also distributed through specialty retailers and catalogs. +HyTest ®. The HyTest ® product line consists primarily of high-quality work boots and shoes designed to protect male and female industrial workers from foot injuries. HyTest ® footwear incorporates various specialty safety features into its product lines, including steel toe, composite toe, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology to provide comfort together with safety for working men and women. HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company's occupational and work footwear brands to workers at industrial facilities and also through direct sales arrangements with large industrial customers. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson ® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work, military and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a network of independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. +Stanley ® Footgear . Pursuant to a license arrangement with The Stanley Works, the Company has exclusive rights to manufacture, market, distribute and sell footwear under the Stanley® brand. The Stanley® Footgear line is designed primarily for and marketed in the value-priced work footwear market. Stanley® Footgear is currently sold in Payless ShoeSource, Inc. stores throughout the United States. +2. The Outdoor Group . The Outdoor Group, which includes Merrell ® and Sebago ® footwear, was established as a separate operating unit of the Company in November 2003, following the Company's acquisition of Sebago, Inc. The Merrell ® product line consists primarily of technical hiking, rugged outdoor and outdoor-inspired casual footwear designed for backpacking, day hiking and everyday use. The Merrell ® product line also includes the "After-Sport" category, incorporating Merrell ® footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers™ and other technical materials to create footwear with unique styling, performance and comfort features. Merrell ® products are sold primarily through outdoor specialty retailers, department stores and catalogs. Merrell ® footwear is marketed in over 120 countries worldwide. +The Sebago ® product line consists primarily of performance nautical and American-inspired casual footwear. Sebago ® brand classic American footwear for men and women such as handsewn loafers and boat shoes have been manufactured and distributed since 1946. Highly recognized Sebago ® line extensions include Docksides , Drysides and Campsides. The Sebago ® product line is distributed in over 85 countries worldwide. The Sebago ® manufacturing and design tradition of quality componentry, durability, comfort and "Americana" heritage is further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. +5 +3. Caterpillar Footwear . Caterpillar Footwear was established as a separate operating unit of the Company in October 2002. Pursuant to a license arrangement with Caterpillar Inc., the Company has exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ®, CAT & Design ®, Walking Machines ® and other trademarks. The Company believes the association with CAT ® equipment enhances the reputation of its boots for quality, ruggedness and durability. CAT ® brand footwear products include work boots and shoes, sport boots, rugged casuals and lifestyle footwear. In addition, the Company also manufactures and markets CAT ® and Marine Power ® footwear, designed for industrial and recreational marine uses. CAT ® footwear products target work and industrial users and active lifestyle users. CAT® footwear is marketed in over 120 countries worldwide. +4. The Hush Puppies Company . Over its 46-year heritage, the Hush Puppies ® brand has been a pioneer of comfortable casual footwear. The diverse product line includes numerous styles for both dress and casual wear and utilizes comfort features, such as the Comfort Curve ® sole, Float Fx ®, patented Bounce ® technology and lightweight Zero-g ™ constructions. Hush Puppies ® shoes and slippers are marketed to men, women and children in over 100 countries through department stores, catalogs, and independent retailers. In addition, the Hush Puppies ® brand is licensed for use on apparel, eyewear, watches and plush toys. +5. Other Branded Footwear . The Company designs and manufactures constructed slippers, aftersport footwear, moccasins and children's footwear on a private label basis according to customer specifications. The styling of the Company's footwear reflects consumer demand for the "rugged indoor" look by using natural leathers such as moosehide, shearling and suede in constructed slipper and indoor and outdoor moccasin designs. In addition to its traditional line of private label products, the Company has developed a College Clogs™ program for the sale of licensed collegiate slipper products. +Other Businesses. +In addition to manufacturing, sourcing, marketing and distributing the Company's footwear products as reported in the Branded Footwear segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly-owned subsidiary Wolverine Procurement, Inc., and (iii) operates 64 domestic retail footwear stores. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces pigskin leathers primarily for use in the footwear industry. Wolverine Leathers® brand products are primarily manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes these leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof and stain resistant leathers are featured in many of the Company's domestic footwear lines and many products offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +6 +3. Wolverine Retail . The Company operates 64 domestic retail shoe stores as of February 2004, consisting of 60 factory outlet stores under the Hush Puppies and Family SM name, and four specialty stores under the Track 'N Trail® name. The Company expects to open at least six new Track 'N Trail® stores in 2004. With the exception of the possible expansion of the Track 'N Trail® concept, the Company expects the scope of its retail operations to remain relatively consistent in the foreseeable future. Most of the Company's 60 factory outlet stores carry a large selection of first quality Company branded footwear at discounted retail prices. The Track 'N Trail® stores feature Company brands such as Wolverine® , Merrell® , Hush Puppies® , CAT® , Sebago® and Harley-Davidson® . These stores also carry a selection of branded footwear from other manufacturers. The Company also operates the direct-to-customer retail websites described below. +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States and international markets to foster a differentiated and consistent image for each of the Company's core footwear brands. Each footwear brand group has its own marketing personnel who develop the marketing strategy for products within that group. Marketing campaigns and strategies vary by brand and may target accounts and/or end users as they strive to increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's footwear. Components of the brand-specific plans vary and may include print, radio and television advertising, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's footwear brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance that may be provided by the Company to its licensees and distributors are (i) direction on the categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting on retail store layout and design. The Company believes its footwear brand names provide a competitive advantage and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution. +The Company uses a wide variety of distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses the following distribution strategies. +• +Traditional wholesale distribution is used to service department stores, large footwear chains, specialty retailers, catalogs, independent retailers and uniform outlets. A dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide branded and private label footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchant and government customers. +7 +• +A network of independent Shoemobile ® distribution outlets is used to distribute the Company's work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and enters bids for contracts to supply specific footwear products. +In addition to its wholesale activities, the Company also operates domestic retail shoe stores as described above. The Company is developing various programs, both independently and with its retail customers, for the distribution of its products over the Internet and operates direct-to-customer sites at www.upfootgear.com, www.hytest.com, www.wolverinebootsandshoes.com, www.wolverine.com, www.trackandtrail.com, www.hushpuppies.com and www.catfootwear.com. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's revenue in fiscal 2003. +Footwear sales are seasonal with significant increases in sales experienced during the U.S. fall and spring seasons. Due to this seasonal nature of footwear sales, the Company experiences some fluctuation in its levels of working capital. The Company provides working capital for such fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects the seasonal sales pattern to continue in future years. +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of sales of branded footwear products generated from the Company's owned operations in Canada, the United Kingdom, Austria, France, Germany, the Netherlands, Belgium, Luxemburg, Spain and Switzerland and from royalty income through a network of independent licensees and distributors. The Company's owned operations include Hush Puppies (UK) Ltd., Merrell Europe B.V., Merrell (Europe) Limited, Hush Puppies Canada Footwear, Ltd., and the Merrell Canada division. In addition, in January 2002, the Company established a new subsidiary to manage the CAT ® footwear brand in the European market. This new subsidiary, Wolverine Europe Limited, purchased ongoing operations and assets of the European CAT® footwear business from Overland Group Limited of London, England. Wolverine Europe Limited will continue to coordinate and oversee support for other European markets served by independently-owned distributors. The Company's owned operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of Company footwear bearing the Hush Puppies ®, Wolverine ®, Bates ®, HyTest ®, Merrell ® and other trademarks by independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the CAT ®, and Harley-Davidson ® trademarks through foreign distributors. License and distribution arrangements enable the Company to develop sales in international markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. In fiscal 2003, the Company's wholly-owned foreign operations, together with the Company's foreign licensees and distributors, sold an estimated 19.6 million pairs of footwear. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent with the global brand position. Independent licensees and distributors purchase goods from either the Company or authorized third-party manufacturers pursuant to distribution agreements or manufacture branded products consistent with Company standards pursuant to license agreements. +8 +Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and manufacture of approximately 73% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the pairs controlled by the Company, approximately 88% are purchased or sourced from third parties, with the remainder produced at Company-owned facilities. Footwear produced by the Company is manufactured at Company-owned facilities in several domestic and certain affiliated foreign facilities located in Michigan, Arkansas, and the Dominican Republic. For some of the Company-produced footwear, a "twin plant" concept is utilized whereby a majority of the labor intensive cutting and fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Dominican Republic and Arkansas, and the technology intensive construction, or "bottoming," is performed at the Company's Michigan facilities. +The Company's factories each have the flexibility to produce a variety of footwear, which departs from the industry's historical practice of dedicating a given facility to production of specific footwear products. This flexibility allows the Company to quickly respond to changes in market preference and demand. The Company currently produces slippers, military footwear and work, casual and dress casual footwear in its domestic and/or Dominican Republic facilities. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, Central and South America, India and Europe. The Company maintains technical offices in the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In addition, the Company has adopted "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +The Company's domestic manufacturing operations allow the Company to (i) reduce its production lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and (iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (i) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (ii) source the highest quality raw materials from around the world, and (iii) avoid additional capital expenditures necessary for owned factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company maximum flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates a pigskin tannery through its Wolverine Leathers Division, which is one of the premier tanners of quality leather for the footwear industry. The Company and its licensees receive virtually all of their pigskin requirements from the tannery. The Company believes the tannery provides a strategic advantage for the Company by producing pigskin leather using proprietary technology at prices below those available from other sources. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of common upper materials and specialty leathers eliminates any reliance by the Company +9 +upon a sole supplier. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over 30 years. Alternative sources of pigskin are available; however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas and tariffs, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could have an adverse impact on the Company's operations and financial condition. +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear products. The owned trademarks that are most widely used by the Company include Hush Puppies ®, Wolverine ®, Bates ®, Wolverine Fusion ®, DuraShocks ®, Wolverine Compressor™, Hidden Tracks ®, Bounce ®, Comfort Curve ®, HyTest ®, Merrell ®, Sebago ®, and Track 'N Trail ®. The Company has obtained license rights to manufacture, market and distribute footwear throughout the world under the CAT ® and Harley-Davidson ® trademarks, and the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark, all pursuant to license arrangements with the respective trademark owners. The CAT ®, Harley-Davidson ®, and Stanley® licenses are long-term and extend for five or more years with conditional renewal options and are subject to early termination for breach. Pigskin leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers ®, Weather Tight ® and All Season Weather Leathers ™. +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of ownership of its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever possible and to vigorously defend its trademarks against infringement or other threats to the greatest extent practicable under the laws of the United States and other countries. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent practicable under applicable laws. +Order Backlog. +At March 13, 2004, the Company had a backlog of footwear orders of approximately $274 million compared with a backlog of approximately $233 million at March 8, 2003. Substantially all of the backlog relates to orders for products expected to be shipped in 2004. While orders in backlog are subject to cancellation by customers, the Company has not experienced significant cancellation of orders in the past. The backlog at a particular time is affected by a number of factors, including seasonality, retail conditions, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments. +10 +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States and Europe. The Company has at least ten major competitors in connection with the sale of its work shoes and boots, at least ten major competitors in connection with the sale of its sport boots, and at least thirty major competitors in connection with the sale of its casual, work and outdoor shoes. Product performance and quality, including technological improvements, product identity, competitive pricing, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing efficiencies, its tannery operations, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and no one company has a dominant market position. +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to the development of new production techniques and to improving the function, performance, reliability and quality of its branded footwear and other products. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, such as Bounce ®, DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company uses and generates certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites and other regulatory issues. +Employees. +As of January 3, 2004, the Company had approximately 4,784 domestic and foreign production, office and sales employees. Approximately 634 employees were covered by four union contracts expiring at various dates through May 1, 2006. The Company presently considers its employee relations to be good. +11 +Available Information. +Information about the Company, including the Company's Code of Conduct & Compliance, Corporate Governance Guidelines, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, Executive Committee Charter and Governance Committee Charter, is available at its website, http://www.wolverineworldwide.com . Printed copies of the documents listed above are available by writing to the Company at 9341 Courtland Drive, N.E., Rockford, MI 49351, Attention: Director of Investor Relations. +The Company also makes available on or through its website, free of charge, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports (along with certain other Company filings with the Securities and Exchange Commission ("SEC")) as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These filings are also accessible on the SEC's website at www.sec.gov. \ No newline at end of file diff --git a/raw/filings/0000110471/2003/0000905729-04-000147/item13.txt b/raw/filings/0000110471/2003/0000905729-04-000147/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..435f7924b4cc4bd754e496c5d303760e2612af87 --- /dev/null +++ b/raw/filings/0000110471/2003/0000905729-04-000147/item13.txt @@ -0,0 +1,2 @@ +Item 13. Certain Relationships and Related Transactions . +The information regarding certain loans under the caption "Executive Compensation," under the subheading "Stock Options," and the information contained under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company dated March 12, 2004, are incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000110471/2003/0000905729-04-000147/item9a.txt b/raw/filings/0000110471/2003/0000905729-04-000147/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..9c6ab89df71b1f74fc02a3eb5bc93c137201157b --- /dev/null +++ b/raw/filings/0000110471/2003/0000905729-04-000147/item9a.txt @@ -0,0 +1,5 @@ +Item 9A. Controls and Procedures . +An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of +28 +the design and operation of the Company's disclosure controls and procedures. Based on and as of the time of such evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filings with the SEC. There was no change in the Company's internal control over financial reporting that occurred during the seventeen-week period ended January 3, 2004 that has materially affected, or that is reasonably likely to materially affect, the Company's internal control over financial reporting. +PART III \ No newline at end of file diff --git a/raw/filings/0000110471/2003/0000905729-04-000147/rp_note.txt b/raw/filings/0000110471/2003/0000905729-04-000147/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000110471/2003/0000905729-04-000147/rpt_disclosure.txt b/raw/filings/0000110471/2003/0000905729-04-000147/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..37ed2ce4bb9fa6a41499b6ec9c88014fa8d44c9a --- /dev/null +++ b/raw/filings/0000110471/2003/0000905729-04-000147/rpt_disclosure.txt @@ -0,0 +1,47 @@ +Certain Relationships and Related +Transactions +Wolverine has entered into agreements with +Grimoldi, S.A., an Argentinean corporation of which +Mr. Alberto Grimoldi, a director of Wolverine, is chairman +and a significant shareholder, granting to Grimoldi, S.A. the +exclusive rights to distribute and sell footwear products in +Argentina under the Hush Puppies® , +Caterpillar® and Merrell® brand names. +Under these agreements, Grimoldi, S.A. or its subsidiary pays +Wolverine royalties and certain sublicense fees based on sales +or purchases of footwear products in Argentina. +43 +Table of Contents +Under the agreements described above, Grimoldi, +S.A. was obligated to pay to Wolverine royalties, sublicense +fees and service fees relating to 2004 totaling $1,013,368. +In the ordinary course of business, Wolverine and +its subsidiaries sell footwear for resale, samples, components +of footwear products (such as leather and shoe soles), +advertising materials and miscellaneous items to licensees, +distributors and customers. In 2004, purchases of such items by +Grimoldi, S.A. totaled $136,019 (including any applicable +sublicense fees for products containing licensed proprietary +technology). +All of the transactions described above occurred +pursuant to continuing contractual arrangements between +Wolverine and Grimoldi, S.A. Wolverine expects similar +transactions to occur between Grimoldi, S.A. and Wolverine and +its subsidiaries during 2005. +During 2002, Wolverine and Grimoldi, S.A. agreed +to payment terms with respect to certain trade accounts owed by +Grimoldi, S.A. to Wolverine. Grimoldi, S.A. executed a +three-year note payable to Wolverine in the face amount of +$635,761 which bears interest at 10 percent per annum. As +of January 1, 2005, the aggregate principal balance of the +note was $233,339. The highest principal balance of the note +between January 4, 2004 and January 1, 2005 was +$461,231. +In the ordinary course of its business, Wolverine +purchases promotional merchandise for use in connection with the +sale of its products. In 2004, Wolverine purchased promotional +merchandise from Bullseye Group, LLC totaling $373,459. One +third of Bullseye Group, LLC is owned by Daniel Mehney, the son +of David P. Mehney, a director of Wolverine. Wolverine +anticipates continuing to purchase promotional materials from +Bullseye Group, LLC in 2005. \ No newline at end of file diff --git a/raw/filings/0000110471/2004/0000905729-05-000124/filing.txt b/raw/filings/0000110471/2004/0000905729-05-000124/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..77d9e411cf023c34865b867fb04b0b45f8410b39 --- /dev/null +++ b/raw/filings/0000110471/2004/0000905729-05-000124/filing.txt @@ -0,0 +1,3453 @@ +10-K +1 +www10k_031605.htm +WOLVERINE WORLD WIDE, INC. FORM 10-K 03-17-05 +WWW Form 10-K - Fiscal Year Ended January 1, 2005 +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +___________________ +Form 10-K +[X] +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended January 1, 2005 +[ ] +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: 1-6024 +WOLVERINE WORLD WIDE, INC. +(Exact name of registrant as specified in its charter) +Delaware +(State or other jurisdiction of +incorporation or organization) +38-1185150 +(I.R.S. Employer Identification No.) +9341 Courtland Drive, Rockford, Michigan +(Address of principal executive offices) +49351 +(Zip Code) +Registrant's telephone number, including area code: (616) 866-5500 +Securities registered pursuant to Section 12(b) of the Securities Exchange Act: +Title of each class +Name of each exchange on which registered +Common Stock, $1 Par Value +New York Stock Exchange/Pacific Exchange, Inc. +Securities registered pursuant to Section 12(g) of the Act: None +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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] +Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). +Yes +X +No +The aggregate market value of the registrant's voting stock held by non-affiliates of the registrant based on the closing price on the New York Stock Exchange on June 19, 2004, the last business day of the registrant's most recently completed second fiscal quarter: $939,739,102. +Number of shares outstanding of the registrant's Common Stock, $1 par value (excluding shares of treasury stock) as of March 11, 2005: 57,903,836. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the definitive proxy statement for the registrant's annual stockholders' meeting to be held April 21, 2005, are incorporated by reference into Part III of this report. +FORWARD-LOOKING STATEMENTS +This Report on Form 10-K contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the footwear business, worldwide economics and the Company itself. Statements, including without limitation, those related to: future revenue, earnings, margins, growth, cash flows, operating measurements, tax rates and tax benefits; expected economic returns; projected 2005 operating results and dividend rates; future share repurchase activity; future strength of the Company; future pension costs; future marketing investments; the introduction of new lines or categories of products; future growth or success in specific countries, categories or market sectors; liquidity; capital resources and market risk are forward-looking statements. In addition, words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "predicts," "projects," "should," "will," variations of such words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("Risk Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. +Risk Factors include, but are not limited to, uncertainties relating to changes in demand for the Company's products; changes in consumer preferences or spending patterns; cancellation of future orders, changes in planned customer demand or at-once orders; the availability and pricing of foreign footwear factory capacity; reliance on foreign sourcing and concentration of production in China; the availability and price of power, labor and resources in key foreign sourcing countries, including China; the impact of competition and pricing; changes in government and regulatory policies; foreign currency fluctuations; changes in trading policies or import and export regulations; changes in interest rates, tax laws, duties, tariffs, quotas or applicable assessments; technological developments; changes in local, domestic or international economic and market conditions; the size and growth of footwear markets; service interruptions at shipping and receiving ports; changes in the price of oil and other raw materials; changes in the amount or severity of inclement weather; changes due to the growth of Internet commerce; popularity of particular designs and categories of footwear; the ability of the Company to manage and forecast its growth and inventories; the ability to secure and protect trademarks, patents and other intellectual property; integration of operations of newly acquired businesses; changes in business strategy or development plans; the ability to attract and retain qualified personnel; labor strikes or disruptions; the ability to retain rights to brands licensed by the Company; loss, bankruptcy and credit limitations of significant customers; relationships with international distributors and licensees; the Company's ability to meet at-once orders; the exercise of future purchase options by the U.S. Department of Defense on previously awarded contracts; the risk of doing business in developing countries and economically volatile areas; domestic and international terrorism and war; retail buying patterns; consolidation in the retail sector; and the acceptability of U.S. brands in international markets. Additionally, concern regarding acts of terrorism, the war in Iraq and subsequent events have created significant global economic and political uncertainties that may have material and adverse effects on consumer demand, foreign sourcing of footwear, shipping and transportation, product imports and exports and the sale of products in foreign markets. These matters are representative of the Risk Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement. Historical operating results are not necessarily indicative of the results that may be expected in the future. The Risk Factors included here are not exhaustive. Other Risk Factors exist, and new Risk Factors emerge from time-to-time, that may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. Furthermore, the Company undertakes no obligation +2 +to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. +PART 1 +Item 1. Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The Company, a Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Consumers around the world purchased more than 42.7 million pairs of Company branded footwear during fiscal 2004, making the Company a global leader among footwear companies in the marketing of branded casual, work and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort and performance. The products are marketed throughout the world under widely recognized brand names, including Bates ® , CAT ® , Harley-Davidson ® , Hush Puppies ® , HyTest ® , Merrell ® , Sebago ® , Stanley ® and Wolverine ® . The Company believes that its primary competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary designs and comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. The Company's footwear products are currently organized under five operating units: (i) the Wolverine Footwear Group, focusing on the Bates ® , HyTest ® , Stanley ® and Wolverine ® product lines of work, outdoor, uniform and lifestyle boots and shoes, (ii) the Outdoor Group, focusing on the Sebago ® and Merrell ® product lines of performance and lifestyle footwear, (iii) the Heritage Brands Group, focusing on the CAT ® product lines of work and lifestyle footwear and the Harley-Davidson ® lines of lifestyle and performance footwear, (iv) The Hush Puppies Company, focusing on the Hush Puppies ® brand of comfortable casual and dress footwear and slippers, and (v) Other Branded Footwear, focusing on the design and manufacture of private label footwear. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, gloves, handbags and plush toys. +The Company's Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support for the various Company brands. The Company's footwear is distributed domestically through 70 Company-owned retail stores and to numerous accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of the retailers to whom Wolverine distributes operate multiple storefront locations. The Company's products are distributed worldwide in over 140 markets through licensees and distributors. +The Company, through its Wolverine Leathers Division, operates a tannery which is one of the premier tanners of quality pigskin leather for the shoe and leather goods industries. Pigskin leather tanned by the Company is used in a significant portion of the footwear marketed by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of footwear. In addition, Wolverine Procurement, Inc., a Company-owned subsidiary, performs skinning operations and purchases +3 +raw pigskins which it then cures and sells to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company and the notes thereto, which are attached as Appendix A to this Form 10-K. The Company has one reportable segment, Branded Footwear and Licensing. The Branded Footwear and Licensing segment is engaged in manufacturing, sourcing, licensing, marketing and distributing branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear. The Company's Other Business units consist of its retail stores, tannery and pigskin procurement operations. Financial information regarding the Company's business segments and financial information about geographic areas is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Form 10-K. +Branded Footwear and Licensing. +The Company sources and markets a broad range of footwear styles including shoes, boots, slippers, moccasins and sandals under many recognizable brand names including Bates ® , CAT ® , Harley-Davidson ® , Hush Puppies ® , HyTest ® , Merrell ® , Sebago ® , Stanley ® and Wolverine ® . The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications at both Company-owned and independent manufacturing facilities. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, handbags and plush toys. Current significant licensing programs include Hush Puppies ® apparel, eyewear, watches and plush toys, and Wolverine ® brand apparel, gloves and eyewear. +The Company's five branded footwear and licensing operating units are described below. +1. Wolverine Footwear Group . The Wolverine Footwear Group encompasses footwear primarily under the Wolverine ® , Bates ® , HyTest ® and Stanley ® brands and markets footwear designed with performance and comfort features to serve a variety of work, outdoor and lifestyle functions. +Wolverine ® Work and Industrial Footwear . The Wolverine ® brand has built its reputation by offering high quality work boots and shoes that incorporate innovative technologies to deliver comfort and durability. The Wolverine ® brand, which has been in existence for 122 years, markets work and outdoor footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® technology and, in 2004, Wolverine MultiShox ™ technology, has allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The Wolverine Fusion ® , DuraShocks SR™ and Wolverine Compressor™ technologies represent the Company's tradition of comfortable work and industrial footwear, a tradition that is continued and enhanced with the development of the Wolverine MultiShox™ Individual Comfort System. The Wolverine ® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female industrial and farm workers. The Wolverine ® rugged casual and outdoor sport product lines incorporate DuraShocks ® technology and other comfort features into products designed for casual and outdoor sport use. The rugged casual line targets active lifestyles and includes walking shoes, rugged casuals and outdoor sandals. The outdoor sport line is designed to meet the demands of hunters, fishermen and other active outdoor sportsmen and women. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® and Thinsulate ® brand fabrics, the Company's performance leathers +4 +and patented DuraShocks ® technologies. In addition, the Wolverine ® brand is licensed for use on apparel, eyewear, watches and gloves. +Bates ® Uniform Footwear . The Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes DuraShocks ® , DuraShocks SR ™, CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and oxfords including the Bates ®, Enforcer Series ® and Special Ops ™ footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and the militaries of several foreign countries to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial occupations. Bates Uniform Footwear Division's products are also distributed through specialty retailers and catalogs. +HyTest ® Safety Footwear . The HyTest ® product line consists primarily of high-quality work boots and shoes designed to protect male and female industrial workers from foot injuries. HyTest ® footwear incorporates various specialty safety features into its product lines, including steel toe, composite toe, metatarsal guards, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology to provide comfort together with safety for working men and women. HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company's occupational and work footwear brands to workers at industrial facilities and also through direct sales arrangements with large industrial customers. +Stanley ® Footgear . Pursuant to a license arrangement with The Stanley Works, the Company has exclusive rights to manufacture, market, distribute and sell footwear under the Stanley ® brand. The Stanley ® Footgear line is designed primarily for and marketed in the value-priced work footwear market. Stanley ® Footgear is currently sold in Payless ShoeSource, Inc. stores throughout the United States. +2. The Outdoor Group . The Outdoor Group consists of Merrell ® and Sebago ® footwear and includes performance outdoor, hiking and nautical footwear as well as casual and after-sport footwear. +Merrell ® Footwear. The Merrell ® product line consists primarily of technical hiking, rugged outdoor and outdoor-inspired casual footwear designed for backpacking, day hiking and everyday use. The Merrell ® product line also includes the "After-Sport" category, incorporating Merrell ® footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers™ and other technical materials to create footwear with unique styling, performance and comfort features. In spring of 2005, the Outdoor Group launched its tightly-focused Merrell ® Continuum™ product offering, featuring four product categories that are organized by end use (Hiking, Active Speed, Multi-Sport, and Aqua Sport). In addition to footwear, the Outdoor Group markets a line of Merrell ® packs, bags and luggage. Merrell ® products are sold primarily through outdoor specialty retailers, department stores and catalogs. Merrell ® footwear is marketed in over 120 countries worldwide. +Sebago ® Footwear. The Sebago ® product line consists primarily of performance nautical and American-inspired casual footwear for men and women such as +5 +handsewn loafers and boat shoes that have been manufactured and distributed since 1946. Highly recognized Sebago ® line extensions include Docksides , Drysides and Campsides. The Sebago ® product line is distributed in over 85 countries worldwide. The Sebago ® manufacturing and design tradition of quality componentry, durability, comfort and "Americana" heritage is further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. +3. The Heritage Brands Group . The Heritage Brands Group was formed in 2004 and consists of Caterpillar ® Footwear and Harley-Davidson ® Footwear . Previously Caterpillar ® Footwear was operated as a separate operating unit and Harley-Davidson ® Footwear was part of the Wolverine Footwear Group. +Caterpillar ® Footwear. Pursuant to a license arrangement with Caterpillar Inc., the Company has exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ® , CAT & Design ® , Walking Machines ® and other trademarks. The Company believes the association with CAT ® equipment enhances the reputation of its footwear for quality, ruggedness and durability. CAT ® brand footwear products include work boots and shoes, sport boots, rugged casuals and lifestyle footwear, including lines of work and casual footwear featuring CAT ® iTechnology ™ and Hidden Tracks ® comfort features. In addition, the Company also manufactures and markets CAT ® Marine Power ® footwear, designed for industrial and recreational marine uses. CAT ® footwear products target work and industrial users and active lifestyle users. CAT ® footwear is marketed in over 130 countries worldwide. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson ® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a network of independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. +4. The Hush Puppies Company . Since 1958, the Hush Puppies ® brand has been a leader in the casual footwear market. The brand offers shoes and boots for men, women and children, and is sold in over 110 countries. The modern styling is complemented by a variety of comfort features and proprietary technologies that have earned the brand its reputation for comfort. In addition, the Hush Puppies ® brand is licensed for use on apparel, eyewear, handbags and plush toys. +5. Other Branded Footwear . The Company designs and manufactures constructed slippers, aftersport footwear, moccasins and children's footwear on a private label basis according to customer specifications. The styling of the Company's footwear reflects consumer demand for the "rugged indoor" look by using natural leathers such as moosehide, shearling and suede in constructed slipper and indoor and outdoor moccasin designs. In addition to its traditional line of private label products, the Company has developed a College Clogs™ program for the sale of licensed collegiate slipper products. +6 +Other Businesses. +In addition to manufacturing, sourcing, marketing and distributing the Company's footwear products as reported in the Branded Footwear and Licensing segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly-owned subsidiary Wolverine Procurement, Inc., and (iii) operates 70 domestic retail footwear stores. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces pigskin leathers primarily for use in the footwear industry. Wolverine Leathers ® brand products are primarily manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes these leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof and stain resistant leathers are featured in many of the Company's domestic footwear lines and many products offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +3. Wolverine Retail . The Company operates 70 domestic retail shoe stores as of February 2005. These stores are under the Hush Puppies and Family SM and Track'n Trail ® names. The Company expects to open new stores under both formats in 2005. Both retail formats carry a large selection of Company branded footwear featuring such brands as Wolverine ® , Merrell ® , Hush Puppies ® , CAT ® , Sebago ® and Harley-Davidson ® . The Company also operates direct-to-customer retail websites, including www.upfootgear.com , www.trackandtrail.com , www.catfootwear.com and www.hushpuppies.com . +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States and international markets to foster a differentiated and consistent image for each of the Company's core footwear brands. Each footwear brand group has its own marketing personnel who develop the marketing strategy for products within that group. Marketing campaigns and strategies vary by brand and may target accounts and/or end users as they strive to increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's footwear. Components of the brand-specific plans vary and may include print, radio and television advertising, event sponsorships, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's footwear brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance that may be provided by the Company to its licensees and distributors are (i) direction on the categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting on retail store layout and design. The Company believes its footwear brand names provide a competitive advantage and the Company makes significant +7 +expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution. +The Company uses a wide variety of distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses the following distribution strategies. +• +Traditional wholesale distribution is used to service department stores, large footwear chains, specialty retailers, catalogs, independent retailers and uniform outlets. A dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide branded and private label footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchant and government customers. +• +A network of independent Shoemobile ® distribution outlets is used to distribute the Company's work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and enters bids for contracts to supply specific footwear products. +In addition to its wholesale activities, the Company also operates a domestic retail operation as described above. The Company continues to develop various programs, both independently and with its retail customers, for the distribution of its products. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's revenue in fiscal 2004. +The Company experiences moderate fluctuations in sales volume during the year as reflected in quarterly revenue (and taking into consideration the 16 weeks or 17 weeks included in the fourth accounting period versus the 12 weeks included in the first three accounting periods). The Company also experiences some fluctuation in its levels of working capital, typically including an increase in working capital requirements near the end of the third quarter. The Company provides working capital for such fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects current seasonal sales patterns to continue in future years. +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of sales of branded footwear products generated from the Company's owned operations in Canada, the United Kingdom, Austria, Finland, France, Germany, The Netherlands, Spain, Sweden and Switzerland and from royalty income through a network of independent licensees and distributors. The Company's owned operations include Hush Puppies (UK) Ltd., Merrell Europe B.V., Merrell (Europe) Limited, Wolverine Europe Limited and Wolverine World Wide Corporation, Inc. (formerly known as Hush Puppies Canada Footwear, Ltd.). In addition, in January 2005, the Company's Canadian subsidiary, Wolverine World Wide Corporation, Inc., purchased selected assets of the Canadian CAT and Wolverine footwear businesses from the Company's former independent distributor, Wolverine Canada, Inc.; and also +8 +acquired the assets of the Company's Merrell Canada division to centralize its Canadian operations. The Company also acquired selected assets of its Merrell distributors in Sweden and Finland and began direct distribution of Sebago ® brand products to retailers in the U.K. and Germany. The Company's owned operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of products (primarily Company footwear) bearing the Hush Puppies ® , Wolverine ® , Bates ® , HyTest ® , Merrell ®, Sebago ® and other trademarks by independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the CAT ® , and Harley-Davidson ® trademarks through foreign distributors. License and distribution arrangements enable the Company to develop sales in international markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent with the global brand position. Independent licensees and distributors purchase goods from either the Company or authorized third-party manufacturers pursuant to distribution agreements or manufacture branded products consistent with Company standards pursuant to license agreements. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and manufacture of approximately 76% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the pairs controlled by the Company, approximately 88% are purchased or sourced from third parties, with the remainder produced at Company-operated facilities. Footwear produced by the Company is manufactured at Company-operated facilities in several domestic and certain affiliated foreign facilities located in Michigan, Arkansas, and the Dominican Republic. For some of the Company-produced footwear, a "twin plant" concept is utilized whereby a majority of the labor intensive cutting and fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Dominican Republic and Arkansas, and the technology intensive construction, or "bottoming," is performed primarily at the Company's Michigan facilities. +The Company's factories each have the flexibility to produce a variety of footwear, which departs from the industry's historical practice of dedicating a given facility to production of specific footwear products. This flexibility allows the Company to quickly respond to changes in market preference and demand. The Company currently produces slippers, military footwear and work, casual and dress casual footwear in its domestic and/or Dominican Republic facilities. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, Central and South America, India and Europe. The Company maintains technical offices in the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In addition, the Company has adopted "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +9 +The Company's domestic manufacturing operations allow the Company to (i) reduce its production lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and (iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (i) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (ii) source the highest quality raw materials from around the world, and (iii) avoid additional capital expenditures necessary for owned factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company maximum flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates a pigskin tannery through its Wolverine Leathers Division, which is one of the premier tanners of quality leather for the footwear industry. The Company and its licensees receive virtually all of their pigskin requirements from the tannery. The Company believes the tannery provides a strategic advantage for the Company by producing pigskin leather using proprietary technology at prices below those available from other sources. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of common upper materials and specialty leathers eliminates any reliance by the Company upon a sole supplier. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over 30 years. Alternative sources of pigskin are available; however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas and tariffs, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could have an adverse impact on the Company's operations and financial condition. +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear products. The owned trademarks that are most widely used by the Company include Hush Puppies ® , Wolverine ® , Bates ® , Wolverine Fusion ® , DuraShocks ® , Wolverine MultiShox ™ , Wolverine Compressor™, Hidden Tracks ® , iTechnology ™ , Bounce ® , Comfort Curve ® , HyTest ® , Merrell ® , Continuum ™, Sebago ® , and Track'n Trail ® . The Company has obtained license rights to manufacture, market and distribute footwear throughout the world under the CAT ® and Harley-Davidson ® trademarks, and the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark, all pursuant to license arrangements with the respective trademark owners. The CAT ® , Harley-Davidson ® , and Stanley ® licenses are long-term and extend for five or more years with conditional renewal options and are subject to early termination for breach. Pigskin leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers ® , Weather Tight ® and All Season Weather Leathers ™. +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of +10 +ownership of its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever possible and to vigorously defend its trademarks against infringement or other threats to the greatest extent practicable under the laws of the United States and other countries. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent practicable under applicable laws. +Order Backlog. +At March 14, 2005, the Company had an order backlog of approximately $326 million compared with an order backlog of approximately $274 million at March 13, 2004. Substantially all of the backlog relates to demand for products expected to be shipped in 2005. Orders in backlog are subject to cancellation by customers and to changes in planned customer demand or at-once orders. The backlog at a particular time is affected by a number of factors, including seasonality, retail conditions, expected customer demand, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments. +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States and Europe. The Company has at least ten major competitors in connection with the sale of its work shoes and boots, at least ten major competitors in connection with the sale of its sport boots, and at least thirty major competitors in connection with the sale of its casual, work and outdoor shoes. Product performance and quality, including technological improvements, product identity, competitive pricing, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing efficiencies, its tannery operations, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and no one company has a dominant market position. +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to the development of new production techniques and to improving the function, performance, reliability and quality of its branded footwear and other products. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, such as Bounce ® , DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. +11 +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company uses and generates certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites and other regulatory issues. +Employees. +As of January 1, 2005, the Company had approximately 5,134 domestic and foreign production, office and sales employees. Approximately 640 employees were covered by three union contracts expiring at various dates through May 1, 2006. The Company presently considers its employee relations to be good. +Available Information. +Information about the Company, including the Company's Code of Conduct & Compliance, Corporate Governance Guidelines, Director Independence Standards, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, Executive Committee Charter and Governance Committee Charter, is available at its website, http://www.wolverineworldwide.com. Printed copies of the documents listed above are available by writing to the Company at 9341 Courtland Drive, N.E., Rockford, MI 49351, Attention: Director of Investor Relations. +The Company also makes available on or through its website, free of charge, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports (along with certain other Company filings with the Securities and Exchange Commission ("SEC")) as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These materials are also accessible on the SEC's website at www.sec.gov. +Item 2. Properties . +The Company operates its domestic administration, sales and marketing operations primarily from an owned facility of approximately 225,000 square feet in Rockford, Michigan. The Company's manufacturing and tanning operations are primarily conducted at a combination of leased and owned facilities in Arkansas, Michigan and the Dominican Republic. The Company operates its warehousing operations primarily through owned warehouses in Rockford, Michigan, totaling approximately 475,000 square feet, a leased warehouse in Cedar Springs, Michigan, of approximately 362,000 square feet and a leased warehouse in Howard City, Michigan, of approximately 350,000 square feet, which the Company currently expects to expand by approximately 100,000 square feet. +The Company also leases and owns various other offices and warehouses in the United States to meet its operational requirements. In addition, the Company's subsidiary, Hush Puppies Retail, Inc., operates retail stores through leases with various third-party landlords. International operations are conducted in Canada, the United Kingdom, and Europe through leased warehouses, offices and +12 +showrooms. The Company believes that its current facilities are suitable and adequate for its current needs. +Item 3. Legal Proceedings . +The Company is involved in litigation and various legal matters arising in the normal course of business, including certain environmental compliance activities. The Company has considered facts related to legal and regulatory matters and opinions of counsel handling these matters, and does not believe the ultimate resolution of such proceedings will have a material adverse effect on the Company's financial condition or future results of operations. +Item 4. Submission of Matters to a Vote of Security Holders . +No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report. +Supplemental Item. Executive Officers of the Registrant . +The following table lists the names and ages of the Executive Officers of the Company as of January 1, 2005, and the positions presently held with the Company. The information provided below the table lists the business experience of each such Executive Officer during the past five years. All Executive Officers serve at the pleasure of the Board of Directors of the Company, or if not appointed by the Board of Directors, they serve at the pleasure of management. +Name +Age +Positions held with the Company +Steven M. Duffy +52 +Executive Vice President and President, +Global Operations Group +V. Dean Estes +55 +Vice President and President, +Wolverine Footwear Group +Stephen L. Gulis, Jr. +47 +Executive Vice President, Chief Financial +Officer and Treasurer +Blake W. Krueger +51 +Executive Vice President, Secretary, and +President, Heritage Brands Group +Timothy J. O'Donovan +59 +Chief Executive Officer and President +Nicholas P. Ottenwess +42 +Vice President of Finance and Corporate +Controller +Robert J. Sedrowski +55 +Vice President of Human Resources +James D. Zwiers +37 +General Counsel and Assistant +Secretary +Steven M. Duffy has served the Company as Executive Vice President since April 1996 and is President of the Company's Global Operations Group. From 1993 to 1996 he served as Vice President. From 1989 to 1993 he served in various senior manufacturing positions. +V. Dean Estes has served the Company as Vice President since 1995. Mr. Estes is also President of the Wolverine Footwear Group. Since he joined the Company in 1975, Mr. Estes has served in various positions relating to the sales, marketing and product development functions of the Company's work boot and shoe related businesses. +13 +Stephen L. Gulis, Jr., has served the Company as Executive Vice President, Chief Financial Officer and Treasurer since April 1996. From 1994 to April 1996 he served as Vice President and Chief Financial Officer. From 1993 to 1994 he served as Vice President of Finance and Corporate Controller and from 1986 to 1993 he was the Vice President of Administration and Controller for The Hush Puppies Company. +Blake W. Krueger has served the Company as Executive Vice President, Secretary and President of the Heritage Brands Group since August 2004. From November 2003 to August 2004 he served the Company as Executive Vice President, Secretary, and President of Caterpillar Footwear. From April 1996 to November 2003 he served the Company as Executive Vice President, General Counsel and Secretary. From 1993 to April 1996 he served as General Counsel and Secretary. From 1985 to 1996 he was a partner with the law firm of Warner Norcross & Judd LLP. +Timothy J. O'Donovan has served the Company as Chief Executive Officer and President since April 2000. From 1996 to April 2000 he served as Chief Operating Officer and President. From 1982 to April 1996 he served as Executive Vice President. +Nicholas P. Ottenwess has served the Company as Vice President of Finance and Corporate Controller since June 2001. From September 1997 to June 2001 he served as Corporate Controller. From 1993 to September 1997 he served as Vice President of Finance and Administration for The Hush Puppies Company. +Robert J. Sedrowski has served the Company as Vice President of Human Resources since October 1993. From 1990 to 1993 he served as Director of Human Resources. +James D. Zwiers has served the Company as General Counsel and Assistant Secretary since December 2003. From January 1998 to December 2003 he served the Company as Associate General Counsel and Assistant Secretary. From 1995 to 1998 he was an attorney with the law firm of Warner Norcross & Judd LLP. +PART II +Item 5. +Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +The Company's common stock is traded on the New York Stock Exchange and the Pacific Exchange under the symbol "WWW." The following table shows the high and low stock prices on the New York Stock Exchange and dividends declared by calendar quarter for 2004 and 2003. The prices and dividends shown below have been retroactively adjusted to reflect the three-for-two stock split distributed on February 1, 2005. The number of stockholders of record on March 1, 2005 was 1,518. +2004 +2003 +Stock Price +High +Low +High +Low +First quarter +$ +16.10 +$ +13.40 +$ +11.72 +$ +9.53 +Second quarter +18.81 +15.38 +12.87 +10.70 +Third quarter +17.92 +14.27 +14.00 +12.35 +Fourth quarter +21.66 +16.18 +14.39 +13.00 +14 +Cash Dividends Declared Per Share: +2004 +2003 +First quarter +$ +.043 +$ +.037 +Second quarter +.043 +.037 +Third quarter +.043 +.037 +Fourth quarter +.065 +.037 +A quarterly dividend of $.065 per share was declared during the first quarter of fiscal 2005. +See Item 12 for information with respect to the Company's equity compensation plans. +The following table relates information regarding the Company's purchases of its own common stock during the fourth quarter: +Issuer Purchases of Equity Securities (1) +Period +Total +Number of +Shares +Purchased +Average +Price Paid +per Share +Total Number +of +Shares +Purchased +as Part of +Publicly +Announced +Plans or +Programs +Maximum +Number +of Shares that +May +Yet Be Purchased +Under the Plans or +Programs +Period 1 (September 12, 2004 to October 9, 2004) +Common Stock Repurchase Program (2) +$ +3,326,832 +Employee Transactions (3) +24,111 +18.30 +N/A +N/A +Period 2 (October 10, 2004 to November 6, 2004) +Common Stock Repurchase Program (2) +3,326,832 +Employee Transactions (3) +256,466 +19.87 +N/A +N/A +Period 3 (November 7, 2004 to December 4, 2004) +Common Stock Repurchase Program (2) +365,550 +19.55 +365,550 +2,961,282 +Employee Transactions (3) +N/A +N/A +Period 4 (December 5, 2004 to January 1, 2005) +Common Stock Repurchase Program (2) +2,961,282 +Employee Transactions (3) +592,545 +20.80 +N/A +N/A +Total for Fourth Quarter ended January 1, 2005 +Common Stock Repurchase Program (2) +365,550 +$ +19.55 +365,550 +2,961,282 +Employee Transactions (3) +873,122 +20.46 +N/A +N/A +1. +The information in this table and in these notes has been adjusted to reflect the three-for-two stock split distributed on February 1, 2005. +2. +The Company's Board of Directors approved two common stock repurchase programs, one on October 5, 2004, and one on December 9, 2003. Each program authorizes the repurchase of 3.0 million shares of common stock over a 24-month period commencing on the effective date of the program. All shares repurchased during the period covered by this report were purchased under publicly announced programs. +3. +Employee transactions include: (1) shares delivered or attested in satisfaction of the exercise price and/or tax withholding obligations by holders of employee stock options who exercised +15 +options and (2) restricted shares withheld to offset tax withholding that occurs upon vesting of restricted shares. The Company's employee stock compensation plans provides that the value of the shares delivered or attested to, or withheld, shall be the average of the high and low price of the Company's common stock on the date the relevant transaction occurs. +Item 6. Selected Financial Data . +Five-Year Operating and Financial Summary (1) +2004 +2003 +2002 +2001 +2000 +(Thousands of Dollars, Except Per Share Data) +Summary of Operations +Revenue +$ +991,909 +$ +888,926 +$ +827,106 +$ +720,066 +$ +701,291 +Net earnings +65,938 +51,716 +47,912 +45,240 +10,690 +Per share of common stock: +Basic net earnings (2)(3) +$ +1.15 +$ +.88 +$ +.79 +$ +.74 +$ +.17 +Diluted net earnings (2)(3) +1.09 +.85 +.77 +.71 +.17 +Cash dividends declared (2) +.19 +.15 +.12 +.11 +.09 +Financial Position at Year End +Total assets +$ +639,571 +$ +593,762 +$ +531,994 +$ +543,678 +$ +494,568 +Long-term debt +43,904 +59,923 +72,915 +90,848 +92,194 +Notes to Five-Year Operating and Financial Summary +1. +This summary should be read in conjunction with the consolidated financial statements and the notes thereto, which are attached as Appendix A to this Form 10-K. In particular, see the discussions of the fiscal 2000 $45.0 million realignment charge as discussed in the Company's 2000 Form 10-K filed with the Securities and Exchange Commission ("SEC") and Note 11 - Business Acquisitions. +2. +On December 15, 2004, the Company announced a three-for-two stock split in the form of a stock dividend on shares of common stock outstanding at January 3, 2005 distributed to stockholders on February 1, 2005. All per share data has been retroactively adjusted for the increased shares resulting from this stock split. Treasury shares were excluded from the stock split. +3. +Basic earnings per share are based on the weighted average number of shares of common stock outstanding during the year after adjustment for nonvested common stock. Diluted earnings per share assume the exercise of dilutive stock options and the vesting of all outstanding restricted stock. +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. +Overview +During 2004, Wolverine World Wide, Inc. (the "Company") achieved record revenue and earnings. Revenue increased 11.6% to $991.9 million, marking a fifth consecutive annual revenue increase. Earnings per share growth extended for a fourth consecutive year, improving 28.2% to $1.09 per share. The Company ended 2004 with $72.2 million in cash on hand and a debt balance at an eight-year low. For the sixth year in a row, the Company recorded positive cash generation from operating activities with 2004 cash generation reaching a record $106.4 million. Continued focus on asset management programs contributed to significant reductions in accounts receivable days sales outstanding as well as improved inventory turnover ratios. +16 +The Company's 2004 performance is a direct result of the execution of the Company's strategic growth plan unveiled several years ago. The key growth strategies of this plan include: +• +Expanding our global reach - Consumers in more than 140 countries purchased over 42.7 million pairs of footwear bearing our brand names during 2004. The Company's European-based wholesale operations represented over 17% of the Company's 2004 revenue and achieved year-over-year revenue growth exceeding 20%. +• +Pursuing and delivering product excellence - Our product development process continues to strengthen as the Company strives to deliver innovative, high quality, market-right products. This strategy has resulted in an increased global market share. A benefit of the evolving product development process is the creation of tightly-focused product collections and improved inventory turns for the Company. +• +Strengthening our brand/business portfolio - The Company successfully integrated the Sebago ® brand, acquired in November 2003, into its business portfolio. The first full year's revenue was on plan while earnings exceeded expectations. The Company continued to reach consumers directly through global concept stores and shop-in-shops for the Merrell ® and Hush Puppies ® brands and expanded its Track'n Trail ® retail concept stores. +• +Providing service excellence to our customers - In an effort to better serve its customers, and to deliver product to market faster, the Company added several enhancements to its strong suite of business systems. SAP ® upgrades included the launch of the business warehouse and strategic enterprise management modules to more effectively meet today's rigorous financial reporting requirements. The Company's Online Account Service capabilities were made available in Canada and Europe. Customers in those markets now have the same 24/7 access to online ordering and account review capabilities that have proven beneficial to U.S. retailers. +• +Building a strong team and Company culture - The Company continues to attract and retain excellent leadership throughout the business. We continue to improve our management strength through training and career development, and our success is a result of the dedication, skills and experience of our global team. +During 2005, the Company expects to achieve a significant milestone - crossing the $1.0 billion revenue mark. Our strategic plan is focused on creating shareholder value through the delivery of consistent revenue and earnings growth, improved operating leverage, effective asset utilization and strong cash generation. The three-year growth goals include: +• +Producing annual revenue growth averaging mid- to upper-single digits - The Company expects this growth to be generated through global expansion and market share gains from its operations. +• +Generating earnings growth at approximately 1.5 times the rate of revenue growth - The Company expects its operating model to generate earnings at a rate significantly greater than revenue growth. +• +Driving the global growth of the Company's brands through investments in marketing and product development - The Company plans to increase its investment in marketing and product development at rates faster than revenue growth by reinvesting a portion of expected margin gains into brand building activities. +17 +The following is a discussion of the Company's results of operations and liquidity and capital resources. This section should be read in conjunction with the consolidated financial statements and notes. All share and per share amounts in management's discussion and analysis of financial condition and results of operations have been adjusted for all periods to reflect the three-for-two stock split distributed on February 1, 2005. +RESULTS OF OPERATIONS - FISCAL 2004 COMPARED TO FISCAL 2003 +Financial Summary - 2004 versus 2003 +2004 +2003 +Change +$ +% +$ +% +$ +% +(Millions of Dollars, Except Per Share Data) +Revenue +Branded footwear and licensing +$ +903.6 +91.1% +$ +812.6 +91.4% +$ +91.0 +11.2% +Other business units +88.3 +8.9% +76.3 +8.6% +12.0 +15.7% +Total revenue +$ +991.9 +100.0% +$ +888.9 +100.0% +$ +103.0 +11.6% +Gross margin +Branded footwear and licensing +$ +343.1 +38.0% +$ +300.1 +36.9% +$ +43.0 +14.3% +Other business units +31.0 +35.1% +26.5 +34.7% +4.5 +17.0% +Total gross margin +$ +374.1 +37.7% +$ +326.6 +36.7% +$ +47.5 +14.5% +Selling and administrative expenses +$ +274.1 +27.6% +$ +246.7 +27.7% +$ +27.4 +11.1% +Interest expense-net +3.2 +0.3% +5.5 +0.6% +(2.3 +) +(41.8% +) +Other income-net +(0.3 +) +0.0% +(0.7 +) +(0.1% +) +(0.4 +) +(57.1% +) +Earnings before income taxes and minority +interest +97.1 +9.8% +75.1 +8.5% +22.0 +29.3% +Net earnings +65.9 +6.6% +51.7 +5.8% +14.2 +27.5% +Diluted earnings per share +$ +1.09 +- +$ +0.85 +- +$ +0.24 +28.2% +The Company has one reportable segment that is engaged in manufacturing, sourcing, marketing and distributing branded footwear, licensed apparel and accessories. Within the Branded Footwear and Licensing segment, the Company has identified five operating units, consisting of the Wolverine Footwear Group (comprised of the Bates ® , HyTest ® , Stanley ® and Wolverine ® brands), the Outdoor Group (comprised of the Merrell ® and Sebago ® brands), the Heritage Group (comprised of Harley-Davidson ® Footwear and CAT ® Footwear), The Hush Puppies Company, and Other Branded Footwear. The Company's other business units consist of Hush Puppies ® Retail and Wolverine ® Leathers (comprised of the Tannery and Procurement operations). The following is supplemental information on total revenue: +Total Revenue +2004 +2003 +Change +$ +% +$ +% +$ +% +(Millions of Dollars) +Wolverine Footwear Group +$ +269.3 +27.1% +$ +255.4 +28.7% +$ +13.9 +5.4% +Outdoor Group +286.6 +28.9% +223.2 +25.1% +63.4 +28.4% +Heritage Group +159.4 +16.1% +152.2 +17.1% +7.2 +4.7% +The Hush Puppies Company +157.8 +15.9% +151.1 +17.0% +6.7 +4.4% +Other Branded Footwear +30.5 +3.1% +30.7 +3.5% +(0.2 +) +(0.7% +) +Total branded footwear and licensing revenue +$ +903.6 +91.1% +$ +812.6 +91.4% +$ +91.0 +11.2% +Other business units +88.3 +8.9% +76.3 +8.6% +12.0 +15.7% +Total revenue +$ +991.9 +100.0% +$ +888.9 +100.0% +$ +103.0 +11.6% +18 +REVENUE +Revenue for 2004 increased $103.0 million over 2003. A full year of revenue from Sebago ® represented $26.3 million of the increase. Increases in unit volume, changes in product mix and changes in selling price for the Branded Footwear and Licensing segment operations, as discussed below, contributed $58.5 million of the revenue increase. The impact of translating foreign denominated revenue to U.S. dollars improved revenue by $18.2 million. Both domestic and international revenue increased with international revenue accounting for 27.6% of total revenue in 2004 compared to 24.5% in 2003. +The Wolverine Footwear Group's revenue increase was due to the success of the Bates ® division. The Bates ® brand improvements were driven by increased shipments of technical boot products to the U.S. military and the civilian uniform markets. A significant portion of the sales gain resulted from accelerated demand under a combat boot contract for the Department of Defense. Wolverine ® Boots and Shoes recorded a decline in revenue principally as a result of lower average selling prices as the business responded to consumer demand for more boot product in the $80 - $120 retail price point category. +The Outdoor Group reported its seventh year of double-digit revenue growth. The Merrell ® business accounted for over half of the increase. Merrell ® experienced double-digit growth in the four wholesale markets that it services - U.S., Canada, U.K. and Europe. The Merrell ® brand's presence continues to grow with 134 U.S. shop-in-shops in operation at year end. The Sebago ® brand, in its first full year of operations, met its planned revenue goal. Approximately 60% of the Sebago ® revenue was generated outside of the United States. +The Heritage Group recorded a mid-single-digit revenue increase for 2004. The Harley-Davidson ® Footwear business recorded a slight increase for the year, with growth coming from new distribution channels. The CAT ® Footwear business recorded revenue growth in the U.S., U.K. and, Europe and with the brand's international distributors. New product technologies introduced during the year as well as the impact of translating foreign denominated revenue to U.S. dollars contributed to the increase. +The Hush Puppies Company's revenue increase was generated from the U.K., Canada and the international licensing businesses. Within The Hush Puppies Company's foreign wholesale operations, Hush Puppies ® U.K. reported a strong increase as a result of expanded distribution with fashion accounts. The Hush Puppies ® Canada business recorded an increase in a challenging retail environment. Hush Puppies ® U.S. experienced a revenue decrease as the business continued its transition plan from mature, lower-priced product to a younger, more contemporary-styled footwear assortment. +Revenue for Other Branded Footwear decreased as the Company executed a strategy to revamp its private label footwear offerings. +Within the Company's other business units, Hush Puppies ® Retail reported a mid-single-digit same-store sales increase. Wolverine ® Leathers recorded a revenue increase driven primarily by market demand for sueded leather footwear. +The Company ended 2004 with an order backlog approximately 13% above 2003 year-end levels. This backlog principally reflects demand for the first half of 2005. +GROSS MARGIN +The total gross margin level for 2004 of 37.7% was a 100 basis point improvement over the prior year. Benefits from favorable exchange rates comprise 60 basis points of the improvement. Inventory management programs as well as a higher margin product mix also contributed to the improvement. +19 +SELLING AND ADMINISTRATIVE EXPENSES +The increase in selling and administrative expenses includes an additional $7.0 million investment in product development and marketing for the Company's branded products. The Company also recognized increases in profit sharing expense of $6.0 million. The impact of translating foreign denominated operating expense to U.S. dollars increased total expense by $4.9 million in 2004. The Company recorded a $1.2 million decrease in pension expense. The remaining increase relates primarily to selling costs that are directly variable to the increase in revenue. +INTEREST, OTHER & TAXES +The net decrease in interest expense reflects lower average outstanding amounts on senior notes and lower working capital borrowings during the year as well as interest income from invested cash. +The change in other income primarily relates to the change in realized gains or losses on foreign currency transactions. +The Company's 2004 effective income tax rate was 31.8% compared to 31.0% for 2003 and was in line with the Company's estimated annualized rate. The 2003 income tax rate included the cumulative impact of research and development tax credits, while 2004 reflected only one year of credit taken. The estimated annualized effective tax rate for fiscal 2005 is 32.0%. +NET EARNINGS +As a result of the revenue, gross margin and expense changes discussed above, the Company achieved 2004 net earnings of $65.9 million, an increase of $14.2 million over 2003. +RESULTS OF OPERATIONS - FISCAL 2003 COMPARED TO FISCAL 2002 +Financial Summary - 2003 versus 2002 +2003 +2002 +Change +$ +% +$ +% +$ +% +(Millions of Dollars, Except Per Share Data) +Revenue +Branded footwear and licensing +$ +812.6 +91.4% +$ +748.8 +90.5% +$ +63.8 +8.5% +Other business units +76.3 +8.6% +78.3 +9.5% +(2.0 +) +(2.6% +) +Total revenue +$ +888.9 +100.0% +$ +827.1 +100.0% +$ +61.8 +7.5% +Gross margin +Branded footwear and licensing +$ +300.1 +36.9% +$ +265.1 +35.2% +$ +35.0 +13.2% +Other business units +26.5 +34.7% +29.1 +39.2% +(2.6 +) +(8.9% +) +Total gross margin +$ +326.6 +36.7% +$ +294.2 +35.6% +$ +32.4 +11.0% +Selling and administrative expenses +$ +246.7 +27.7% +$ +217.2 +26.3% +$ +29.5 +13.6% +Interest expense +5.5 +0.6% +6.5 +0.8% +(1.0 +) +(15.3% +) +Other income-net +(0.7 +) +0.1% +(1.0 +) +0.1% +0.3 +(34.4% +) +Earnings before income taxes and +minority interest +75.1 +8.5% +71.7 +8.7% +3.4 +4.9% +Net earnings +51.7 +5.8% +47.9 +5.8% +3.8 +7.9% +Diluted earnings per share +$ +0.85 +- +$ +0.77 +- +$ +0.08 +10.4% +20 +The following is supplemental information on total revenue: +Total Revenue +2003 +2002 +Change +$ +% +$ +% +$ +% +(Millions of Dollars) +Wolverine Footwear Group +$ +255.4 +28.7% +$ +243.9 +29.6% +$ +11.5 +4.7% +Outdoor Group +223.2 +25.1% +180.0 +21.7% +43.2 +24.0% +Heritage Group +152.2 +17.1% +149.8 +18.1% +2.4 +1.6% +The Hush Puppies Company +151.1 +17.0% +143.9 +17.4% +7.2 +5.0% +Other Branded Footwear +30.7 +3.5% +31.2 +3.7% +(0.5 +) +(1.6% +) +Total branded footwear and +licensing revenue +$ +812.6 +91.4% +$ +748.8 +90.5% +$ +63.8 +8.5% +Other business units +76.3 +8.6% +78.3 +9.5% +(2.0 +) +(2.6% +) +Total revenue +$ +888.9 +100.0% +$ +827.1 +100.0% +$ +61.8 +7.5% +REVENUE +Revenue for 2003 increased $61.8 million over 2002. Increases in unit volume, changes in product mix and changes in selling prices for the branded footwear operations as discussed below contributed $45.1 million of the revenue increase. The impact of translating foreign denominated revenue to U.S. dollars improved revenue by $15.6 million. The acquisition of Sebago ® added $3.1 million to revenue. These increases were offset by a $2.0 million decrease in the other business units. Both domestic and international revenue increased, with international revenue accounting for 24.1% of total revenue. +The Wolverine Footwear Group's revenue increase was largely due to the success of the Bates ® division. The Bates ® brand improvements were driven by increased shipments of technical boot products to the U.S. military and tactical ultra-light uniform footwear for the civilian uniform market. Wolverine ® Boots and Shoes (including HyTest ® and Stanley ® ) recognized an increase in units sold, but experienced a slight decline in revenue dollars per unit sold reflecting a continued shift in the marketplace to more moderately priced footwear. +The Outdoor Group reported its sixth consecutive year of double-digit revenue growth. The Merrell ® U.S. footwear business accounted for approximately half of the increase, with growth coming from the outdoor/sporting goods and department store distribution channels. The Merrell ® European and Canadian wholesale businesses also contributed to the increase, due to the expansion of multi-sport and casual footwear product sales. Revenue from the Merrell ® international business increased with Italy, Japan, Argentina and Sweden/Finland each recognizing over a 100,000 pair increase from the prior year. Sebago ® , which was purchased in November 2003, also contributed to the revenue increase for the Outdoor Group. +The Heritage Group had a slight sales increase for the year. Revenue from Harley-Davidson ® Footwear improved due to expanded product offerings in the existing Harley-Davidson ® dealerships, as well as in new distribution channels. CAT ® Footwear realized a revenue decrease due to lower sales in the CAT ® U.S. wholesale business, primarily caused by a reduction in shipments of work and industrial product resulting from cautious inventory reorders by large national chain retailers. The CAT ® international distribution business reported improved revenues, reflecting an increase in pairs sold in Canada, South Africa, Saudi Arabia, Mexico and the Pacific Rim. The CAT ® European business recognized an increase in revenue reflecting the impact of translating foreign denominated revenue to U.S. dollars. +21 +The Hush Puppies Company's increase was generated primarily from the international divisions as a result of expanded retail distribution and higher royalty income from international licensees in the Pacific Rim and Europe. Within The Hush Puppies Company's foreign wholesale operations, Hush Puppies ® U.K. reported strong increases in revenue as a result of expanded distribution of its better grade products while Hush Puppies ® Canada revenue was up slightly for the year. Hush Puppies ® U.S. experienced a slight decrease in revenue as it continued to transition from lower-priced, more mature products in favor of higher-priced, better-grade footwear aimed at a younger, more contemporary consumer. +Revenue for Other Branded Footwear decreased slightly due to lower shipments of private label product. +Within the Company's other business units, Hush Puppies ® Retail reported an increase in the low-single-digit range as a result of same-store revenue increases and new store openings. Wolverine ® Leathers recorded decreases in revenue due to reduced market demand for sueded leather used for footwear. +The Company ended 2003 with an order backlog of approximately 19% above 2002 year-end levels. The purchase of Sebago ® contributed 4% of the increase. +GROSS MARGIN +The gross margin dollar and percentage increases for the branded footwear segment relate to the increased sales mix of the Company's lifestyle product offerings (80 basis points), fewer required markdowns on slow moving inventories (50 basis points) and favorable foreign exchange rate changes (20 basis points). The gross margin percentage for the other business units decreased as a result of inefficiencies and overhead absorption losses experienced in the Wolverine ® Leathers operation due to reduced production levels. Hush Puppies ® Retail's gross margin level remained flat. +SELLING AND ADMINISTRATIVE EXPENSES +The increase in selling and administrative expenses includes planned increases of $7.3 million in pension expense, due to reductions in the market value of assets and interest rates used in the actuarial valuation, and $2.3 million in employee benefit costs. The impact of translating foreign denominated operating expense to U.S. dollars increased total expenses by $6.6 million in 2003. The remaining increase relates primarily to selling and distribution costs that are directly variable to the increase in revenue. +INTEREST, OTHER & TAXES +The decrease in interest expense reflects lower average outstanding amounts on senior notes and minimal borrowing under the revolving credit facility. +The change in other income primarily relates to the change in realized gains or losses on foreign currency transactions. +The Company's 2003 effective income tax rate was 31.0% compared to 32.9% for 2002. This reduced effective tax rate reflects the overall profit mix from the Company's foreign entities and the cumulative impact of research and development tax credits recorded in 2003. The Company expects the research and development tax credit will have an ongoing positive benefit. +NET EARNINGS +As a result of the revenue, gross margin and expense changes discussed above, the Company achieved 2003 net earnings of $51.7 million, an increase of $3.8 million over 2002. +22 +LIQUIDITY AND CAPITAL RESOURCES +January 1, +January 3, +Change +2005 +2004 +$ +% +(Millions of Dollars) +Cash +$ 72.2 +$ 55.4 +$ 16.8 +30.4% +Accounts receivable +151.2 +146.9 +4.3 +2.9% +Inventories +182.9 +164.9 +18.0 +10.9% +Accounts payable +50.5 +26.3 +24.2 +91.9% +Accrued salaries and wages +19.4 +16.7 +2.7 +16.4% +Other accrued liabilities +28.6 +26.7 +1.9 +6.9% +Debt +43.9 +59.9 +(16.0 +) +(26.7% +) +Cash provided by operating activities +106.4 +102.2 +4.2 +4.1% +Additions to property, plant and equipment +18.1 +16.0 +2.1 +12.9% +Depreciation and amortization +19.1 +17.9 +1.2 +6.3% +The Company continued to strengthen its balance sheet in 2004. Accounts receivable increased 2.9% on an 11.6% revenue gain. Cash of $106.4 million was generated from operating activities in 2004, with cash of $12.2 million generated from working capital improvements. Inventory levels were up 10.9%, which was slightly less than the revenue gain. The inventory increase reflects receipt of the Merrell ® Continuum™ product line for spring 2005, which was accelerated as retail demand was high. The accounts receivable days sales outstanding was reduced by 10.2% and inventory SKU (stock keeping unit) levels were reduced by 5.1%. +The increase in accounts payable was attributed to the timing of inventory purchases from contract suppliers, specifically the acceleration of the Merrell ® Continuum™ product noted above. The increase in accrued salaries and wages was due to profit sharing accruals. The increase in other accrued liabilities was a result of a 50% increase in the level of cash dividends declared in the fourth quarter and distributed on February 1, 2005. +The majority of capital expenditures were for information system enhancements, distribution equipment and building improvements and consumer-direct initiatives. The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2018. +The Company has a long-term revolving credit agreement that expires in May 2006 and allows for borrowings up to $150.0 million, of which $10.0 million is allocated to the Company's Canadian subsidiary. Of the remaining $140.0 million facility, $35.0 million can be utilized by the Company's European subsidiaries. The revolving credit facility is used to support working capital requirements. No amounts were outstanding under revolving credit facilities at January 1, 2005 or January 3, 2004. The Company was in compliance with all debt covenant requirements at January 1, 2005. Proceeds from existing credit facilities and anticipated renewals, along with cash flows from operations, are expected to be sufficient to meet capital needs in the foreseeable future. Any excess cash flows from operating activities are expected to be used to purchase property, plant and equipment, pay down existing debt, fund internal and external growth initiatives, pay dividends or repurchase the Company's common stock. +The decrease in debt was the result of annual principal payments on the Company's senior notes. The Company had commercial letter-of-credit facilities outstanding of $3.2 million and $2.4 million at the end +23 +of 2004 and 2003, respectively. The total debt to total capital ratio for the Company was 8.7% in 2004 and 12.2% in 2003. +The Company's pension benefit results are based upon actuarial valuations. Inherent in these valuations are key assumptions, including discount rates and expected returns on plan assets. The Company is required to consider market conditions, including changes in interest rates, in selecting these assumptions. Pre-tax expense resulting from the Company's qualified defined benefit pension plans decreased $1.2 million ($0.01 per share) for 2004 when compared to 2003 as a result of market conditions that positively affected asset values of the plan investments. The Company also recorded a net change of $1.0 million within the accumulated other comprehensive income component of stockholders' equity in 2004 which reduced a portion of the previously recorded minimum pension liability. This adjustment had no impact on the net earnings or cash flows of the Company. The Company estimates that pre-tax expense related to qualified defined benefit pension plans will increase by an additional $3.1 million (approximately $0.04 per share) in 2005 as compared to 2004 as a result of the amortization of prior losses incurred as a result of market value declines and discount rate deductions. +Applying the provisions of Statement of Financial Accounting Standards (SFAS) No. 87 and SFAS No. 132, the Company's qualified pension plans (the "Plans") were overfunded by $3.5 million in 2004 and underfunded by $2.4 million in 2003. Under the Employee Retirement Income Security Act of 1974, the Plans had no minimum funding requirements for 2004 and a requirement of $0.6 million for 2003. Discretionary cash contributions were made to the Plans totaling $5.0 million in 2004 and $8.9 million in 2003 to provide long-term stability to the Plans. +No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the undistributed earnings ($96.1 million at January 1, 2005 and $69.6 million at January 3, 2004) of foreign subsidiaries as the Company expects such earnings will be reinvested overseas indefinitely. However, the Company is analyzing the potential impact of the repatriation provision of the American Jobs Creation Act of 2004 (the "Act"), which would allow the Company to bring these foreign earnings back to the United States at reduced tax rates effective until December 31, 2005. If elected, the amount of repatriation is not expected to exceed $70.0 million because a dividend of earnings from certain jurisdictions would not result in a tax benefit where foreign statutory rates exceed the U.S. rate. Technical corrections to the Act are pending issuance and therefore it is not currently practicable to estimate the potential range of impact on income taxes. +The Company's Board of Directors has approved three common stock repurchase programs each authorizing the repurchase of 3.0 million shares of common stock over a 24-month period commencing on the effective dates listed below. The primary purpose of these stock repurchase programs is to increase shareholder value. The Company intends to continue to repurchase shares of its common stock in open market or privately negotiated transactions, from time to time, depending upon market conditions and other factors. +24 +Effective date +Shares +repurchased +in 2004 +Market +price of +shares +repurchased +Shares +repurchased +in 2003 +Market +price of +shares +repurchased +Cumulative +shares +repurchased +Market +price of +cumulative +shares +October 5, 2004 +38,718 +$ 773,000 +- +- +38,718 +$ 773,000 +December 9, 2003 +3,000,000 +49,020,000 +- +- +3,000,000 +49,020,000 +August 19, 2002 +211,500 +3,219,000 +1,933,800 +$24,296,000 +3,000,000 +36,529,000 +The Company declared dividends of $11.2 million in 2004, or $0.19 per share, which was a 26.7% increase over the $8.6 million, or $0.15 per share, declared in 2003. On February 10, 2005, the Company declared a quarterly cash dividend of $0.065 per share of common stock, an increase of 50.0% as compared to the same period of 2004. The quarterly dividend is payable on May 2, 2005, to shareholders of record on April 1, 2005. On December 15, 2004 the Company announced a three-for-two stock split in the form of a stock dividend on shares of common stock outstanding at January 3, 2005 distributed on February 1, 2005. +On January 3, 2005, the Company expanded its owned Wolverine ® and CAT ® operations in Canada. Based on a preliminary purchase price allocation, assets consisting primarily of inventory and fixed assets totaling approximately $1.7 million were acquired from the Company's former Wolverine ® and CAT ® Footwear distributor for cash of $2.2 million, subject to certain post-closing adjustments, and resulted in goodwill and intangible assets of approximately $0.5 million. +On January 3, 2005, the Company expanded its owned Merrell ® operations in Sweden and Finland and its Sebago ® operations in the United Kingdom and Germany. Based on a preliminary purchase price allocation, assets consisting primarily of inventory totaling approximately $0.5 million were acquired from former distributors for cash. +On November 3, 2003, the Company acquired significant operating assets of Sebago, Inc., a global distributor of performance nautical and American-inspired footwear, consisting of accounts receivable, inventory, fixed assets, trademarks and other amortizable intangible assets totaling approximately $18.6 million and assumed liabilities of approximately $2.0 million. Subject to certain post-closing adjustments, the total purchase price of Sebago, Inc., was $16.9 million, which consisted of $14.9 million paid in cash and a note payable for $2.0 million ($1.0 million paid in 2004 and $1.0 million payable in 2005), resulting in goodwill of $0.2 million. +These acquisitions are discussed further in Note 11 to the consolidated financial statements. +NEW ACCOUNTING STANDARDS +On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), Share-Based Payment , which would require all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated statements of operations based on their fair values, effective for public companies for interim periods beginning after June 15, 2005. The Company intends to adopt SFAS No. 123(R) effective June 19, 2005. SFAS No. 123(R) permits public companies to adopt its requirements using either the modified prospective or retrospective method. The Company is currently evaluating the alternative methods of adoption. +The impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123(R) in prior periods, the impact of that standard would have approximated the pro forma impact of +25 +SFAS No. 123 as disclosed in Note 1 to the consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. +CRITICAL ACCOUNTING POLICIES +The preparation of the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates these estimates. Estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Historically, actual results have not been materially different from the Company's estimates. However, actual results may differ from these estimates under different assumptions or conditions. +The Company has identified the following critical accounting policies used in determining estimates and assumptions in the amounts reported. Management believes that an understanding of these policies is important to an overall understanding of the consolidated financial statements. +REVENUE RECOGNITION +The Company's revenue consists of sales to customers, license fees and royalties. Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped and legal title has passed to the customer. Revenue generated through programs with licensees and distributors involving products bearing the Company's trademarks is recognized as earned according to stated contractual terms upon either the purchase or shipment of branded products by distributors and licensees. +The Company records provisions against gross revenue for estimated stock returns and cash discounts in the period when the related revenue is recorded. These estimates are based on factors that include, but are not limited to, historical stock returns, historical discounts taken and analysis of credit memorandum activity. The actual amount of customer returns or allowances, which is uncertain, may differ from the Company's estimates. The Company would record either an increase or decrease to net sales in the period in which it determined an adjustment to be appropriate. +ACCOUNTS RECEIVABLE +The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from its customers' inability to make required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. Historically, losses have been within the Company's expectations. Adjustments to these estimates may be required if the financial condition of the Company's customers were to change. If the Company were to determine that increases or decreases to the allowance for uncollectible accounts were appropriate, the Company would record either an increase or decrease to general and administrative expenses in the period the Company made such a determination. At January 1, 2005 and January 3, 2004, management believes that it has provided sufficient reserves to address future collection uncertainties. +INVENTORY +The Company values its inventory at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for all domestic raw materials and work-in-process inventories, and most domestic finished goods inventories. Cost is determined using methods approximating cost under the first-in, first-out (FIFO) method for all raw materials, work-in-process and finished goods inventories in foreign +26 +countries where LIFO is not permitted. The FIFO method is also used for all finished goods inventories of the Company's retail business, due to the unique nature of that operation, and for certain domestic finished goods inventories that were acquired as part of asset purchase transactions. Once elected, the Company has applied these inventory cost valuation methods consistently from year to year. The Company reduces the value of its inventories to the lower of cost or market for excess or obsolete inventories based upon assumptions about future demand and market conditions. If the Company were to determine that the estimated market value of its inventory is less than the carrying value of such inventory, the Company would provide a reserve for such difference as a charge to cost of sales. If actual market conditions are different from those projected, adjustments to those inventory reserves may be required. The adjustments would increase or decrease the Company's cost of sales and net income in the period in which they were realized or recorded. Inventory quantities are verified at various times throughout the year by performing annual physical inventory observations and perpetual inventory cycle count procedures. If the Company determines that adjustments to the inventory quantities are appropriate, an increase or decrease to the Company's cost of sales and inventory would be recorded in the period in which such determination was made. +GOODWILL AND OTHER NON-AMORTIZABLE INTANGIBLES +Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually. The first step of the goodwill impairment test requires that the fair value of the applicable reporting unit be compared with its recorded value. The Company establishes fair value by calculating the present value of the future cash flows of the reporting unit. The Company uses assumptions about expected future operating performance in determining estimates of those cash flows, which may differ from actual cash flows. If the recorded values of these assets are not recoverable, based on this discounted cash flow analysis, management performs the next step which compares the fair value of the reporting unit calculated in step one to the fair value of the tangible and intangible assets of the reporting unit, which results in an implied fair value of goodwill. Goodwill is reduced by any shortfall of implied goodwill to its carrying value. Impairment tests for other non-amortizable intangibles require the determination of the fair value of the intangible asset. The carrying value is reduced by any excess over fair value. The Company reviewed the carrying amounts of goodwill and other non-amortizable intangible assets and there was no impairment indicated for 2004 or 2003. +INCOME TAXES +The Company operates in multiple tax jurisdictions both inside and outside the United States. Accordingly, management must determine the appropriate allocation of income in accordance with local law for each of these jurisdictions. The Company believes its tax accruals are adequate to cover exposures related to changes in income allocation between tax jurisdictions. The carrying value of the Company's deferred tax assets assumes that the Company will be able to generate sufficient taxable income in future years to utilize these deferred tax assets. If these assumptions change, the Company may be required to record valuation allowances against its gross deferred tax assets in future years, which would result in additional income tax expense in the Company's consolidated statements of operations. Management evaluates the potential for realizing gross deferred tax assets and assesses the need for valuation allowances on a quarterly basis. The Company did not record a valuation allowance in 2004 or 2003. +On a periodic basis, the Company estimates what the effective tax rate will be for the full fiscal year and records a quarterly income tax provision in accordance with the anticipated annual rate. As the fiscal year progresses, that estimate is refined based upon actual events and earnings by tax jurisdictions during the year. This continual estimation process periodically results in a change to the expected effective tax rate for the fiscal year. When this occurs, the Company adjusts the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date provision equals the expected annual rate. +27 +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +The Company faces market risk to the extent that changes in foreign currency exchange rates affect the Company's foreign assets, liabilities and inventory purchase commitments and to the extent that its long-term debt requirements are affected by changes in interest rates. The Company manages these risks by attempting to denominate contractual and other foreign arrangements in U.S. dollars and by maintaining a significant percentage of its debt on a fixed-rate basis. The Company does not believe that there has been a material change in the nature of the Company's primary market risk exposures, including the categories of market risk to which the Company is exposed and the particular markets that present the primary risk of loss to the Company. As of the date of this Annual Report, the Company does not know of or expect there to be any material change in the general nature of its primary market risk exposure in the near term. +Under the provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS Nos. 137 and 138, the Company is required to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings or recognized in accumulated other comprehensive gain (loss) until the hedged item is recognized in earnings. +The Company conducts wholesale operations outside of the United States in Europe and Canada where the functional currencies are primarily the British pound, euro, and Canadian dollar. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with inventory purchases made by non-U.S. wholesale operations in foreign currencies in the normal course of business. At January 1, 2005 and January 3, 2004, the Company had outstanding forward currency exchange contracts to purchase $47.0 million and $37.9 million, respectively, of various currencies (principally U.S. dollars) with maturities ranging up to 280 days. +The Company also has production facilities in the Dominican Republic where financial statements reflect U.S. dollars as the functional currency; however, operating costs are paid in the local currency. Royalty revenue generated by the Company from third party foreign licensees is calculated in the licensees' local currencies, but paid in U.S. dollars. Accordingly, the Company could be subject to related foreign currency remeasurement gains and losses in 2005 and beyond. +Assets and liabilities outside the United States are primarily located in the United Kingdom, Canada and The Netherlands. The Company's investments in foreign subsidiaries with a functional currency other than the U.S. dollar are generally considered long-term. Accordingly, the Company does not hedge these net investments. For the years ended January 1, 2005 and January 3, 2004, the strengthening of foreign currencies increased the value of these investments in net assets by $9.7 million and $10.9 million, respectively. This gain resulted in cumulative foreign currency translation adjustments at January 1, 2005 and January 3, 2004 of $23.8 million and $14.1 million, respectively, that are deferred and recorded as a component of accumulated other comprehensive income (loss) in stockholders' equity. +Because the Company markets, sells and licenses its products throughout the world, it could be affected by weak economic conditions in foreign markets that could reduce demand for its products. +The Company is exposed to changes in interest rates primarily as a result of its long-term debt requirements. The Company's interest rate risk management objectives are to limit the effect of interest rate changes on earnings and cash flows and to effectively manage overall borrowing costs. To achieve its objectives, the Company maintains substantially all fixed-rate debt to take advantage of lower relative +28 +interest rates currently available and finances seasonal working capital needs with variable-rate debt. The Company has not historically utilized interest rate swaps or similar hedging arrangements to fix interest rates; however, in 1998 the Company entered into an interest rate lock agreement to fix the interest rate prior to the issuance of 6.5% senior notes in the amount of $75 million. The contract was settled in 1998 and resulted in a prepayment of interest of $2.2 million that is being amortized over the term of the senior notes. The amortization of the prepayment creates an effective interest rate of 6.78% on the senior notes. +The Company does not enter into contracts for speculative or trading purposes, nor is it a party to any leveraged derivative instruments. +The following table lists required principal payments and related interest rates for the Company's short- and long-term debt by fiscal year of maturity. +2004 +2003 +2005 +2006 +2007 +2008 +2009 +There- +after +Total +Fair +Value +Total +Fair +Value +(Millions of Dollars, Except Percentages) +Denominated in U.S. Dollars: +Fixed rate +$11.7 +$10.8 +$10.7 +$10.7 +- +- +$43.9 +$46.0 +$59.9 +$65.5 +Average interest rate +6.4 +% +6.5 +% +6.5 +% +6.5 +% +- +- +6.5 +% +- +6.5 +% +- +The Company has the following payments under contractual obligations due by period: +Less than +More than +Total +1 year +1-3 years +3-5 years +5 years +(Thousands of Dollars) +Long-term debt +$ 43,857 +$ 11,714 +$21,429 +$10,714 +$ - +Estimated interest on long-term debt +2,834 +746 +1,392 +696 +- +Capital leases +47 +20 +23 +4 +- +Operating leases +55,517 +10,736 +16,901 +12,503 +15,377 +Purchase obligations (1) +147,720 +147,720 +- +- +- +Deferred compensation +2,356 +325 +628 +544 +859 +Pension (2) +3,000 +3,000 +- +- +- +SERP +12,871 +589 +1,177 +1,177 +9,928 +Dividends declared +7,387 +7,387 +- +- +- +Minimum royalties +4,620 +1,118 +1,788 +1,714 +- +Minimum advertising +7,606 +1,433 +2,995 +3,178 +- +Total +$287,815 +$184,788 +$46,333 +$30,530 +$26,164 +(1) +Purchase obligations primarily relate to inventory and capital expenditure commitments. +(2) +Pension obligations reflect only planned pension funding as there are currently no required funding obligations under government regulation. Funding amounts are calculated on an annual basis and no required or planned funding beyond one year has been determined. +Should additional funds be required, the Company had $173.5 million of additional borrowing capacity available under all of its existing credit facilities at January 1, 2005. The Company's additional borrowing capacity is summarized as follows: +29 +Expiration of availability +Total commitments +available +Less than +1 year +1 year or +greater +(Millions of Dollars) +Revolving credit +$150.0 +$ - +$150.0 +Commercial letters of credit +21.5 +21.5 +- +Standby letters of credit +2.0 +2.0 +- +Item 7A. Quantitative and Qualitative Disclosures About Market Risk. +The response to this Item is set forth under the caption "Quantitative and Qualitative Disclosures About Market Risk" in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and is incorporated herein by reference. +Item 8. Financial Statements and Supplementary Data . +The response to this Item is set forth in Appendix A of this Annual Report on Form 10-K and is incorporated herein by reference. +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . +None. +Item 9A. Controls and Procedures . +Evaluation of Disclosure Controls and Procedures. +An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on and as of the time of such evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filings with the SEC. +Management's Report on Internal Control Over Financial Reporting. +Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of January 1, 2005, based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of January 1, 2005. +Management's assessment of the effectiveness of our internal control over financial reporting as of January 1, 2005 has been audited by Ernst & Young LLP, an independent registered public accounting +30 +firm, as stated in their attestation report which is included in Appendix A and is incorporated into this Item 9A by reference. +Changes in Internal Control Over Financial Reporting. +There was no change in the Company's internal control over financial reporting that occurred during the sixteen-week period ended January 1, 2005 that has materially affected, or that is reasonably likely to materially affect, the Company's internal control over financial reporting. +PART III +Item 10. Directors and Executive Officers of the Registrant . +The Company's Audit Committee is comprised of four Board members, all of whom are independent under independence standards adopted by the Board and applicable regulations of the SEC and the New York Stock Exchange (including independence standards related specifically to Audit Committee membership). The Audit Committee members each have financial and business experience with companies of substantial size and complexity and have a significant understanding of generally accepted accounting principles, financial statements, internal controls and audit committee functions. The Company's Board of Directors has determined that David T. Kollat and Phillip D. Matthews are audit committee financial experts as defined by the SEC. Additional information regarding the Audit Committee is provided in the Definitive Proxy Statement of the Company dated March 14, 2005, under the caption "Wolverine's Board of Directors" under the subheading "Board Committees and Meetings-Audit Committee." +The Company has adopted an Accounting and Finance Code of Ethics that applies to the Company's principal executive officer, principal financial officer and principal accounting officer. The Accounting and Finance Code of Ethics is available on the Company's website, www.wolverineworldwide.com. Any waiver from or amendment to the Accounting and Finance Code of Ethics will be disclosed on the Company's website. +The information regarding directors of the Company contained under the caption "Election of Directors" and under the caption "Wolverine's Board of Directors" under the subheadings "Nominees for Terms Expiring in 2008," "Continuing Directors - Terms Expiring in 2007," and "Continuing Directors - Terms Expiring in 2006" in the definitive Proxy Statement of the Company dated March 14, 2005, is incorporated herein by reference. +In addition to the directors discussed in the definitive Proxy Statement, the Company's Board of Directors currently includes Elizabeth A. Sanders (age 59), who will retire at this year's annual meeting. Her term was scheduled to expire at the annual meeting in 2006. Ms. Sanders is retiring after 10 years of service as a director. Ms. Sanders is the principal of The Sanders Partnership, a management consulting practice. Ms. Sanders has held that position since 1990. Ms. Sanders was previously Vice President of Nordstrom, Inc., a retailer. Ms. Sanders is also a director of Washington Mutual, Inc.; Denny's Corporation; and Wellpoint Health Networks, Inc. +The information regarding directors and executive officers of the Company under the caption "Related Matters" under the subheading "Section 16(a) Beneficial Ownership Reporting Compliance" in the definitive Proxy Statement of the Company dated March 14, 2005, is incorporated herein by +31 +reference. Additional information regarding Executive Officers is provided in the Supplemental Item following Item 4 of Part I above. +Item 11. +Executive Compensation . +The information contained under the caption "Wolverine's Board of Directors" under the subheadings "Compensation of Directors" and "Board Committees and Meetings-Compensation Committee," and under the captions "Executive Compensation," "Compensation Committee Report on Executive Compensation," "Employment Agreements and Termination of Employment and Change in Control Arrangements" and "Wolverine's Stock Price Performance" in the definitive Proxy Statement of the Company dated March 14, 2005, is incorporated herein by reference. +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters . +The information contained under the caption "Ownership of Wolverine Stock" and under the caption "Executive Compensation" under the subheading "Equity Compensation Plan Information" contained in the definitive Proxy Statement of the Company dated March 14, 2005, is incorporated herein by reference. +Item 13. Certain Relationships and Related Transactions . +The information contained under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company dated March 14, 2005, are incorporated herein by reference. +Item 14. Principal Accountant Fees and Services . +The information contained under the caption "Selection of Auditors" in the definitive Proxy Statement of the Company dated March 14, 2005, is incorporated herein by reference. +PART IV +Item 15. Exhibits and Financial Statement Schedules . +Item 15(a)(1). Financial Statements . Attached as Appendix A. +The following consolidated financial statements of Wolverine World Wide, Inc. and subsidiaries are filed as a part of this report: +• +Consolidated Balance Sheets as of January 1, 2005 and January 3, 2004. +• +Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Fiscal Years Ended January 1, 2005, January 3, 2004 and December 28, 2002. +• +Consolidated Statements of Operations for the Fiscal Years Ended January 1, 2005, January 3, 2004 and December 28, 2002. +• +Consolidated Statements of Cash Flows for the Fiscal Years Ended January 1, 2005, January 3, 2004 and December 28, 2002. +32 +• +Notes to the Consolidated Financial Statements as of January 1, 2005. +• +Reports of Independent Registered Public Accounting Firm. +Item 15(a)(2). Financial Statement Schedules . Attached as Appendix B. +The following consolidated financial statement schedule of Wolverine World Wide, Inc. and subsidiaries is filed as a part of this report: +• +Schedule II--Valuation and Qualifying Accounts of Continuing Operations. +All other schedules (I, III, IV, and V) for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and, therefore, have been omitted. +Item 15(a)(3). Exhibits . +The following exhibits are filed as part of this report: +Exhibit +Number +Document +3.1 +Certificate of Incorporation, as amended. Previously filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.1 +Certificate of Incorporation, as amended. See Exhibit 3.1 above. +4.2 +Amended and Restated By-laws. See Exhibit 3.2 above. +4.3 +Rights Agreement dated as of April 17, 1997. Previously filed with the Company's Form 8-A filed April 12, 1997. Here incorporated by reference. +4.4 +Amendment No. 1 dated as of June 30, 2000, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.5 +Second Amendment dated as of February 11, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.6 +Third Amendment dated as of December 10, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2002. Here incorporated by reference. +33 +4.7 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. +4.8 +The Registrant has several classes of long-term debt instruments outstanding in addition to those described in Exhibits 4.7 and 4.9. The authorized amount of none of these classes of debt exceeds 10% of the Company's total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +4.9 +Credit Agreement dated as of May 29, 2001, with Bank One, Michigan, as agent. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 16, 2001. Here incorporated by reference. +4.10 +First Amendment dated as of February 8, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.11 +Second Amendment dated as of August 30, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.12 +Third Amendment dated as of December 19, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.13 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2002. Here incorporated by reference. +4.13 +Fourth Amendment dated as of April 30, 2003, to the Credit Agreement dated as of May 29, 2001. +4.14 +Fifth Amendment dated as of August 31, 2004, to the Credit Agreement dated as of May 29, 2001. +10.1 +1988 Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed July 21, 1988, Registration No. 33-23196. Here incorporated by reference. +10.2 +1993 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed June 22, 1993, Registration No. 33-64854. Here incorporated by reference. +10.3 +1995 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed October 26, 1995, Registration No. 33-63689. Here incorporated by reference. +10.4 +1997 Stock Incentive Plan.* Previously filed as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2001. Here incorporated by reference. +34 +10.5 +Stock Incentive Plan of 1999.* +10.6 +Stock Incentive Plan of 2001.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 26, 2001. Here incorporated by reference. +10.7 +Stock Incentive Plan of 2003.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 24, 2003. Here incorporated by reference. +10.8 +Amended and Restated Directors Stock Option Plan.* Previously filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.9 +Amended and Restated Directors' Stock Option Plan.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 14, 2003. Here incorporated by reference. +10.10 +Amended and Restated Outside Directors' Deferred Compensation Plan.* Previously filed as Appendix E to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.11 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.12 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Appendix C to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.13 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +10.14 +Executive Severance Agreement.* An updated participant schedule is attached as Exhibit 10.14. +10.15 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. Previously filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.16 +Benefit Trust Agreement dated May 19, 1987, and Amendments Number 1, 2, 3 and 4 thereto.* Previously filed as Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +35 +10.17 +Amended and Restated Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. An updated participant schedule is attached as Exhibit 10.17. +10.18 +Employees' Pension Plan (Restated as amended through July 7, 2004).* +10.19 +Form of Incentive Stock Option Agreement. Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 9, 2005.* +10.20 +Form of Non-Qualified Stock Option Agreement for Steven M. Duffy, Stephen L. Gulis, Blake W. Krueger and Timothy J. O'Donovan. Previously filed as Exhibit 10.2 to the Company's Current Report on Form 8-K dated February 9, 2005.* +10.21 +Form of Non-Qualified Stock Option Agreement for other employees. Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K dated February 9, 2005.* +10.22 +Form of Restricted Stock Agreement. Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K dated February 9, 2005.* +10.23 +Form of Stock Option Agreement for non-employee directors.* +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31.1 +Certification of President and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Executive Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +____________________________ +*Management contract or compensatory plan or arrangement. +The Company will furnish a copy of any exhibit listed above to any stockholder without charge upon written request to Mr. Blake W. Krueger, Executive Vice President and Secretary, 9341 Courtland Drive, Rockford, Michigan 49351. +36 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +WOLVERINE WORLD WIDE, INC. +Dated March 16, 2005 +By: +/s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, +Chief Financial Officer and Treasurer +(Principal Financial Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. +Signature +Title +Date +*/s/ Geoffrey B. Bloom +Geoffrey B. Bloom +Chairman of the Board +of Directors +March 16, 2005 +/s/ Timothy J. O'Donovan +Timothy J. O'Donovan +Chief Executive Officer, +President (Principal Executive Officer) +and Director +March 16, 2005 +/s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, Chief +Financial Officer and Treasurer +(Principal Financial Officer) +March 16, 2005 +/s/ Nicholas P. Ottenwess +Nicholas P. Ottenwess +Vice President of Finance and +Corporate Controller (Principal +Accounting Officer) +March 16, 2005 +*/s/ Donald V. Fites +Donald V. Fites +Director +March 16, 2005 +*/s/ Alberto L. Grimoldi +Alberto L. Grimoldi +Director +March 16, 2005 +37 +*/s/ David T. Kollat +David T. Kollat +Director +March 16, 2005 +*/s/ Brenda J. Lauderback +Brenda J. Lauderback +Director +March 16, 2005 +*/s/ Phillip D. Matthews +Phillip D. Matthews +Director +March 16, 2005 +*/s/ David P. Mehney +David P. Mehney +Director +March 16, 2005 +*/s/ Elizabeth A. Sanders +Elizabeth A. Sanders +Director +March 16, 2005 +*/s/ Paul D. Schrage +Paul D. Schrage +Director +March 16, 2005 +*by /s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Attorney-in-Fact +Executive Vice President, Chief +Financial Officer and Treasurer +(Principal Financial Officer) +March 16, 2005 +38 +APPENDIX A +Financial Statements +1 +CONSOLIDATED BALANCE SHEETS +As of Fiscal Year End +2004 +2003 +(Thousands of Dollars) +Assets +Current assets: +Cash and cash equivalents +$ +72,172 +$ +55,356 +Accounts receivable, less allowances (2004-$8,200; 2003-$10,462) +151,174 +146,879 +Inventories: +Finished products +161,315 +143,127 +Raw materials and work-in-process +21,609 +21,777 +182,924 +164,904 +Deferred income taxes +6,113 +6,528 +Other current assets +18,472 +12,969 +Total current assets +430,855 +386,636 +Property, plant and equipment: +Land +962 +1,080 +Buildings and improvements +65,246 +64,235 +Machinery and equipment +136,950 +128,954 +Software +49,686 +44,081 +252,844 +238,350 +Less accumulated depreciation +157,914 +142,343 +94,930 +96,007 +Other assets: +Goodwill +35,552 +34,391 +Other non-amortizable intangibles +8,090 +7,739 +Cash surrender value of life insurance +26,930 +24,880 +Prepaid pension costs +35,289 +34,332 +Other +7,925 +9,777 +113,786 +111,119 +Total assets +$ +639,571 +$ +593,762 +Liabilities and Stockholders' Equity +Current liabilities: +Accounts payable +$ +50,521 +$ +26,328 +Salaries, wages and other compensation +19,435 +16,696 +Income taxes +- +1,513 +Taxes, other than income taxes +4,736 +3,416 +Other accrued expenses +23,824 +21,793 +Current maturities of long-term debt +11,735 +16,020 +Total current liabilities +110,251 +85,766 +Long-term debt, less current maturities +32,169 +43,903 +Deferred compensation +9,024 +5,736 +Accrued pension liabilities +14,979 +14,881 +Deferred income taxes +14,291 +13,068 +Minority interest +566 +314 +Stockholders' equity: +Common stock, $1 par value: authorized 80,000,000 shares; issued, +including treasury shares: 2004-67,350,495; 2003-66,389,233 +67,350 +66,389 +Additional paid-in capital +99,518 +81,980 +Retained earnings +437,406 +382,603 +Accumulated other comprehensive income +19,446 +8,540 +Unearned compensation +(4,954 +) +(4,138 +) +Cost of shares in treasury: 2004-9,452,361 shares; 2003-7,209,313 shares +(160,474 +) +(105,280 +) +Total stockholders' equity +458,291 +430,094 +Total liabilities and stockholders' equity +$ +639,571 +$ +593,762 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +2 +CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME +Fiscal Year +2004 +2003 +2002 +(Thousands of Dollars, Except Per Share Data) +Common Stock +Balance at beginning of the year +$ +66,389 +$ +65,825 +$ +66,192 +Common stock issued under stock incentive plans +(2004-2,081,586 shares; 2003-1,234,893 shares; +2002-639,814 shares) +2,082 +1,235 +640 +Impact of stock split on treasury shares +(1,121 +) +(671 +) +(1,007 +) +Balance at end of the year +67,350 +66,389 +65,825 +Additional Paid-In Capital +Balance at beginning of the year +81,980 +71,009 +65,993 +Amounts associated with common stock issued +under stock incentive plans: +Proceeds over par value +8,878 +8,281 +3,333 +Income tax benefits +7,782 +1,710 +531 +Impact of stock split on treasury shares +1,121 +671 +1,007 +Issuance of treasury shares (2004-8,924 shares; +2003-27,886 shares; 2002-142,894 shares) +87 +51 +409 +Net change in employee notes receivable +(330 +) +258 +(264 +) +Balance at end of the year +99,518 +81,980 +71,009 +Retained Earnings +Balance at beginning of the year +382,603 +339,475 +298,755 +Net earnings +65,938 +51,716 +47,912 +Cash dividends (2004-$.19 per share; +2003-$.15 per share; 2002-$.12 per share) +(11,135 +) +(8,588 +) +(7,192 +) +Balance at end of the year +437,406 +382,603 +339,475 +Accumulated Other Comprehensive Income (Loss) +Balance at beginning of the year +8,540 +(23,522 +) +(4,109 +) +Foreign currency translation adjustments +9,727 +10,922 +6,101 +Change in fair value of foreign exchange contracts, net of +taxes (2004-$174; 2003-$730; 2002- $89) +160 +(1,393 +) +(244 +) +Minimum pension liability adjustment, net of taxes +(2004-$524; 2003-$11,608; 2002-$13,016) +1,019 +22,533 +(25,270 +) +Balance at end of the year +19,446 +8,540 +(23,522 +) +Unearned Compensation +Balance at beginning of the year +(4,138 +) +(3,833 +) +(4,649 +) +Awards under restricted stock incentive plans +(4,165 +) +(2,488 +) +(2,037 +) +Compensation expense +3,349 +2,183 +2,853 +Balance at end of the year +(4,954 +) +(4,138 +) +(3,833 +) +Cost of Shares in Treasury +Balance at beginning of the year +(105,280 +) +(79,857 +) +(48,030 +) +Common stock purchased for treasury +(2004-2,251,972 shares; 2003-1,367,770 shares; +2002-2,154,335 shares) +(55,331 +) +(25,656 +) +(33,626 +) +Issuance of treasury shares (2004-8,924 shares; +2003-27,886 shares; 2002-142,894 shares) +137 +233 +1,799 +Balance at end of the year +(160,474 +) +(105,280 +) +(79,857 +) +Total stockholders' equity at end of the year +$ +458,291 +$ +430,094 +$ +369,097 +Comprehensive Income +Net earnings +$ +65,938 +$ +51,716 +$ +47,912 +Foreign currency translation adjustments +9,727 +10,922 +6,101 +Change in fair value of foreign exchange contracts, net of taxes +160 +(1,393 +) +(244 +) +Minimum pension liability adjustment, net of taxes +1,019 +22,533 +(25,270 +) +Total comprehensive income +$ +76,844 +$ +83,778 +$ +28,499 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +3 +CONSOLIDATED STATEMENTS OF OPERATIONS +Fiscal Year +2004 +2003 +2002 +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +991,909 +$ +888,926 +$ +827,106 +Cost and expenses: +Cost of products sold +617,774 +562,338 +532,878 +Selling and administrative expenses +274,125 +246,652 +217,154 +Interest expense +4,185 +5,896 +6,721 +Interest income +(940 +) +(422 +) +(255 +) +Other income - net +(305 +) +(686 +) +(1,046 +) +894,839 +813,778 +755,452 +Earnings before income taxes and minority interest +97,070 +75,148 +71,654 +Income taxes +30,879 +23,262 +23,599 +Earnings before minority interest +66,191 +51,886 +48,055 +Minority interest +253 +170 +143 +Net earnings +$ +65,938 +$ +51,716 +$ +47,912 +Net earnings per share: +Basic +$ +1.15 +$ +0.88 +$ +0.79 +Diluted +1.09 +0.85 +0.77 +See accompanying notes to consolidated financial statements. +4 +CONSOLIDATED STATEMENTS OF CASH FLOWS +Fiscal Year +2004 +2003 +2002 +(Thousands of Dollars) +Operating Activities +Net earnings +$ +65,938 +$ +51,716 +$ +47,912 +Adjustments necessary to reconcile net earnings +to net cash provided by operating activities: +Depreciation +18,683 +17,664 +16,633 +Amortization +388 +283 +227 +Deferred income taxes (credit) +1,179 +(902 +) +216 +Unearned compensation +3,349 +2,183 +2,853 +Other +4,624 +(3,721 +) +(185 +) +Changes in operating assets and liabilities: +Accounts receivable +(2,332 +) +15,534 +(5,879 +) +Inventories +(15,833 +) +17,069 +24,884 +Other operating assets +(2,776 +) +529 +(1,076 +) +Accounts payable +21,229 +(5,820 +) +(656 +) +Other operating liabilities +11,912 +7,668 +3,350 +Net cash provided by operating activities +106,361 +102,203 +88,279 +Investing Activities +Business acquisitions, net of cash acquired +- +(14,780 +) +(27,366 +) +Additions to property, plant and equipment +(18,080 +) +(16,015 +) +(13,875 +) +Other +(104 +) +58 +607 +Net cash used in investing activities +(18,184 +) +(30,737 +) +(40,634 +) +Financing Activities +Payments of short-term debt +- +- +(90 +) +Proceeds from long-term borrowings +44,385 +66,194 +94,215 +Payments of long-term debt +(60,404 +) +(81,176 +) +(112,226 +) +Cash dividends +(11,135 +) +(8,588 +) +(7,192 +) +Purchase of common stock for treasury +(55,331 +) +(25,656 +) +(33,626 +) +Proceeds from shares issued under stock incentive plans +6,688 +7,570 +2,202 +Net cash used in financing activities +(75,797 +) +(41,656 +) +(56,717 +) +Effect of foreign exchange rate changes +4,436 +(1,532 +) +330 +Increase (decrease) in cash and cash equivalents +16,816 +28,278 +(8,742 +) +Cash and cash equivalents at beginning of the year +55,356 +27,078 +35,820 +Cash and cash equivalents at end of the year +$ +72,172 +$ +55,356 +$ +27,078 +Other Cash Flow Information +Interest paid +$ +4,056 +$ +5,461 +$ +6,633 +Net income taxes paid +23,868 +22,725 +18,201 +( ) Denotes reduction in cash and cash equivalents. +See accompanying notes to consolidated financial statements. +5 +NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS +1. Summary of Significant Accounting Policies +NATURE OF OPERATIONS +Wolverine World Wide, Inc. (NYSE: WWW) is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, performance outdoor footwear, work shoes and boots, uniform shoes and boots, constructed slippers and moccasins. The Company's global portfolio of owned and licensed brands includes: Bates, CAT®, Harley-Davidson®, Hush Puppies®, HyTest®, Merrell®, Sebago®, Stanley® and Wolverine®. Apparel and licensing programs are utilized to extend the Company's owned brands into product categories beyond footwear. The Company also operates a retail division to showcase its brands and branded footwear from other manufacturers, a tannery that produces Wolverine Performance Leathers™ and a pigskin procurement operation. +PRINCIPLES OF CONSOLIDATION +The consolidated financial statements include the accounts of Wolverine World Wide, Inc. and its wholly and majority owned subsidiaries (collectively, the "Company"). All intercompany accounts and transactions have been eliminated in consolidation. +FISCAL YEAR +The Company's fiscal year is the 52- or 53-week period that ends on the Saturday nearest to December 31. Fiscal years presented in this report include the 52-week period ended January 1, 2005, the 53-week period ended January 3, 2004 and the 52-week period ended December 28, 2002. +USE OF ESTIMATES +The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. +REVENUE RECOGNITION +Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped and legal title has passed to the customer. Revenue generated through programs with licensees and distributors involving products bearing the Company's trademarks is recognized as earned according to stated contractual terms upon either the purchase or shipment of branded products by distributors and licensees. +The Company records provisions against gross revenue for estimated stock returns and cash discounts in the period when the related revenue is recorded. These estimates are based on factors that include, but are not limited to, historical stock returns, historical discounts taken and analysis of credit memorandum activity. +COST OF PRODUCTS SOLD +Cost of products sold for the Company's operations include the actual product costs, including inbound freight charges, purchasing and receiving costs, inspection costs, and internal transfer costs. Warehousing costs are included in selling and administrative expenses. +SHIPPING AND HANDLING COSTS +Shipping and handling costs that are charged to and reimbursed by the customer are recognized as revenue, while the related expenses incurred by the Company are recorded as cost of products sold in the consolidated statements of operations. +CASH EQUIVALENTS +All short-term investments with a maturity of three months or less when purchased are considered cash equivalents. +6 +ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS +The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from its customers' inability to make required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. Adjustments to these estimates may be required if the financial condition of the Company's customers were to change. The Company does not require collateral or other security on trade accounts receivable. +INVENTORIES +Inventories are valued at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for all domestic raw materials and work-in-process inventories, and certain domestic finished goods inventories. Cost is determined using methods approximating cost under the first-in, first-out (FIFO) method for all raw materials, work-in-process and finished goods inventories in foreign countries where LIFO is not permitted. The FIFO method is also used for all finished goods inventories of the Company's retail business, due to the unique nature of that operation, and for certain domestic finished goods inventories that were acquired as part of asset purchase transactions. Once elected, the Company has applied these inventory cost valuation methods consistently from year to year. +PROPERTY, PLANT AND EQUIPMENT +Property, plant and equipment are stated on the basis of cost and include expenditures for new facilities, major renewals, betterments and software. Normal repairs and maintenance are expensed as incurred. +Depreciation of property, plant and equipment is computed using the straight-line method. The depreciable lives range from five to forty years for buildings and improvements and from three to ten years for machinery, equipment and software. +GOODWILL AND OTHER INTANGIBLES +Goodwill represents the excess of the purchase price over the fair value of net tangible and identifiable intangible assets of acquired businesses. Other intangibles consist primarily of trademarks, brand names, patents and customer lists. Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets . The Company reviews the carrying amounts of goodwill and other non-amortizable intangible assets annually to determine if such assets may be impaired. If the carrying amounts of these assets are not recoverable based upon a discounted cash flow analysis, such assets are reduced by the estimated shortfall of fair value to recorded value. Other amortizable intangible assets (principally patents) are amortized using the straight-line method over their estimated useful lives (periods ranging from two to fifteen years). Other amortizable intangible assets are included in other assets on the consolidated balance sheets and have net carrying amounts of $1,492,000 and $986,000 for 2004 and 2003, respectively, and accumulated amortization of $1,159,000 and $694,000 for 2004 and 2003, respectively. Estimated aggregate amortization expense for such intangibles for each of the five fiscal years subsequent to 2004 are as follows: 2005-$440,000; 2006-$407,000; 2007-$317,000; 2008-$181,000; 2009-$89,000. +The Company has performed the required annual impairment tests and has determined that there was no impairment indicated for recorded goodwill and other non-amortizable intangibles. +The changes in the carrying amount of goodwill and other non-amortizable intangibles for the years ended January 1, 2005 and January 3, 2004 are as follows: +Goodwill +Trademarks +Total +(Thousands of Dollars) +Balance at December 28, 2002 +$ +30,706 +$ +2,582 +$ +33,288 +Intangibles acquired +820 +5,157 +5,977 +Purchase accounting adjustments +(614 +) +- +(614 +) +Foreign currency translation effects +3,479 +- +3,479 +Balance at January 3, 2004 +34,391 +7,739 +42,130 +Intangibles acquired +- +351 +351 +Purchase accounting adjustments +(613 +) +- +(613 +) +Foreign currency translation effects +1,774 +- +1,774 +Balance at January 1, 2005 +$ +35,552 +$ +8,090 +$ +43,642 +7 +IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS +The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or an asset group may not be recoverable. Each impairment test is based on a comparison of the carrying amount of the assets to the future undiscounted net cash flows expected to be generated by the assets or asset group. If such assets are considered to be impaired, the impairment amount to be recognized is the amount by which the carrying value of the assets exceeds their fair value. +STOCK-BASED COMPENSATION +The Company has elected to follow Accounting Principles Board (APB) Opinion No. 25 , Accounting for Stock Issued to Employees , and related interpretations, in accounting for its stock incentive awards. Under APB Opinion No. 25, compensation expense is recognized when the market price of the stock underlying an award on the date of grant exceeds any related exercise price. +Where compensation expense has been determined by APB Opinion No. 25, pro forma information regarding net earnings and earnings per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its stock awards using the fair value method. The fair value of these awards was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: risk-free interest rate of 3.4% (2.9% in 2003 and 4.2% in 2002); dividend yield of 1.0% (1.3% in 2003 and 1.1% in 2002); expected market price volatility factor of 0.317 (0.386 in 2003 and 0.420 in 2002); and an expected option life of four years. +The estimated weighted-average fair value for each option granted was $4.68 in 2004, $3.30 in 2003 and $3.65 in 2002. +For purposes of pro forma disclosures, the estimated fair values of stock options are amortized to expense over the related vesting periods. The Company recognizes compensation cost for fixed awards with pro rata vesting using the straight-line attribution method. The Company's pro forma information under SFAS No. 123 is as follows: +2004 +2003 +2002 +(Thousands of Dollars, Except Per Share Data) +Net earnings, as reported +$ +65,938 +$ +51,716 +$ +47,912 +Add: +Total stock-based employee compensation +expense included in reported net income, net of +related tax effects +3,374 +2,326 +2,862 +Deduct: +Total stock-based employee compensation +expense determined under fair value +method for all awards, net of related tax effects +8,330 +5,456 +5,873 +Pro forma net earnings +$ +60,982 +$ +48,586 +$ +44,901 +Net earnings per share: +Basic-as reported +$ +1.15 +$ +0.88 +$ +0.79 +Basic-pro forma +1.06 +0.83 +0.75 +Diluted-as reported +1.09 +0.85 +0.77 +Diluted-pro forma +1.01 +0.79 +0.72 +On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), Share-Based Payment , which would require all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated statements of operations based on their fair values, effective for public companies for interim periods beginning after June 15, 2005. The Company intends to adopt SFAS No. 123(R) effective June 19, 2005. SFAS No. 123(R) permits public companies to adopt its requirements using either the modified prospective or retrospective method. The Company is currently evaluating the alternative methods of adoption. +The impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123(R) in prior periods, the impact of that standard would have approximated the pro forma impact of SFAS No. 123 as disclosed above. SFAS No.123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. +8 +ADVERTISING COSTS +Advertising costs are expensed as incurred and customer specific advertising dollars are expensed when earned by customers. Total advertising expense was $38,611,000 in 2004, $35,254,000 in 2003, and $33,584,000 in 2002 and includes customer specific advertising dollars of $9,689,000 in 2004, $9,652,000 in 2003, and $8,311,000 in 2002. The Company provides sales incentives to certain retail customers in the form of a cooperative advertising program and accounts for this in accordance with EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products) . Under this program, customers are reimbursed for Company-approved advertising expenditures where the value to the Company is objectively verifiable. +INCOME TAXES +The provision for income taxes is based on the earnings reported in the consolidated financial statements. A deferred income tax asset or liability is determined by applying currently enacted tax laws and rates to the cumulative temporary differences between the carrying values of assets and liabilities for financial statement and income tax purposes. +EARNINGS PER SHARE +Basic earnings per share is computed based on weighted average shares of common stock outstanding during each year after adjustment for restricted nonvested common stock issued under restricted stock incentive plans. Diluted earnings per share assumes the exercise of dilutive stock options and the vesting of all common stock under restricted stock programs. +The following table sets forth the reconciliation of weighted average shares used in the computation of basic and diluted earnings per share: +2004 +2003 +2002 +Weighted average shares outstanding during the year +58,498,042 +59,846,151 +61,524,543 +Adjustment for nonvested common stock +(1,099,677 +) +(1,081,869 +) +(1,156,123 +) +Denominator for basic earnings per share +57,398,365 +58,764,282 +60,368,420 +Effect of dilutive stock options +2,265,984 +1,570,782 +1,165,296 +Adjustment for nonvested common stock - treasury method +809,708 +746,343 +799,695 +Denominator for diluted earnings per share +60,474,057 +61,081,407 +62,333,411 +Options to purchase 588,978 shares of common stock in 2004, 988,601 shares in 2003 and 1,194,730 shares in 2002 have not been included in the denominator for the computation of diluted earnings per share because the related exercise prices were greater than the average market price for the period and, therefore, they were antidilutive. +STOCK SPLIT +On December 15, 2004 the Company announced a three-for-two stock split in the form of a stock dividend on shares of common stock outstanding at January 3, 2005 distributed to shareholders on February 1, 2005. All share and per share amounts in the consolidated financial statements and related notes have been adjusted for all periods to reflect the stock split. Treasury shares were excluded from the stock split. +FOREIGN CURRENCY +For the Company's international subsidiaries, the local currency is the functional currency. Assets and liabilities of these subsidiaries are translated into U.S. dollars at the year-end exchange rate. Operating statement amounts are translated at average exchange rates for the period. The cumulative translation adjustments resulting from changes in exchange rates are included in the consolidated balance sheets as a component of accumulated other comprehensive income (loss) in stockholders' equity. Transaction gains and losses are included in the consolidated statements of operations and were not material. +9 +FINANCIAL INSTRUMENTS AND RISK MANAGEMENT +The Company's financial instruments consist of cash and cash equivalents, accounts and notes receivable, accounts and notes payable and long-term debt. Except for fixed rate long-term debt with a carrying value of $43,857,000 and a fair value of $45,996,000 at January 1, 2005 and a carrying value of $59,857,000 and a fair value of $65,465,000 at January 3, 2004, the Company's estimate of the fair values of these financial instruments approximates their carrying amounts for the respective years. Fair value was determined using discounted cash flow analyses and current interest rates for similar instruments. The Company does not hold or issue financial instruments for trading purposes. +The Company follows SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS Nos. 137 and 138, which requires that all derivative instruments be recorded on the consolidated balance sheets at fair value and establishes criteria for designation and effectiveness of hedging relationships. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with foreign currency inventory purchases made by non-U.S. wholesale operations in the normal course of business. At January 1, 2005 and January 3, 2004, foreign exchange contracts with a notional value of $46,974,500 and $37,902,000, respectively, were outstanding to purchase various currencies (principally U.S. dollars) with maturities ranging up to 280 days. These contracts have been designated as cash flow hedges. As of January 1, 2005 and January 3, 2004, a liability of $1,821,000 and $2,270,000, respectively, has been recognized for the fair value of the foreign currency forward exchange contracts. +The fair value of the foreign currency forward exchange contracts represents the estimated receipts or payments necessary to terminate the contracts. Hedge effectiveness is evaluated by the hypothetical derivative method. Any hedge ineffectiveness is reported within the cost of products sold caption of the consolidated statements of operations. Hedge ineffectiveness was not material in 2004 or 2003. If, in the future, the foreign exchange contracts are determined to be ineffective hedges or terminated before their contractual termination dates, the Company would be required to reclassify into earnings all or a portion of the unrealized amounts related to the cash flow hedges that are currently included in accumulated other comprehensive income (loss) within stockholders' equity. +COMPREHENSIVE INCOME (LOSS) +Comprehensive income (loss) represents net earnings and any revenue, expenses, gains and losses that, under accounting principles generally accepted in the United States, are excluded from net earnings and recognized directly as a component of stockholders' equity. +Ending accumulated other comprehensive income (loss) is as follows: +2004 +2003 +(Thousands of Dollars) +Foreign currency translation adjustments +$ +23,787 +$ +14,060 +Foreign currency cash flow hedge adjustments, net of taxes +(2004 - $993; 2003 - $819) +(1,477 +) +(1,637 +) +Minimum pension liability adjustments, net of taxes +(2004 - $1,476; 2003 - $2,000) +(2,864 +) +(3,883 +) +Accumulated other comprehensive income +$ +19,446 +$ +8,540 +RECLASSIFICATIONS +Certain amounts previously reported in 2003 and 2002 have been reclassified to conform with the presentation used in 2004. +2. Inventories +Inventories of $81,771,000 at January 1, 2005 and $90,368,000 at January 3, 2004 have been valued using the LIFO method. If the FIFO method had been used, inventories would have been $8,614,000 and $9,324,000 higher than reported at January 1, 2005 and January 3, 2004, respectively. +10 +3. Debt +Long-term debt consists of the following obligations: +2004 +2003 +(Thousands of Dollars) +6.5% senior notes payable +$ +42,857 +$ +53,571 +7.81% senior notes payable +- +4,286 +Revolving credit obligations +- +- +Other +1,047 +2,066 +43,904 +59,923 +Less current maturities +11,735 +16,020 +$ +32,169 +$ +43,903 +The 6.5% unsecured senior notes payable require annual principal payments of $10,714,000 due through the maturity date of December 8, 2008. In connection with the issuance of these senior notes, the Company entered into an interest rate lock agreement with a bank that was settled in 1998 and resulted in a prepayment of interest of $2,200,000. This prepayment is being amortized over the remaining term of the notes using the effective interest method. +The 7.81% unsecured senior notes payable was paid in full on August 13, 2004. +The Company has an unsecured revolving credit agreement that allows for borrowings up to $150,000,000, of which $10,000,000 pertains to the Company's Canadian subsidiary. Of the remaining $140,000,000 facility available to the U.S. operations, $35,000,000 may also be utilized by the European subsidiaries. This agreement, which expires May 2006, requires that interest be paid at a variable rate based on one of the following options elected by the Company: prime or LIBOR or money market rate plus applicable spread. +The Company had commercial letters of credit outstanding of $3,175,000 and $2,380,000 at January 1, 2005 and January 3, 2004, respectively. +The long-term loan agreements contain restrictive covenants that, among other things, require the Company to maintain certain financial ratios and minimum levels of consolidated net worth. At January 1, 2005, the Company was in compliance with all restrictive covenants and retained earnings in excess of covenant requirements were $83,968,000. The agreements also impose restrictions on securing additional debt, sale and merger transactions and the disposition of significant assets. +Principal maturities of long-term debt subsequent to 2005 are as follows: 2006-$10,730,000; 2007-$10,721,000; 2008-$10,718,000. +Interest costs of $408,000 in 2004, $235,000 in 2003 and $254,000 in 2002 were capitalized in connection with various capital improvement and computer hardware and software installation projects. +4. Leases +The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2018. At January 1, 2005, minimum rental payments due under all noncancelable leases were as follows: 2005-$10,736,000; 2006-$9,082,000; 2007-$7,819,000; 2008-$6,762,000; 2009-$5,741,000; thereafter-$15,377,000. +Rental expense under all operating leases consisted primarily of minimum rentals and totaled $11,542,000 in 2004, $11,614,000 in 2003 and $11,011,000 in 2002. +5. Capital Stock +The Company has 2,000,000 authorized shares of $1 par value preferred stock, of which none is issued or outstanding. +The Company has a preferred stock rights plan that is designed to protect stockholder interests in the event the Company is confronted with coercive or unfair takeover tactics. Two-thirds of one right is associated with each share of common stock currently outstanding. The rights trade with the common stock and become exercisable only upon the occurrence of certain triggering events. Each right, when exercisable, will entitle the holder to purchase one one- +11 +hundredth of a share of Series B junior participating preferred stock for $120. The Company has designated 500,000 shares of preferred stock as Series B junior participating preferred stock for possible future issuance under the Company's preferred stock rights plan. Upon issuance for reasons other than liquidation, each share of Series B junior participating preferred stock will have 100 votes and a preferential quarterly dividend equal to the greater of $21 per share or 100 times the dividend declared on common stock. +If, after a triggering event, the Company is a party to a merger or other business combination, regardless of whether the Company is the surviving corporation, right holders other than the party to the merger will be entitled to receive common stock of the surviving corporation worth twice the exercise price of the rights. The plan also provides for protection against self-dealing transactions by certain 15% stockholders or the activities of an adverse person (as defined in the plan). The Company may redeem the rights for $.01 each at any time prior to a person being designated as an adverse person or fifteen days after a triggering event. Unless redeemed earlier, all rights expire on May 7, 2007. The Board of Directors can elect to exclude certain transactions from triggering the exercise of preferred stock rights and other actions under the plan. +The Company has stock incentive plans under which options to purchase shares of common stock may be granted to officers, other key employees and non-employee directors. Options granted are exercisable over no more than ten years and vest over various periods. All unexercised options are available for future grant upon their cancellation. +A summary of the transactions under the stock option plans is as follows: +Shares Under +Option +Weighted-Average +Option Price +Outstanding at December 29, 2001 +5,971,896 +$ +9.65 +Granted +1,196,991 +10.39 +Exercised +(482,803 +) +7.25 +Cancelled +(67,787 +) +10.57 +Outstanding at December 28, 2002 +6,618,297 +9.93 +Granted +1,208,001 +10.81 +Exercised +(1,127,250 +) +7.96 +Cancelled +(66,084 +) +13.45 +Outstanding at January 3, 2004 +6,632,964 +10.41 +Granted +1,938,069 +17.75 +Exercised +(2,880,662 +) +9.90 +Cancelled +(108,186 +) +13.60 +Outstanding at January 1, 2005 +5,582,185 +$ +13.14 +Shares available for grant under the stock option plans were 2,067,445 at January 1, 2005, 3,147,514 at January 3, 2004, and 2,416,321 at December 28, 2002. +The exercise prices of options outstanding at January 1, 2005 range from $4.36 to $21.13. A summary of stock options outstanding and options exercisable at January 1, 2005 is as follows: +Options Outstanding +Options Exercisable +Range of +Exercise +Price +Number +Weighted- +Average +Exercise Price +Average +Remaining +Contractual Life +Number +Weighted- +Average +Exercise Price +Less than $10 +903,207 +$ +7.46 +3.7 years +901,933 +$ +7.46 +$10 to $15 +2,348,358 +10.58 +6.6 years +1,677,360 +10.60 +Greater than $15 +2,330,620 +17.91 +6.2 years +1,763,673 +18.72 +5,582,185 +$ +13.14 +6.0 years +4,342,966 +$ +13.25 +12 +The number of options exercisable at January 3, 2004 and December 28, 2002 totaled 5,273,376 and 5,256,171, respectively, with weighted-average exercise prices of $10.40 and $9.98, respectively. +The Company also has stock award plans for officers and other key employees. Common stock issued under these plans is subject to certain restrictions, including a prohibition against any sale, transfer or other disposition by the officer or employee (except for certain transfers for estate planning purposes for certain officers), a requirement to forfeit the award upon certain terminations of employment in cases other than death, disability, retirement or consensual severance and performance criteria in certain instances. These restrictions lapse over a three- to five-year period from the date of the award. Shares aggregating 294,120 in 2004, 242,850 in 2003 and 242,550 in 2002 were awarded under these plans. The weighted-average grant date fair value was $15.37 in 2004, $10.57 in 2003 and $10.31 in 2002 for the shares awarded. There were 13,734 awards cancelled in 2004 and 27,336 awards cancelled in 2002. There were no awards cancelled in 2003. The market value of the shares awarded without performance criteria is recognized as unearned compensation in the consolidated statements of stockholders' equity and is amortized to operations over the vesting period. Awards based on performance criteria are amortized to operations over the combined performance and vesting period. +6. Retirement Plans +The Company has noncontributory, defined benefit pension plans covering a majority of its domestic employees. The Company's principal defined benefit pension plan provides benefits based on the employees' years of service and final average earnings (as defined in the plan), while the other plan provides benefits at a fixed rate per year of service. The Company intends to annually contribute amounts deemed necessary to maintain the plans on a sound actuarial basis. +The Company has a Supplemental Executive Retirement Plan ("SERP") for certain current and former employees that entitles them to receive payments from the Company following retirement based on the employees' years of service and final average earnings (as defined in the SERP). Under the SERP, the employees can elect early retirement with a corresponding reduction in benefits. The Company also has individual deferred compensation agreements with certain former employees that entitle them to receive payments from the Company for a period of fifteen to eighteen years following retirement. The Company maintains life insurance policies with a cash surrender value of $26,245,000 at January 1, 2005 and $24,648,000 at January 3, 2004 that are intended to fund deferred compensation benefits under the SERP and deferred compensation agreements. +The Company has a defined contribution money accumulation plan covering substantially all domestic employees that provides for Company contributions based on earnings. This plan is combined with the principal defined benefit pension plan for funding purposes to the extent allowable under applicable regulations. The Company recognized expense for the money accumulation plan of $1,788,000 in 2004, $1,620,000 in 2003 and $1,500,000 in 2002. The Company also has certain defined contribution plans at foreign subsidiaries. Contributions to these plans were $832,000 in 2004, $662,000 in 2003, and $506,000 in 2002. +13 +The Company uses a September 30 measurement date for its defined benefit plans. The following summarizes the status of and changes in the Company's pension assets and related obligations for its pension plans (which include the Company's defined benefit pension plans and the SERP) as of: +September 30 +2004 +2003 +(Thousands of Dollars) +Change in projected benefit obligations: +Projected benefit obligations at beginning of the year +$ +146,486 +$ +132,544 +Service cost pertaining to benefits earned during the year +3,983 +3,243 +Interest cost on projected benefit obligations +8,991 +8,634 +Effect of changes in actuarial assumptions +37 +(401 +) +Actuarial losses +4,176 +9,027 +Benefits paid to plan participants +(6,805 +) +(6,561 +) +Projected benefit obligations at end of the year +$ +156,868 +$ +146,486 +Change in fair value of pension assets: +Fair value of pension assets at beginning of the year +$ +127,854 +$ +102,486 +Actual net investment gain +17,559 +22,195 +Company contributions +5,664 +9,734 +Benefits paid to plan participants +(6,805 +) +(6,561 +) +Fair value of pension assets at end of the year +$ +144,272 +$ +127,854 +Funded status +$ +(12,596 +) +$ +(18,632 +) +Unrecognized prior service costs +3,253 +3,879 +Unrecognized net actuarial losses +35,118 +41,465 +Net amount recognized +$ +25,775 +$ +26,712 +Amounts recognized in the consolidated balance sheets: +Prepaid benefit cost +$ +36,416 +$ +37,578 +Accrued benefit cost +(16,778 +) +(18,887 +) +Intangible assets +1,797 +2,138 +Accumulated other comprehensive loss +4,340 +5,883 +Net amount recognized +$ +25,775 +$ +26,712 +Funded status of pension plans and SERP (supplemental): +Funded status of qualified defined benefit plans and SERP +$ +(12,596 +) +$ +(18,632 +) +Nonqualified trust assets (cash surrender value of life insurance) recorded +in other assets and intended to satisfy the projected benefit obligation +of unfunded supplemental employee retirement plans +23,631 +21,708 +Net funded status of pension plans and SERP (supplemental) +$ +11,035 +$ +3,076 +The Company made contributions of $159,000 and $194,000 subsequent to the measurement date and before the fiscal years ended 2004 and 2003, respectively. +Information for pension plans with an accumulated benefit obligation in excess of plan assets: +September 30 +2004 +2003 +(Thousands of Dollars) +Projected benefit obligations +$ +28,381 +$ +27,805 +Accumulated benefit obligations +27,295 +26,502 +Fair value of plan assets +10,517 +7,615 +The accumulated benefit obligations for all defined benefit pension plans and the SERP were $147,933,000 and $138,419,000 at September 30, 2004 and 2003, respectively. +14 +The following is a summary of net pension and SERP expense recognized by the Company: +2004 +2003 +2002 +(Thousands of Dollars) +Service cost pertaining to benefits earned during the year +$ +(3,983 +) +$ +(3,243 +) +$ +(4,435 +) +Interest cost on projected benefit obligations +(8,991 +) +(8,634 +) +(8,959 +) +Expected return on pension assets +11,906 +10,175 +12,477 +Net amortization loss +(5,548 +) +(5,491 +) +(1,010 +) +Net pension expense +$ +(6,616 +) +$ +(7,193 +) +$ +(1,927 +) +Expense for qualified defined benefit pension plans was $4,825,000 in 2004 and $6,014,000 in 2003, and pension income was $1,314,000 in 2002 +2004 +2003 +Weighted average assumptions used to determine benefit obligations at September 30: +Discount rate +5.98% +6.11% +Rate of compensation increase +3.50% +3.50% +Weighted average assumptions used to determine net periodic benefit cost for the years ended: +Discount rate +6.11% +6.76% +Expected long-term rate of return on plan assets +8.75% +8.90% +Rate of compensation increase-qualified plans +3.50% +3.50% +Rate of compensation increase-SERP +3.50% +3.85% +Unrecognized net experience losses exceeding certain corridors are amortized over a five-year period, unless the minimum amortization method based on average remaining service periods produces a higher amortization. +The long-term rate of return is based on overall market expectations for a balanced portfolio with an asset mix similar to the Company's, utilizing historic returns for broad market and fixed income indices. +2004 +2003 +Weighted average asset allocations at September 30 by asset category are as follows: +Equity securities +72.3% +71.8% +Debt instruments +22.7% +22.9% +Cash and money market investments +5.0% +5.3% +100.0% +100.0% +The Company's investment policy for plan assets uses a blended approach of U.S. and foreign equities combined with U.S. fixed income investments. Policy guidelines indicate that total equities should not exceed 80% and fixed income securities should not exceed 50%. Within the equity and fixed income classifications, the investments are diversified. +Equity securities include shares of the Company's common stock with a fair value of $9,477,000 at September 30, 2003. There were no holdings of Company common stock at September 30, 2004. Dividends received on Company common stock holdings were $10,000 in 2004, $134,000 in 2003 and $120,000 in 2002. +The Company expects to contribute $3,000,000 to its qualified defined benefit pension plans and $588,000 to the SERP in 2005. +Expected benefit payments for the five years subsequent to 2004 and the sum of the five years following those are as follows: 2005 - $7,040,000; 2006 - $7,543,000; 2007 - $7,805,000; 2008 - $8,074,000; 2009 - $8,349,000; and 2010 through 2014 - $48,935,000. +15 +7. Income Taxes +The provisions for income taxes consist of the following: +2004 +2003 +2002 +(Thousands of Dollars) +Currently payable: +Federal +$ +23,096 +$ +19,818 +$ +20,002 +State and foreign +6,604 +4,346 +3,381 +Deferred (credit) expense +1,179 +(902 +) +216 +$ +30,879 +$ +23,262 +$ +23,599 +A reconciliation of the Company's total income tax expense and the amount computed by applying the statutory federal income tax rate of 35% to earnings before income taxes is as follows: +2004 +2003 +2002 +(Thousands of Dollars) +Income taxes at statutory rate +$ +33,975 +$ +26,302 +$ +25,079 +State income taxes, net of federal income tax reduction +343 +183 +271 +Nontaxable earnings of foreign affiliates +(2,186 +) +(1,605 +) +(1,674 +) +Research and development credits +(550 +) +(1,870 +) +- +Foreign earnings taxed at rates differing from +the U.S. statutory rate +(313 +) +718 +121 +Other +(390 +) +(466 +) +(198 +) +$ +30,879 +$ +23,262 +$ +23,599 +Significant components of the Company's deferred income tax assets and liabilities as of the end of 2004 and 2003 are as follows: +2004 +2003 +(Thousands of Dollars) +Deferred income tax assets: +Accounts receivable and inventory valuation allowances +$ +2,444 +$ +3,086 +Deferred compensation accruals +2,163 +2,187 +Future benefit of foreign net operating losses +254 +254 +Accrued pension costs +1,476 +2,000 +Other amounts not deductible until paid +6,470 +5,906 +Total deferred income tax assets +12,807 +13,433 +Deferred income tax liabilities: +Tax over book depreciation +(10,336 +) +(9,256 +) +Prepaid pension costs +(9,250 +) +(9,738 +) +Other +(1,399 +) +(979 +) +Total deferred income tax liabilities +(20,985 +) +(19,973 +) +Net deferred income tax liabilities +$ +(8,178 +) +$ +(6,540 +) +No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the undistributed earnings ($96,052,000 at January 1, 2005 and $69,558,000 at January 3, 2004) of foreign subsidiaries as the Company expects such earnings will be reinvested overseas indefinitely. However, the Company is analyzing the potential impact of the repatriation provision of the American Jobs Creation Act of 2004 (the "Act"), which would allow the Company to bring these foreign earnings back to the United States at reduced tax rates effective until December 31, 2005. If elected, the amount of repatriation is not expected to exceed $70,000,000 because a dividend of earnings from certain jurisdictions would not result in a tax benefit where foreign statutory rates exceed the U.S. rate. Technical corrections to the Act are pending issuance and therefore it is not currently practicable to estimate the potential range of impact on income taxes. +16 +8. Litigation and Contingencies +The Company is involved in various environmental claims and other legal actions arising in the normal course of business. The environmental claims include sites where the Environmental Protection Agency has notified the Company that it is a potentially responsible party with respect to environmental remediation. These remediation claims are subject to ongoing environmental impact studies, assessment of remediation alternatives, allocation of costs between responsible parties and concurrence by regulatory authorities and have not yet advanced to a stage where the Company's liability is fixed. However, after taking into consideration legal counsel's evaluation of all actions and claims against the Company, management is currently of the opinion that their outcome will not have a material effect on the Company's consolidated financial position or future results of operations. +Pursuant to certain of the Company's lease agreements, the Company has provided financial guarantees to third parties in the form of indemnification provisions. These provisions indemnify and reimburse the third parties for costs, including but not limited to adverse judgments in lawsuits and taxes and operating costs. The terms of the guarantees are equal to the terms of the related lease agreements. The Company is not able to calculate the maximum potential amount of future payments it could be required to make under these guarantees, as the potential payment is dependent upon the occurrence of future unknown events. +The Company has future minimum royalty obligations due under the terms of certain licenses held by the Company. These minimum future obligations are as follows: +2005 +2006 +2007 +2008 +2009 +(Thousands of Dollars) +Minimum royalties +$1,118 +$969 +$820 +$844 +$869 +Minimum royalties are based on both fixed obligations and assumptions regarding the consumer price index. Royalty obligations in excess of minimum requirements are based upon future sales levels. In accordance with these agreements, the Company incurred royalty expense of $3,083,000, $3,132,000 and $2,929,000 for 2004, 2003 and 2002, respectively. +The terms of certain license agreements also require advertising expenditures based on the level of sales. In accordance with these agreements, the Company's advertising obligations, based on actual sales, totaled $1,982,000, $2,915,000 and $2,741,000 for 2004, 2003 and 2002, respectively. +9. Business Segments +The Company has one reportable segment that is engaged in manufacturing, sourcing, marketing, licensing and distributing branded footwear and licensed apparel and accessories to the retail sector, including casual shoes, dress shoes, performance outdoor footwear, boots, uniform shoes, work shoes, slippers, moccasins and apparel and accessories. Revenue of this segment is derived from the sale of branded footwear to external customers as well as royalty income from the licensing of the Company's trademarks and brand names to licensees and distributors. The business units comprising the branded footwear and licensing segment manufacture or source, market and distribute products in a similar manner. Branded footwear and licensed products are distributed through wholesale channels and under licensing and distributor arrangements. +The other business units in the following tables consist of the Company's retail, tannery and pigskin procurement operations. The Company operated 70 domestic retail stores and 5 consumer-direct internet sites at January 1, 2005 that sell Company-manufactured and sourced products, as well as footwear manufactured by unaffiliated companies. The other business units distribute products through retail and wholesale channels. +The Company measures segment profits as earnings before income taxes and minority interest. The accounting policies used to determine profitability and total assets of the branded footwear and other business segments are the same as disclosed in Note 1. +17 +Business segment information is as follows: +2004 +Branded +Footwear +and Licensing +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +903,611 +$ +88,298 +$ +- +$ +991,909 +Intersegment sales +30,750 +2,939 +- +33,689 +Interest (income) expense - net +9,266 +968 +(6,989 +) +3,245 +Depreciation expense +6,585 +3,215 +8,883 +18,683 +Earnings (loss) before income taxes +and minority interest +111,261 +4,226 +(18,417 +) +97,070 +Total assets +453,522 +39,260 +146,789 +639,571 +Additions to property, plant and equipment +8,920 +3,890 +5,270 +18,080 +2003 +Branded +Footwear +and Licensing +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +812,590 +$ +76,336 +$ +- +$ +888,926 +Intersegment sales +27,288 +2,471 +- +29,759 +Interest (income) expense - net +9,314 +1,059 +(4,899 +) +5,474 +Depreciation expense +5,667 +2,587 +9,410 +17,664 +Earnings (loss) before income taxes +and minority interest +85,294 +1,357 +(11,503 +) +75,148 +Total assets +399,276 +36,594 +157,922 +593,792 +Additions to property, plant and equipment +6,229 +3,355 +6,431 +16,015 +2002 +Branded +Footwear +and Licensing +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +748,807 +$ +78,299 +$ +- +$ +827,106 +Intersegment sales +24,814 +3,099 +- +27,913 +Interest (income) expense - net +10,458 +1,706 +(5,698 +) +6,466 +Depreciation expense +5,340 +2,406 +8,887 +16,633 +Earnings (loss) before income taxes +and minority interest +81,266 +4,361 +(13,973 +) +71,654 +Total assets +384,723 +40,453 +106,818 +531,994 +Additions to property, plant and equipment +8,732 +1,700 +3,443 +13,875 +Geographic information, based on shipping destination, related to revenue from external customers included in the consolidated statements of operations is as follows: +18 +2004 +2003 +2002 +(Thousands of Dollars) +United States +$ +718,674 +$ +674,794 +$ +644,647 +Foreign countries: +Europe and Russia +193,461 +150,643 +127,461 +Canada +49,797 +45,422 +39,363 +Central and South America +9,084 +6,639 +6,417 +Asia +11,990 +8,132 +6,780 +Middle East/Africa +8,903 +3,296 +2,438 +Total foreign countries revenue +273,235 +214,132 +182,459 +$ +991,909 +$ +888,926 +$ +827,106 +The Company's long-lived assets (primarily property, plant and equipment and intangible assets) are as follows: +2004 +2003 +2002 +(Thousands of Dollars) +United States +$ +132,651 +$ +135,914 +$ +135,346 +Foreign countries +40,776 +36,880 +32,005 +The Company does not believe that it is dependent upon any single customer, since none accounts for more than 10% of consolidated revenue. +The Company sources approximately 88% (based on pairs) of its footwear products from unrelated suppliers primarily located in Asia. The remainder is produced in Company-owned manufacturing facilities in the United States and the Dominican Republic. All licensed apparel and accessories are sourced from unrelated suppliers. While changes in suppliers could cause delays in manufacturing and a possible loss of sales, management believes that other suppliers could provide similar products on comparable terms. +No product groups, other than branded footwear and licensing, account for more than 10% of consolidated revenue. Revenues derived from the sale and licensing of footwear, apparel and accessories accounted for approximately 91% of revenue in 2004, 2003 and 2002. +Approximately 12% of the Company's employees are subject to bargaining unit contracts extending through various dates through 2006. +10. Quarterly Results of Operations (unaudited) +The Company reports its quarterly results of operations on the basis of 12-week periods for each of the first three quarters and a 16- or 17-week period for the fourth quarter. The fourth quarter of 2004 includes 16 weeks and the fourth quarter of 2003 includes 17 weeks. +The Company's unaudited quarterly results of operations are as follows: +2004 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +224,871 +$ +198,774 +$ +260,897 +$ +307,367 +Gross margin +85,441 +75,514 +98,177 +115,003 +Net earnings +12,299 +10,985 +21,946 +20,708 +Net earnings per share: +Basic +$ +.21 +$ +.19 +$ +.38 +$ +.37 +Diluted +.20 +.18 +.37 +.34 +19 +2003 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +191,485 +$ +184,040 +$ +230,571 +$ +282,830 +Gross margin +69,196 +65,724 +86,714 +104,954 +Net earnings +7,414 +9,281 +16,414 +18,607 +Net earnings per share: +Basic +$ +.13 +$ +.16 +$ +.28 +$ +.31 +Diluted +.12 +.15 +.27 +.31 +Adjustments in the fourth quarter were immaterial in 2004 and resulted in an increase in net earnings of $579,000 ($0.01 per share) in 2003. These adjustments related primarily to inventories. +11. Business Acquisitions +On January 3, 2005, the Company expanded its owned Wolverine® brand operations in Canada. Based on a preliminary purchase price allocation, assets consisting primarily of inventory and fixed assets totaling approximately $1,700,000 were acquired from a former Wolverine® and CAT® Footwear distributor for cash of $2,200,000, subject to certain post-closing adjustments, and resulted in goodwill and intangible assets of approximately $500,000. +On January 3, 2005, the Company expanded its owned Merrell® operations in Sweden and Finland and its Sebago® operations in the United Kingdom and Germany. Based on a preliminary purchase price allocation, assets consisting primarily of inventory totaling approximately $544,000 were acquired from former distributors for cash. +On November 3, 2003, the Company acquired significant operating assets of Sebago, Inc., an international distributor of performance nautical and American-inspired footwear, consisting of accounts receivable, inventory, fixed assets, trademarks and other amortizable intangible assets totaling approximately $18,627,000 and assumed liabilities of approximately $1,987,000. The total purchase price of Sebago, Inc., was $16,886,000, which consisted of $14,886,000 paid in cash and a note payable for $2,000,000 ($1,000,000 paid in 2004 and $1,000,000 due in 2005), resulting in goodwill of $246,000 after allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. The acquisition has been accounted for using the purchase method of accounting and, accordingly, the results of operations since November 3, 2003 are included in the Company's consolidated statements of operations. +An independent valuation of the Sebago® trademarks was performed as of the date of the acquisition, which totaled $4,904,000. Pursuant to SFAS No. 142, goodwill and indefinite-lived intangibles will not be amortized, but will be evaluated for impairment annually. Goodwill was assigned to the Company's Branded Footwear and Licensing segment. The majority of the goodwill is expected to be deductible for tax purposes. The other amortizable intangible assets have a weighted average useful life of approximately nine years. +The following table sets forth the unaudited pro forma information for the Company as if the Sebago® acquisition had occurred as of the beginning of 2002 utilizing the Company's effective tax rate. The unaudited pro forma financial information is provided for informational purposes only and does not purport to be indicative of the Company's results of operations that would actually have been achieved had the acquisition been completed at the beginning of the periods presented or that may be achieved in the future. The unaudited pro forma financial information was derived from the annual financial statements of the acquired company and does not give effect to any operational synergies or integration costs that may occur as a result of or following the acquisition. +20 +2003 +2002 +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +921,944 +$ +865,469 +Net earnings +53,460 +49,732 +Basic earnings per share +$ +0.91 +$ +0.83 +Diluted earnings per share +0.87 +0.80 +Immediately after the acquisition was consummated, management of the Company began to implement an integration plan for the Sebago acquisition. In conjunction with the integration plan, the Company recorded additional liabilities of approximately $1,792,000, which were included in the acquisition cost allocation in accordance with Emerging Issues Task Force Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination . The additional liabilities include severance and related costs for approximately 100 manufacturing and administrative employees in Maine, and exit costs for specific product lines of Sebago, Inc. +The following table is a summary of the activity in the reserves by category: +Employee +Severance +Exit Costs +Total +(Thousands of Dollars) +Amounts recognized as charges in 2003 and accrued at +January 3, 2004 +$ +1,496 +$ +296 +$ +1,792 +Payments +(1,187 +) +(282 +) +(1,469 +) +Adjustments +(309 +) +- +(309 +) +Balance at January 1, 2005 +$ +- +$ +14 +$ +14 +On January 16, 2002, the Company established a new subsidiary to operate the CAT® footwear business in the European market. This new entity, Wolverine Europe Limited, purchased assets consisting of accounts receivable, inventory, limited amortizable intangible assets and fixed assets totaling approximately $21,247,000 from Overland Group Limited of London, England and assumed liabilities of approximately $8,514,000. Cash and other consideration of $27,790,000 was remitted for the acquisition, resulting in goodwill of $15,057,000 after allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. The former owner of Overland Group Limited is a 5% minority stockholder in the new subsidiary. The markets served directly by Wolverine Europe Limited include Austria, France, Germany, Ireland, The Netherlands, Switzerland and the United Kingdom. Wolverine Europe Limited also coordinates and supports other European markets served by independently-owned distributors. Consolidated pro forma revenue for 2002, assuming the transaction occurred at the beginning of the year, would not have been materially different from reported amounts. Consolidated pro forma net earnings for 2002, assuming the transaction occurred at the beginning of that year, are not materially different from reported amounts. +21 +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +Wolverine World Wide, Inc. +We have audited the accompanying consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of January 1, 2005 and January 3, 2004, and the related consolidated statements of stockholders' equity and comprehensive income, operations and cash flows for each of the three fiscal years in the period ended January 1, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Wolverine World Wide, Inc. and subsidiaries at January 1, 2005 and January 3, 2004, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended January 1, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Wolverine World Wide, Inc.'s internal control over financial reporting as of January 1, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 23, 2005 expressed an unqualified opinion thereon. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +February 23, 2005 +22 +Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting +The Board of Directors and Stockholders +Wolverine World Wide, Inc. +We have audited management's assessment, included in the accompanying management's report on internal control over financial reporting, that Wolverine World Wide, Inc. maintained effective internal control over financial reporting as of January 1, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Wolverine World Wide, Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, management's assessment that Wolverine World Wide, Inc. maintained effective internal control over financial reporting as of January 1, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Wolverine World Wide, Inc. maintained, in all material respects, effective internal control over financial reporting as of January 1, 2005, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2004 consolidated financial statements of Wolverine World Wide, Inc. and subsidiaries and our report dated February 23, 2005 expressed an unqualified opinion thereon. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +February 23, 2005 +23 +APPENDIX B +Schedule II +Valuation and Qualifying Accounts of Continuing Operations +Wolverine World Wide, Inc. and Subsidiaries +Column A +Column B +Column C +Column D +Column E +Additions +Description +Balance at +Beginning of +Period +(1) +Charged to +Costs and +Expenses +(2) +Charged to +Other Accounts +(Describe) +Deductions +(Describe) +Balance at +End of +Period +Fiscal year ended January 1, 2005 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +7,335,000 +$ +3,638,000 +$ +6,139,000 +(A) +$ +4,834,000 +Allowance for sales returns +1,997,000 +23,611,000 +23,822,000 +(B) +1,786,000 +Allowance for cash discounts +1,130,000 +13,539,000 +13,089,000 +(C) +1,580,000 +Inventory valuation allowances +6,355,000 +8,622,000 +9,133,000 +(D) +5,844,000 +$ +16,817,000 +$ +49,410,000 +$ +52,183,000 +$ +14,044,000 +Fiscal year ended January 3, 2004 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +7,387,000 +$ +4,962,000 +$ +5,014,000 +(A) +$ +7,335,000 +Allowance for sales returns +1,587,000 +26,610,000 +26,200,000 +(B) +1,997,000 +Allowance for cash discounts +1,217,000 +12,632,000 +12,719,000 +(C) +1,130,000 +Inventory valuation allowances +4,751,000 +12,011,000 +10,407,000 +(D) +6,355,000 +$ +14,942,000 +$ +56,215,000 +$ +54,340,000 +$ +16,817,000 +Fiscal year ended December 28, 2002 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +5,438,000 +$ +5,717,000 +$ +3,768,000 +(A) +$ +7,387,000 +Allowance for sales returns +1,110,000 +29,433,000 +28,956,000 +(B) +1,587,000 +Allowance for cash discounts +834,000 +11,081,000 +10,698,000 +(C) +1,217,000 +Inventory valuation allowances +4,014,000 +7,698,000 +6,961,000 +(D) +4,751,000 +$ +11,396,000 +$ +53,929,000 +$ +50,383,000 +$ +14,942,000 +(A) +Accounts charged off, net of recoveries. +(B) +Actual customer returns. +(C) +Discounts given to customers. +(D) +Adjustment upon disposal of related inventories. +Commission File No. 1-6024 +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +EXHIBITS +TO +FORM 10-K +For the Fiscal Year Ended +January 1, 2005 +Wolverine World Wide, Inc. +9341 Courtland Drive +Rockford, Michigan 49351 +EXHIBIT INDEX +Exhibit +Number +Document +3.1 +Certificate of Incorporation, as amended. Previously filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.1 +Certificate of Incorporation, as amended. See Exhibit 3.1 above. +4.2 +Amended and Restated By-laws. See Exhibit 3.2 above. +4.3 +Rights Agreement dated as of April 17, 1997. Previously filed with the Company's Form 8-A filed April 12, 1997. Here incorporated by reference. +4.4 +Amendment No. 1 dated as of June 30, 2000, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.5 +Second Amendment dated as of February 11, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.6 +Third Amendment dated as of December 10, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2002. Here incorporated by reference. +4.7 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. +4.8 +The Registrant has several classes of long-term debt instruments outstanding in addition to those described in Exhibits 4.7 and 4.9. The authorized amount of none of these classes of debt exceeds 10% of the Company's total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +4.9 +Credit Agreement dated as of May 29, 2001, with Bank One, Michigan, as agent. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 16, 2001. Here incorporated by reference. +4.10 +First Amendment dated as of February 8, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.11 +Second Amendment dated as of August 30, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +i +4.12 +Third Amendment dated as of December 19, 2002, to the Credit Agreement dated as of May 29, 2001. Previously filed as Exhibit 4.13 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2002. Here incorporated by reference. +4.13 +Fourth Amendment dated as of April 30, 2003, to the Credit Agreement dated as of May 29, 2001. +4.14 +Fifth Amendment dated as of August 31, 2004, to the Credit Agreement dated as of May 29, 2001. +10.1 +1988 Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed July 21, 1988, Registration No. 33-23196. Here incorporated by reference. +10.2 +1993 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed June 22, 1993, Registration No. 33-64854. Here incorporated by reference. +10.3 +1995 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed October 26, 1995, Registration No. 33-63689. Here incorporated by reference. +10.4 +1997 Stock Incentive Plan.* Previously filed as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2001. Here incorporated by reference. +10.5 +Stock Incentive Plan of 1999.* +10.6 +Stock Incentive Plan of 2001.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 26, 2001. Here incorporated by reference. +10.7 +Stock Incentive Plan of 2003.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 24, 2003. Here incorporated by reference. +10.8 +Amended and Restated Directors Stock Option Plan.* Previously filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.9 +Amended and Restated Directors' Stock Option Plan.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 14, 2003. Here incorporated by reference. +10.10 +Amended and Restated Outside Directors' Deferred Compensation Plan.* Previously filed as Appendix E to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.11 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +ii +10.12 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Appendix C to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.13 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +10.14 +Executive Severance Agreement.* An updated participant schedule is attached as Exhibit 10.14. +10.15 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. Previously filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.16 +Benefit Trust Agreement dated May 19, 1987, and Amendments Number 1, 2, 3 and 4 thereto.* Previously filed as Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.17 +Amended and Restated Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. An updated participant schedule is attached as Exhibit 10.17. +10.18 +Employees' Pension Plan (Restated as amended through July 7, 2004).* +10.19 +Form of Incentive Stock Option Agreement. Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 9, 2005.* +10.20 +Form of Non-Qualified Stock Option Agreement for Steven M. Duffy, Stephen L. Gulis, Blake W. Krueger and Timothy J. O'Donovan. Previously filed as Exhibit 10.2 to the Company's Current Report on Form 8-K dated February 9, 2005.* +10.21 +Form of Non-Qualified Stock Option Agreement for other employees. Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K dated February 9, 2005.* +10.22 +Form of Restricted Stock Agreement. Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K dated February 9, 2005.* +10.23 +Form of Stock Option Agreement for non-employee directors.* +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31.1 +Certification of President and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Executive Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +____________________________ +*Management contract or compensatory plan or arrangement. +iii \ No newline at end of file diff --git a/raw/filings/0000110471/2004/0000905729-05-000124/filing_metadata.csv b/raw/filings/0000110471/2004/0000905729-05-000124/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..cbe2c42e8c3d2f224e33590d60c110130f9e2aa4 --- /dev/null +++ b/raw/filings/0000110471/2004/0000905729-05-000124/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000110471,WWW,WOLVERINE WORLD WIDE INC /DE/,10-K,2005-03-17,2005-01-01,2005-03-17T14:02:36.000Z,0000905729-05-000124,www10k_031605.htm,"WOLVERINE WORLD WIDE, INC. FORM 10-K 03-17-05",1658004,0,0,https://www.sec.gov/Archives/edgar/data/110471/000090572905000124/www10k_031605.htm,https://www.sec.gov/Archives/edgar/data/110471/000090572905000124/,2004,2004,1 diff --git a/raw/filings/0000110471/2004/0000905729-05-000124/item1.txt b/raw/filings/0000110471/2004/0000905729-05-000124/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..2357d89a4aa0c949b5c873ee6eb87d403c292916 --- /dev/null +++ b/raw/filings/0000110471/2004/0000905729-05-000124/item1.txt @@ -0,0 +1,89 @@ +Item 1. Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The Company, a Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Consumers around the world purchased more than 42.7 million pairs of Company branded footwear during fiscal 2004, making the Company a global leader among footwear companies in the marketing of branded casual, work and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort and performance. The products are marketed throughout the world under widely recognized brand names, including Bates ® , CAT ® , Harley-Davidson ® , Hush Puppies ® , HyTest ® , Merrell ® , Sebago ® , Stanley ® and Wolverine ® . The Company believes that its primary competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary designs and comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. The Company's footwear products are currently organized under five operating units: (i) the Wolverine Footwear Group, focusing on the Bates ® , HyTest ® , Stanley ® and Wolverine ® product lines of work, outdoor, uniform and lifestyle boots and shoes, (ii) the Outdoor Group, focusing on the Sebago ® and Merrell ® product lines of performance and lifestyle footwear, (iii) the Heritage Brands Group, focusing on the CAT ® product lines of work and lifestyle footwear and the Harley-Davidson ® lines of lifestyle and performance footwear, (iv) The Hush Puppies Company, focusing on the Hush Puppies ® brand of comfortable casual and dress footwear and slippers, and (v) Other Branded Footwear, focusing on the design and manufacture of private label footwear. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, gloves, handbags and plush toys. +The Company's Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support for the various Company brands. The Company's footwear is distributed domestically through 70 Company-owned retail stores and to numerous accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of the retailers to whom Wolverine distributes operate multiple storefront locations. The Company's products are distributed worldwide in over 140 markets through licensees and distributors. +The Company, through its Wolverine Leathers Division, operates a tannery which is one of the premier tanners of quality pigskin leather for the shoe and leather goods industries. Pigskin leather tanned by the Company is used in a significant portion of the footwear marketed by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of footwear. In addition, Wolverine Procurement, Inc., a Company-owned subsidiary, performs skinning operations and purchases +3 +raw pigskins which it then cures and sells to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company and the notes thereto, which are attached as Appendix A to this Form 10-K. The Company has one reportable segment, Branded Footwear and Licensing. The Branded Footwear and Licensing segment is engaged in manufacturing, sourcing, licensing, marketing and distributing branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear. The Company's Other Business units consist of its retail stores, tannery and pigskin procurement operations. Financial information regarding the Company's business segments and financial information about geographic areas is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Form 10-K. +Branded Footwear and Licensing. +The Company sources and markets a broad range of footwear styles including shoes, boots, slippers, moccasins and sandals under many recognizable brand names including Bates ® , CAT ® , Harley-Davidson ® , Hush Puppies ® , HyTest ® , Merrell ® , Sebago ® , Stanley ® and Wolverine ® . The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications at both Company-owned and independent manufacturing facilities. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, handbags and plush toys. Current significant licensing programs include Hush Puppies ® apparel, eyewear, watches and plush toys, and Wolverine ® brand apparel, gloves and eyewear. +The Company's five branded footwear and licensing operating units are described below. +1. Wolverine Footwear Group . The Wolverine Footwear Group encompasses footwear primarily under the Wolverine ® , Bates ® , HyTest ® and Stanley ® brands and markets footwear designed with performance and comfort features to serve a variety of work, outdoor and lifestyle functions. +Wolverine ® Work and Industrial Footwear . The Wolverine ® brand has built its reputation by offering high quality work boots and shoes that incorporate innovative technologies to deliver comfort and durability. The Wolverine ® brand, which has been in existence for 122 years, markets work and outdoor footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® technology and, in 2004, Wolverine MultiShox ™ technology, has allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The Wolverine Fusion ® , DuraShocks SR™ and Wolverine Compressor™ technologies represent the Company's tradition of comfortable work and industrial footwear, a tradition that is continued and enhanced with the development of the Wolverine MultiShox™ Individual Comfort System. The Wolverine ® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female industrial and farm workers. The Wolverine ® rugged casual and outdoor sport product lines incorporate DuraShocks ® technology and other comfort features into products designed for casual and outdoor sport use. The rugged casual line targets active lifestyles and includes walking shoes, rugged casuals and outdoor sandals. The outdoor sport line is designed to meet the demands of hunters, fishermen and other active outdoor sportsmen and women. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® and Thinsulate ® brand fabrics, the Company's performance leathers +4 +and patented DuraShocks ® technologies. In addition, the Wolverine ® brand is licensed for use on apparel, eyewear, watches and gloves. +Bates ® Uniform Footwear . The Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes DuraShocks ® , DuraShocks SR ™, CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and oxfords including the Bates ®, Enforcer Series ® and Special Ops ™ footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and the militaries of several foreign countries to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial occupations. Bates Uniform Footwear Division's products are also distributed through specialty retailers and catalogs. +HyTest ® Safety Footwear . The HyTest ® product line consists primarily of high-quality work boots and shoes designed to protect male and female industrial workers from foot injuries. HyTest ® footwear incorporates various specialty safety features into its product lines, including steel toe, composite toe, metatarsal guards, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology to provide comfort together with safety for working men and women. HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company's occupational and work footwear brands to workers at industrial facilities and also through direct sales arrangements with large industrial customers. +Stanley ® Footgear . Pursuant to a license arrangement with The Stanley Works, the Company has exclusive rights to manufacture, market, distribute and sell footwear under the Stanley ® brand. The Stanley ® Footgear line is designed primarily for and marketed in the value-priced work footwear market. Stanley ® Footgear is currently sold in Payless ShoeSource, Inc. stores throughout the United States. +2. The Outdoor Group . The Outdoor Group consists of Merrell ® and Sebago ® footwear and includes performance outdoor, hiking and nautical footwear as well as casual and after-sport footwear. +Merrell ® Footwear. The Merrell ® product line consists primarily of technical hiking, rugged outdoor and outdoor-inspired casual footwear designed for backpacking, day hiking and everyday use. The Merrell ® product line also includes the "After-Sport" category, incorporating Merrell ® footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers™ and other technical materials to create footwear with unique styling, performance and comfort features. In spring of 2005, the Outdoor Group launched its tightly-focused Merrell ® Continuum™ product offering, featuring four product categories that are organized by end use (Hiking, Active Speed, Multi-Sport, and Aqua Sport). In addition to footwear, the Outdoor Group markets a line of Merrell ® packs, bags and luggage. Merrell ® products are sold primarily through outdoor specialty retailers, department stores and catalogs. Merrell ® footwear is marketed in over 120 countries worldwide. +Sebago ® Footwear. The Sebago ® product line consists primarily of performance nautical and American-inspired casual footwear for men and women such as +5 +handsewn loafers and boat shoes that have been manufactured and distributed since 1946. Highly recognized Sebago ® line extensions include Docksides , Drysides and Campsides. The Sebago ® product line is distributed in over 85 countries worldwide. The Sebago ® manufacturing and design tradition of quality componentry, durability, comfort and "Americana" heritage is further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. +3. The Heritage Brands Group . The Heritage Brands Group was formed in 2004 and consists of Caterpillar ® Footwear and Harley-Davidson ® Footwear . Previously Caterpillar ® Footwear was operated as a separate operating unit and Harley-Davidson ® Footwear was part of the Wolverine Footwear Group. +Caterpillar ® Footwear. Pursuant to a license arrangement with Caterpillar Inc., the Company has exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ® , CAT & Design ® , Walking Machines ® and other trademarks. The Company believes the association with CAT ® equipment enhances the reputation of its footwear for quality, ruggedness and durability. CAT ® brand footwear products include work boots and shoes, sport boots, rugged casuals and lifestyle footwear, including lines of work and casual footwear featuring CAT ® iTechnology ™ and Hidden Tracks ® comfort features. In addition, the Company also manufactures and markets CAT ® Marine Power ® footwear, designed for industrial and recreational marine uses. CAT ® footwear products target work and industrial users and active lifestyle users. CAT ® footwear is marketed in over 130 countries worldwide. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson ® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a network of independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. +4. The Hush Puppies Company . Since 1958, the Hush Puppies ® brand has been a leader in the casual footwear market. The brand offers shoes and boots for men, women and children, and is sold in over 110 countries. The modern styling is complemented by a variety of comfort features and proprietary technologies that have earned the brand its reputation for comfort. In addition, the Hush Puppies ® brand is licensed for use on apparel, eyewear, handbags and plush toys. +5. Other Branded Footwear . The Company designs and manufactures constructed slippers, aftersport footwear, moccasins and children's footwear on a private label basis according to customer specifications. The styling of the Company's footwear reflects consumer demand for the "rugged indoor" look by using natural leathers such as moosehide, shearling and suede in constructed slipper and indoor and outdoor moccasin designs. In addition to its traditional line of private label products, the Company has developed a College Clogs™ program for the sale of licensed collegiate slipper products. +6 +Other Businesses. +In addition to manufacturing, sourcing, marketing and distributing the Company's footwear products as reported in the Branded Footwear and Licensing segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly-owned subsidiary Wolverine Procurement, Inc., and (iii) operates 70 domestic retail footwear stores. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces pigskin leathers primarily for use in the footwear industry. Wolverine Leathers ® brand products are primarily manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes these leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof and stain resistant leathers are featured in many of the Company's domestic footwear lines and many products offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +3. Wolverine Retail . The Company operates 70 domestic retail shoe stores as of February 2005. These stores are under the Hush Puppies and Family SM and Track'n Trail ® names. The Company expects to open new stores under both formats in 2005. Both retail formats carry a large selection of Company branded footwear featuring such brands as Wolverine ® , Merrell ® , Hush Puppies ® , CAT ® , Sebago ® and Harley-Davidson ® . The Company also operates direct-to-customer retail websites, including www.upfootgear.com , www.trackandtrail.com , www.catfootwear.com and www.hushpuppies.com . +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States and international markets to foster a differentiated and consistent image for each of the Company's core footwear brands. Each footwear brand group has its own marketing personnel who develop the marketing strategy for products within that group. Marketing campaigns and strategies vary by brand and may target accounts and/or end users as they strive to increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's footwear. Components of the brand-specific plans vary and may include print, radio and television advertising, event sponsorships, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's footwear brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance that may be provided by the Company to its licensees and distributors are (i) direction on the categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting on retail store layout and design. The Company believes its footwear brand names provide a competitive advantage and the Company makes significant +7 +expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution. +The Company uses a wide variety of distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses the following distribution strategies. +• +Traditional wholesale distribution is used to service department stores, large footwear chains, specialty retailers, catalogs, independent retailers and uniform outlets. A dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide branded and private label footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchant and government customers. +• +A network of independent Shoemobile ® distribution outlets is used to distribute the Company's work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and enters bids for contracts to supply specific footwear products. +In addition to its wholesale activities, the Company also operates a domestic retail operation as described above. The Company continues to develop various programs, both independently and with its retail customers, for the distribution of its products. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's revenue in fiscal 2004. +The Company experiences moderate fluctuations in sales volume during the year as reflected in quarterly revenue (and taking into consideration the 16 weeks or 17 weeks included in the fourth accounting period versus the 12 weeks included in the first three accounting periods). The Company also experiences some fluctuation in its levels of working capital, typically including an increase in working capital requirements near the end of the third quarter. The Company provides working capital for such fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects current seasonal sales patterns to continue in future years. +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of sales of branded footwear products generated from the Company's owned operations in Canada, the United Kingdom, Austria, Finland, France, Germany, The Netherlands, Spain, Sweden and Switzerland and from royalty income through a network of independent licensees and distributors. The Company's owned operations include Hush Puppies (UK) Ltd., Merrell Europe B.V., Merrell (Europe) Limited, Wolverine Europe Limited and Wolverine World Wide Corporation, Inc. (formerly known as Hush Puppies Canada Footwear, Ltd.). In addition, in January 2005, the Company's Canadian subsidiary, Wolverine World Wide Corporation, Inc., purchased selected assets of the Canadian CAT and Wolverine footwear businesses from the Company's former independent distributor, Wolverine Canada, Inc.; and also +8 +acquired the assets of the Company's Merrell Canada division to centralize its Canadian operations. The Company also acquired selected assets of its Merrell distributors in Sweden and Finland and began direct distribution of Sebago ® brand products to retailers in the U.K. and Germany. The Company's owned operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of products (primarily Company footwear) bearing the Hush Puppies ® , Wolverine ® , Bates ® , HyTest ® , Merrell ®, Sebago ® and other trademarks by independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the CAT ® , and Harley-Davidson ® trademarks through foreign distributors. License and distribution arrangements enable the Company to develop sales in international markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent with the global brand position. Independent licensees and distributors purchase goods from either the Company or authorized third-party manufacturers pursuant to distribution agreements or manufacture branded products consistent with Company standards pursuant to license agreements. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and manufacture of approximately 76% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the pairs controlled by the Company, approximately 88% are purchased or sourced from third parties, with the remainder produced at Company-operated facilities. Footwear produced by the Company is manufactured at Company-operated facilities in several domestic and certain affiliated foreign facilities located in Michigan, Arkansas, and the Dominican Republic. For some of the Company-produced footwear, a "twin plant" concept is utilized whereby a majority of the labor intensive cutting and fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Dominican Republic and Arkansas, and the technology intensive construction, or "bottoming," is performed primarily at the Company's Michigan facilities. +The Company's factories each have the flexibility to produce a variety of footwear, which departs from the industry's historical practice of dedicating a given facility to production of specific footwear products. This flexibility allows the Company to quickly respond to changes in market preference and demand. The Company currently produces slippers, military footwear and work, casual and dress casual footwear in its domestic and/or Dominican Republic facilities. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, Central and South America, India and Europe. The Company maintains technical offices in the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In addition, the Company has adopted "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +9 +The Company's domestic manufacturing operations allow the Company to (i) reduce its production lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and (iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (i) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (ii) source the highest quality raw materials from around the world, and (iii) avoid additional capital expenditures necessary for owned factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company maximum flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates a pigskin tannery through its Wolverine Leathers Division, which is one of the premier tanners of quality leather for the footwear industry. The Company and its licensees receive virtually all of their pigskin requirements from the tannery. The Company believes the tannery provides a strategic advantage for the Company by producing pigskin leather using proprietary technology at prices below those available from other sources. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of common upper materials and specialty leathers eliminates any reliance by the Company upon a sole supplier. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over 30 years. Alternative sources of pigskin are available; however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas and tariffs, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could have an adverse impact on the Company's operations and financial condition. +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear products. The owned trademarks that are most widely used by the Company include Hush Puppies ® , Wolverine ® , Bates ® , Wolverine Fusion ® , DuraShocks ® , Wolverine MultiShox ™ , Wolverine Compressor™, Hidden Tracks ® , iTechnology ™ , Bounce ® , Comfort Curve ® , HyTest ® , Merrell ® , Continuum ™, Sebago ® , and Track'n Trail ® . The Company has obtained license rights to manufacture, market and distribute footwear throughout the world under the CAT ® and Harley-Davidson ® trademarks, and the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark, all pursuant to license arrangements with the respective trademark owners. The CAT ® , Harley-Davidson ® , and Stanley ® licenses are long-term and extend for five or more years with conditional renewal options and are subject to early termination for breach. Pigskin leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers ® , Weather Tight ® and All Season Weather Leathers ™. +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of +10 +ownership of its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever possible and to vigorously defend its trademarks against infringement or other threats to the greatest extent practicable under the laws of the United States and other countries. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent practicable under applicable laws. +Order Backlog. +At March 14, 2005, the Company had an order backlog of approximately $326 million compared with an order backlog of approximately $274 million at March 13, 2004. Substantially all of the backlog relates to demand for products expected to be shipped in 2005. Orders in backlog are subject to cancellation by customers and to changes in planned customer demand or at-once orders. The backlog at a particular time is affected by a number of factors, including seasonality, retail conditions, expected customer demand, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments. +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States and Europe. The Company has at least ten major competitors in connection with the sale of its work shoes and boots, at least ten major competitors in connection with the sale of its sport boots, and at least thirty major competitors in connection with the sale of its casual, work and outdoor shoes. Product performance and quality, including technological improvements, product identity, competitive pricing, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing efficiencies, its tannery operations, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and no one company has a dominant market position. +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to the development of new production techniques and to improving the function, performance, reliability and quality of its branded footwear and other products. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, such as Bounce ® , DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. +11 +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company uses and generates certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites and other regulatory issues. +Employees. +As of January 1, 2005, the Company had approximately 5,134 domestic and foreign production, office and sales employees. Approximately 640 employees were covered by three union contracts expiring at various dates through May 1, 2006. The Company presently considers its employee relations to be good. +Available Information. +Information about the Company, including the Company's Code of Conduct & Compliance, Corporate Governance Guidelines, Director Independence Standards, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, Executive Committee Charter and Governance Committee Charter, is available at its website, http://www.wolverineworldwide.com. Printed copies of the documents listed above are available by writing to the Company at 9341 Courtland Drive, N.E., Rockford, MI 49351, Attention: Director of Investor Relations. +The Company also makes available on or through its website, free of charge, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports (along with certain other Company filings with the Securities and Exchange Commission ("SEC")) as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These materials are also accessible on the SEC's website at www.sec.gov. \ No newline at end of file diff --git a/raw/filings/0000110471/2004/0000905729-05-000124/item13.txt b/raw/filings/0000110471/2004/0000905729-05-000124/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..5e64578fdcc123a11190058508fd643422a1c8b5 --- /dev/null +++ b/raw/filings/0000110471/2004/0000905729-05-000124/item13.txt @@ -0,0 +1,2 @@ +Item 13. Certain Relationships and Related Transactions . +The information contained under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company dated March 14, 2005, are incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000110471/2004/0000905729-05-000124/item9a.txt b/raw/filings/0000110471/2004/0000905729-05-000124/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..8a90660fcae53cdb824a44548376345d79b5ec04 --- /dev/null +++ b/raw/filings/0000110471/2004/0000905729-05-000124/item9a.txt @@ -0,0 +1,11 @@ +Item 9A. Controls and Procedures . +Evaluation of Disclosure Controls and Procedures. +An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on and as of the time of such evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filings with the SEC. +Management's Report on Internal Control Over Financial Reporting. +Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of January 1, 2005, based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of January 1, 2005. +Management's assessment of the effectiveness of our internal control over financial reporting as of January 1, 2005 has been audited by Ernst & Young LLP, an independent registered public accounting +30 +firm, as stated in their attestation report which is included in Appendix A and is incorporated into this Item 9A by reference. +Changes in Internal Control Over Financial Reporting. +There was no change in the Company's internal control over financial reporting that occurred during the sixteen-week period ended January 1, 2005 that has materially affected, or that is reasonably likely to materially affect, the Company's internal control over financial reporting. +PART III \ No newline at end of file diff --git a/raw/filings/0000110471/2004/0000905729-05-000124/rp_note.txt b/raw/filings/0000110471/2004/0000905729-05-000124/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000110471/2004/0000905729-05-000124/rpt_disclosure.txt b/raw/filings/0000110471/2004/0000905729-05-000124/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..3aea6dc961995a6e3e9718ea38cc1ddc85997fe6 --- /dev/null +++ b/raw/filings/0000110471/2004/0000905729-05-000124/rpt_disclosure.txt @@ -0,0 +1,48 @@ +Certain Relationships and Related +Transactions +Wolverine has entered into agreements with +Grimoldi, S.A., an Argentinean corporation of which +Mr. Alberto Grimoldi, a director of Wolverine, is chairman +and a significant shareholder, granting to Grimoldi, S.A. the +exclusive rights to distribute and sell footwear products in +Argentina under the Hush +Puppies ® , +Caterpillar ® +and +Merrell ® +brand names. Under these agreements, Grimoldi, S.A. or its +subsidiary pays Wolverine royalties and certain sublicense fees +based on sales or purchases of footwear products in Argentina. +Under the agreements described above, Grimoldi, +S.A. was obligated to pay to Wolverine royalties, sublicense +fees and service fees relating to 2005 totaling $1,439,938. +In the ordinary course of business, Wolverine and +its subsidiaries sell footwear for resale, samples, components +of footwear products (such as leather and shoe soles), +advertising materials and miscellaneous items to licensees, +distributors and customers. In 2005, purchases of such items by +Grimoldi, S.A. totaled $194,367 (including any applicable +sublicense fees for products containing licensed proprietary +technology). +All of the transactions described above occurred +pursuant to continuing contractual arrangements between +Wolverine and Grimoldi, S.A. Wolverine expects similar +transactions to occur between Grimoldi, S.A. and Wolverine and +its subsidiaries during 2006. +During 2002, Wolverine and Grimoldi, S.A. agreed +to payment terms with respect to certain trade accounts owed by +Grimoldi, S.A. to Wolverine. Grimoldi, S.A. executed a +three-year note payable to Wolverine in the face amount of +$635,761 which bears interest at 10 percent per annum. As +of December 31, 2005, the aggregate principal balance of +the note was $40,520. The note was paid in full in January 2006. +The highest principal balance of the note between +January 1, 2005 and December 31, 2005 was $233,339. +In the ordinary course of its business, Wolverine +purchases promotional merchandise for use in connection with the +sale of its products. In 2005, Wolverine purchased promotional +merchandise from Bullseye Group, LLC totaling $402,500. One +third of Bullseye Group, LLC is owned by Daniel Mehney, the son +of David P. Mehney, a director of Wolverine. Wolverine +anticipates purchasing promotional materials from Bullseye +Group, LLC in 2006. \ No newline at end of file diff --git a/raw/filings/0000110471/2005/0000905729-06-000156/filing.txt b/raw/filings/0000110471/2005/0000905729-06-000156/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..f9dae69fcf0bb2700d466f8368eee9341c99d6cc --- /dev/null +++ b/raw/filings/0000110471/2005/0000905729-06-000156/filing.txt @@ -0,0 +1,3638 @@ +10-K +1 +www10k_031506.htm +WOLVERINE WORLD WIDE FORM 10-K (YE 12/31/05) +Wolverine World Wide, Inc. Form 10-K - 03/15/06 +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +___________________ +FORM 10-K +[X] +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2005 +[ ] +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: 001-6024 +WOLVERINE WORLD WIDE, INC. +(Exact name of registrant as specified in its charter) +Delaware +(State or other jurisdiction of +incorporation or organization) +38-1185150 +(I.R.S. Employer Identification No.) +9341 Courtland Drive, Rockford, Michigan +(Address of principal executive offices) +49351 +(Zip Code) +Registrant's telephone number, including area code: (616) 866-5500 +Securities registered pursuant to Section 12(b) of the Securities Exchange Act: +Title of each class +Name of each exchange on which registered +Common Stock, $1 Par Value +New York Stock Exchange/Pacific Exchange, Inc. +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes +X +No +Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. +Yes +No +X +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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X +Indicate by check mark whether the registrant is a large accelerated filer (as defined in Exchange Act Rule 12b-2), an accelerated filer (as defined in Exchange Act Rule 12b-2) or a non-accelerated filer. +Large accelerated filer +X +Accelerated filer +Non-accelerated filer +Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). +Yes +No +X +The aggregate market value of the registrant's voting stock held by non-affiliates of the registrant based on the closing price on the New York Stock Exchange on June 17, 2005, the last business day of the registrant's most recently completed second fiscal quarter: $1,384,458,962. +Number of shares outstanding of the registrant's Common Stock, $1 par value (excluding shares of treasury stock) as of March 10, 2006: 54,557,595. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the definitive proxy statement for the registrant's annual stockholders' meeting to be held April 20, 2006, are incorporated by reference into Part III of this report. +FORWARD-LOOKING STATEMENTS +This Report on Form 10-K contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the footwear business, worldwide economics and the Company itself. Statements, including without limitation, those related to: future revenue, earnings, margins, growth, cash flows, operating measurements, tax rates and tax benefits; expected economic returns; projected 2006 operating results and dividend rates; future share repurchase activity; future strength of the Company; future brand positioning; achievement of the Company vision; future pension costs; future marketing investments; the introduction of new lines or categories of products, including Merrell® Apparel and Patagonia® Footwear; future growth or success in specific countries, categories or market sectors; liquidity; capital resources and market risk are forward-looking statements. In addition, words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "predicts," "projects," "should," "will," variations of such words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("Risk Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. +Risk Factors include, but are not limited to, the following risk factors, as well as the risk factors more fully described in Item 1A "Risk Factors": uncertainties relating to changes in demand for the Company's products; changes in consumer preferences or spending patterns; the cost and availability of inventories, services, labor and equipment furnished to the Company; the cost and availability of contract manufacturers; the cost and availability of raw materials, including leather and petroleum based materials; changes in planned consumer demand or at-once orders; customer order cancellations; the impact of competition and pricing by the Company's competitors; changes in government and regulatory policies; foreign currency fluctuation in valuations compared to the U.S. dollar; changes in monetary controls and valuations of the Chinese yuan renminbi and the relative value to the U.S. dollar; changes in duty structures in countries of import and export; anti-dumping measures in Europe that are currently being recommended by the European Commission with respect to leather footwear imported into the European Union from China and Vietnam at additional duty rates progressing to 19.4% and 16.8% respectively by September of 2006 for certain leather footwear; anti-dumping measures being considered with respect to safety footwear imported from China and India; changes in interest rates, tax laws, duties, tariffs, quotas or applicable assessments; technological developments; changes in local, domestic or international economic and market conditions; the size and growth of footwear markets; service interruptions at shipping and receiving ports; changes in the amount or severity of inclement weather; changes due to the growth of Internet commerce; popularity of particular designs and categories of footwear; the ability of the Company to manage and forecast its growth and inventories; the ability to secure and protect trademarks, patents and other intellectual property; integration of operations of newly acquired businesses; changes in business strategy or development plans; the Company's ability to adapt and compete in global apparel and accessory markets; customer acceptance of the Patagonia® Footwear products to be introduced in 2006; the ability to attract and retain qualified personnel; the ability to retain rights to brands licensed by the Company; loss of significant customers; relationships with international distributors and licensees; the Company's ability to meet at-once orders; the exercise of future purchase options by the U.S. Department of Defense on previously awarded contracts; the risk of doing business in developing countries and economically volatile areas; retail buying patterns; consolidation in the retail sector; and the acceptability of U.S. brands in international markets. Additionally, concerns regarding acts of terrorism, the war in Iraq and subsequent events have created significant global economic and political uncertainties that may have material and adverse effects on consumer demand, foreign sourcing of footwear, shipping and transportation, product imports and exports and the sale of products in foreign +2 +markets. These matters are representative of the Risk Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement. Historical operating results are not necessarily indicative of the results that may be expected in the future. The Risk Factors included here are not exhaustive. Other Risk Factors exist, and new Risk Factors emerge from time-to-time, that may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. Furthermore, the Company undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. +PART I +Item 1. Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The Company, a Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +The Company sold approximately 44 million pairs of Company branded footwear during fiscal 2005, making the Company a global leader among footwear companies in the marketing of branded casual, work and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort and performance. The products are marketed throughout the world under widely recognized brand names, including Bates ® , CAT ® , Harley-Davidson ® , Hush Puppies ® , HyTest ® , Merrell ® , Sebago ®, Stanley ® and Wolverine ® and, beginning with the expected product launch in Spring 2007, Patagonia ® footwear. The Company believes that its primary competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary designs and comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. For 2005, the Company's footwear products were organized under five operating units: (i) the Wolverine Footwear Group, focusing on the Bates ®, HyTest ®, Stanley ® and Wolverine ® product lines of work, outdoor, uniform and lifestyle boots and shoes, (ii) the Outdoor Group, currently focusing on the Sebago ® and Merrell ® product lines of performance and lifestyle footwear, and, beginning with anticipated product launches in fiscal 2007, Merrell ® brand apparel and Patagonia ® brand footwear (iii) the Heritage Brands Group, focusing on the CAT ® product lines of work and lifestyle footwear and the Harley-Davidson ® lines of lifestyle and performance footwear, (iv) The Hush Puppies Company, focusing on the Hush Puppies ® brand of comfortable casual and dress footwear and slippers, and (v) Other Branded Footwear, focusing on the design and manufacture of private label footwear. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, gloves, handbags and plush toys. +The Company's Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support for the various Company brands. The Company's footwear is distributed domestically through 76 Company-owned retail stores and to numerous accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of the +3 +retailers to which Wolverine distributes operate multiple storefront locations. The Company's products are marketed worldwide in over 170 markets through licensees and distributors. +The Company, through its Wolverine Leathers Division, operates a tannery which is one of the premier tanners of quality pigskin leather for the shoe and leather goods industries. Pigskin leather tanned by the Company is used in a significant portion of the footwear marketed by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of footwear. In addition, Wolverine Procurement, Inc., a Company-owned subsidiary, performs skinning operations and purchases raw pigskins which it then cures and sells to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company and the notes thereto, which are attached as Appendix A to this Form 10-K. The Company has one reportable segment, Branded Footwear and Licensing. The Branded Footwear and Licensing segment is engaged in manufacturing, sourcing, licensing, marketing and distributing branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear. The Company's Other Business units consist of its retail stores, tannery and pigskin procurement operations. Financial information regarding the Company's business segments and financial information about geographic areas is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Form 10-K. +Branded Footwear and Licensing. +The Company sources and markets a broad range of footwear styles including shoes, boots, slippers, moccasins and sandals under many recognizable brand names including Bates ® , CAT ® , Harley-Davidson ® , Hush Puppies ® , HyTest ® , Merrell ® , Sebago ® , Stanley ® and Wolverine ® and, with the expected product launch in Spring 2007, Patagonia ® footwear. The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications at both Company-owned and independent manufacturing facilities. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, handbags and plush toys. Current significant licensing programs include Hush Puppies ® apparel, eyewear, watches and plush toys, and Wolverine ® brand apparel, gloves and eyewear. +The Company's five branded footwear and licensing operating units are described below. +1. The Outdoor Group . The Outdoor Group consists of Merrell ®, Sebago ®, and, with its expected launch in Spring 2007, Patagonia ® footwear and includes performance outdoor, hiking and nautical footwear as well as casual and after-sport footwear. +Merrell ® Footwear. The Merrell ® product line consists primarily of technical hiking, rugged outdoor and outdoor-inspired casual footwear designed for backpacking, day hiking and everyday use. The Merrell ® product line also includes the "After-Sport" category, incorporating Merrell ® footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers™ and other technical materials to create footwear with unique styling, performance and comfort features. In spring of 2005, the Outdoor Group launched its tightly-focused Merrell ® Continuum ® product offering, featuring four product categories that are organized by end use (Hiking, Active Speed, Multi-Sport, and Aqua Sport). In addition to footwear, the Outdoor Group markets a line of Merrell ® packs, bags and luggage. The Outdoor Group also intends to launch a line of Merrell ® brand apparel in fiscal 2007. Merrell ® products are sold primarily through outdoor +4 +specialty retailers, department stores and catalogs. Merrell ® footwear is marketed in over 125 countries worldwide. +Sebago ® Footwear. The Sebago ® product line consists primarily of performance nautical and American-inspired casual footwear for men and women such as boat shoes and handsewn loafers that have been manufactured and distributed since 1946. Highly recognized Sebago ® line extensions include Sebago Docksides ® , Drysides™ , Campsides™ and Athletic Marine. The Sebago ® product line is distributed in over 80 countries worldwide. The Sebago ® manufacturing and design tradition of quality componentry, durability, comfort and "Americana" heritage is further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. +Patagonia® Footwear. In 2005, the Company entered into a license agreement providing the Company with exclusive worldwide rights to manufacture, market, distribute and sell footwear under the Patagonia®, Water Girl® and other trademarks. The Outdoor Group anticipates the launch of its Patagonia® Footwear line for Spring 2007. +2. Wolverine Footwear Group . The Wolverine Footwear Group encompasses footwear primarily under the Wolverine ® , Bates ® , HyTest ® and Stanley ® brands and markets footwear designed with performance and comfort features to serve a variety of work, outdoor and lifestyle functions. +Wolverine ® Work and Industrial Footwear . The Wolverine ® brand has built its reputation by offering high quality work boots and shoes that incorporate innovative technologies to deliver comfort and durability. The Wolverine ® brand, which has been in existence for 123 years, markets work and outdoor footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® technology and, in 2004, Wolverine MultiShox™ technology, has allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The Wolverine Fusion ® , DuraShocks SR™ and Wolverine Compressor™ technologies represent the Company's tradition of comfortable work and industrial footwear, a tradition that is continued and enhanced with the development of the Wolverine MultiShox™ Individual Comfort System. The Wolverine ® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female industrial and farm workers. The Wolverine ® rugged casual and outdoor sport product lines incorporate DuraShocks ® technology and other comfort features into products designed for casual and outdoor sport use. The rugged casual line targets active lifestyles and includes trail shoes, rugged casuals and outdoor sandals. The outdoor sport line is designed to meet the demands of hunters, fishermen and other active outdoor sportsmen and women. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® and Thinsulate ® brand fabrics, the Company's performance leathers and patented DuraShocks ® technologies. In addition, the Wolverine ® brand is licensed for use on apparel, eyewear, watches and gloves. +Bates ® Uniform Footwear . The Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes DuraShocks ® , DuraShocks SR ™ , CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and +5 +oxfords including the Bates ®, Enforcer Series ® and Special Ops ™ footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and the militaries of several foreign countries to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial occupations. Bates Uniform Footwear Division's products are also distributed through specialty retailers and catalogs. +HyTest ® Safety Footwear . The HyTest ® product line consists primarily of high-quality work boots and shoes designed to protect male and female industrial workers from foot injuries. HyTest ® footwear incorporates various specialty safety features into its product lines, including steel toe, composite toe, metatarsal guards, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology to provide comfort together with safety for working men and women. HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company's occupational and work footwear brands to workers at industrial facilities and also through direct sales arrangements with large industrial customers. +Stanley ® Footgear . Pursuant to a license arrangement with The Stanley Works, the Company has exclusive rights to manufacture, market, distribute and sell footwear under the Stanley ® brand. The Stanley ® Footgear line is designed primarily for and marketed in the value-priced work footwear market. Stanley ® Footgear is currently sold in Payless ShoeSource, Inc. stores throughout the United States. +3. The Heritage Brands Group . The Heritage Brands Group consists of Caterpillar ® Footwear and Harley-Davidson ® Footwear . +Caterpillar ® Footwear. Pursuant to a license arrangement with Caterpillar Inc., the Company has exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ® , CAT & Design ® , Walking Machines ® and other trademarks. The Company believes the association with CAT ® equipment enhances the reputation of its footwear for quality, ruggedness and durability. CAT ® brand footwear products include work boots and shoes, sport boots, rugged casuals and lifestyle footwear, including lines of work and casual footwear featuring CAT ® iTechnology™ and Hidden Tracks ® comfort features. In addition, the Company also manufactures and markets CAT ® Marine Power ® footwear, designed for industrial and recreational marine uses. CAT ® footwear products target work and industrial users and active lifestyle users. CAT ® footwear is marketed in over 150 countries worldwide. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson ® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a network of independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. +4. The Hush Puppies Company . Since 1958, the Hush Puppies ® brand has been a leader in the casual footwear market. The brand offers shoes and boots for men, women and children, and is sold in over 120 countries. The modern styling is complemented by a variety of +6 +comfort features and proprietary technologies that have earned the brand its reputation for comfort. In addition, the Hush Puppies ® brand is licensed for use on apparel, eyewear, handbags and plush toys. +5. Other Branded Footwear . The Company designs and manufactures constructed slippers, aftersport footwear, moccasins and children's footwear on a private label basis according to customer specifications. The styling of the Company's footwear reflects consumer demand for the "rugged indoor" look by using natural leathers such as moosehide, shearling and suede in constructed slipper and indoor and outdoor moccasin designs. In addition to its traditional line of private label products, the Company has developed a College Clogs™ program for the sale of licensed collegiate slipper products. +Other Businesses. +In addition to manufacturing, sourcing, marketing and distributing the Company's footwear products as reported in the Branded Footwear and Licensing segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly-owned subsidiary Wolverine Procurement, Inc., and (iii) operates 76 domestic retail footwear stores. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces pigskin leathers primarily for use in the footwear industry. Wolverine Leathers® brand products are primarily manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes these leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof and stain resistant leathers are featured in many of the Company's domestic footwear lines and many products offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +3. Wolverine Retail . The Company operates 76 domestic retail shoe stores as of February 2006. These stores are under the Hush Puppies ®, Hush Puppies and Family SM , Track'N Trail® and Rockford Footwear Depot SM names. The Company expects to open new stores under both the Hush Puppies ® and Track'N Trail® formats in 2006. Both retail formats carry a large selection of Company branded footwear featuring such brands as Wolverine® , Merrell® , Hush Puppies® , CAT® , Sebago® and Harley-Davidson® . The Company also operates direct-to-customer retail websites, including www.upfootgear.com , www.trackandtrail.com , www.catfootwear.com , www.hushpuppies.com and www.sebago.com . +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States and international markets to foster a differentiated and consistent image for each of the Company's core footwear brands. Each footwear brand group has its own marketing personnel who develop the marketing strategy for products within that group. Marketing campaigns and strategies vary by brand and may target accounts and/or end users as they strive to +7 +increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's footwear. Components of the brand-specific plans vary and may include print, radio and television advertising, event sponsorships, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's footwear brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance that may be provided by the Company to its licensees and distributors are (i) direction on the categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting on retail store layout and design. The Company believes its footwear brand names provide a competitive advantage and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution. +The Company uses a wide variety of distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses the following distribution strategies. +• +Traditional wholesale distribution is used to service department stores, large footwear chains, specialty retailers, catalogs, independent retailers and uniform outlets. A dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide branded and private label footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchant and government customers. +• +A network of independent Shoemobile ® distribution outlets is used to distribute the Company's work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and enters bids for contracts to supply specific footwear products. Such contracts typically contain future purchase options that are not required to be exercised. +In addition to its wholesale activities, the Company also operates a domestic retail operation as described above. The Company continues to develop various programs, both independently and with its retail customers, for the distribution of its products. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's revenue in fiscal 2005. +The Company experiences moderate fluctuations in sales volume during the year as reflected in quarterly revenue (and taking into consideration the 16 weeks or 17 weeks included in the fourth accounting period versus the 12 weeks included in the first three accounting periods). The Company also experiences some fluctuation in its levels of working capital, typically including an increase in working capital requirements near the end of the third quarter. The Company provides working capital for such +8 +fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects current seasonal sales patterns to continue in future years. +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of sales of branded footwear products generated from the Company's owned operations in Canada, the United Kingdom, Austria, Finland, France, Germany, The Netherlands, Spain, Sweden and Switzerland and from royalty income through a network of independent licensees and distributors. The Company's owned operations include Hush Puppies (UK) Ltd., Merrell Europe B.V., Merrell (Europe) Limited, Wolverine Europe Limited and Wolverine World Wide Corporation, Inc. (formerly known as Hush Puppies Canada Footwear, Ltd.). In addition, in January 2005, the Company's Canadian subsidiary, Wolverine World Wide Corporation, Inc., purchased selected assets of the Canadian CAT and Wolverine footwear businesses from the Company's former independent distributor, Wolverine Canada, Inc.; and also acquired the assets of the Company's Merrell Canada division to centralize its Canadian operations. The Company also acquired selected assets of its Merrell distributors in Sweden and Finland and began direct distribution of Sebago ® brand products to retailers in the U.K. and Germany. The Company's owned operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of products (primarily Company footwear) bearing the Hush Puppies ® , Wolverine ® , Bates ® , HyTest ® , Merrell ®, Sebago ® and other trademarks by independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the CAT ® , and Harley-Davidson ® trademarks through foreign distributors. License and distribution arrangements enable the Company to develop sales in international markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent with the global brand position. Independent licensees and distributors purchase goods from either the Company or authorized third-party manufacturers pursuant to distribution agreements or manufacture branded products consistent with Company standards pursuant to license agreements. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and manufacture of approximately 77% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the pairs controlled by the Company, approximately 90% are purchased or sourced from third parties, with the remainder produced at Company-operated facilities. Footwear produced by the Company is manufactured at Company-operated facilities in several domestic and certain affiliated foreign facilities located in Michigan, Arkansas, and the Dominican Republic. For some of the Company-produced footwear, a "twin plant" concept is utilized whereby a majority of the labor intensive cutting and fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Dominican Republic and Arkansas, and the technology intensive construction, or "bottoming," is performed primarily at the Company's Michigan facilities. +The Company's factories each have the flexibility to produce a variety of footwear, which departs from the industry's historical practice of dedicating a given facility to production of specific footwear +9 +products. This flexibility allows the Company to quickly respond to changes in market preference and demand. The Company currently produces slippers, military footwear and work, casual and dress casual footwear in its owned facilities. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, Central and South America, India and Europe. The Company maintains technical offices in the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In addition, the Company has adopted "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +The Company's domestic manufacturing operations allow the Company to (i) reduce its production lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and (iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (i) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (ii) source the highest quality raw materials from around the world, and (iii) avoid additional capital expenditures necessary for owned factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company the flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates a pigskin tannery through its Wolverine Leathers Division, which is one of the premier tanners of quality leather for the footwear industry. The Company and its licensees receive virtually all of their pigskin leather requirements from the tannery. The Company believes the tannery provides a strategic advantage for the Company by producing pigskin leather using proprietary technology at prices below those available from other sources. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of common upper materials and specialty leathers eliminates any reliance by the Company upon a sole supplier. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over 30 years. Alternative sources of pigskin are available; however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas, tariffs and duties, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could have an adverse impact on the Company's operations and financial condition. +10 +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear products. The owned trademarks that are most widely used by the Company include Hush Puppies ® , Wolverine ® , Bates ® , Wolverine Fusion ® , DuraShocks ® , Wolverine MultiShox TM , Wolverine Compressor TM , Hidden Tracks ® , iTechnology TM , Bounce ® , Comfort Curve ® , HyTest ® , Merrell ® , Continuum ® , Sebago ® , and Track'N Trail ® . The Company has obtained license rights to manufacture, market and distribute footwear throughout the world under the CAT ® , Harley-Davidson ® and Patagonia ® trademarks, and the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark, all pursuant to license arrangements with the respective trademark owners. The CAT ®, Harley-Davidson ®, Patagonia ® and Stanley ® licenses are long-term and extend for five or more years with conditional renewal options and are subject to early termination for breach. Pigskin leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers ® , Wolverine Warrior Leather ® , Weather Tight ® and All Season Weather Leathers ™. +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of ownership of its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever possible and to vigorously defend its trademarks against infringement or other threats to the greatest extent practicable under the laws of the United States and other countries. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent practicable under applicable laws. +Order Backlog. +At March 11, 2006, the Company had an order backlog of approximately $357 million compared with an order backlog of approximately $318 million at March 12, 2005, determined on a basis consistent with the current year. Substantially all of the backlog relates to demand for products expected to be shipped in 2006. Orders in backlog are subject to cancellation by customers and to changes in planned customer demand or at-once orders. The backlog at a particular time is affected by a number of factors, including seasonality, retail conditions, expected customer demand, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments. +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States and Europe. The Company has at least ten major competitors in connection with the sale of its work shoes and boots, at least ten major competitors in connection with the sale of its sport boots, and at least thirty major competitors in connection with the sale of its casual, work and outdoor shoes. Product performance and quality, including technological improvements, product identity, competitive pricing and ability to control costs, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing and sourcing efficiencies, its tannery operations, and the style, comfort and +11 +value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and no one company has a dominant market position. +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to the development of new production techniques and to improving the function, performance, reliability and quality of its branded footwear and other products. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, such as Bounce ® , DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company uses and generates certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites and other regulatory issues. +Employees. +As of December 31, 2005, the Company had approximately 4,502 domestic and foreign production, office and sales employees. Approximately 614 employees were covered by three union contracts expiring at various dates through March 31, 2007. The Company presently considers its employee relations to be good. +Available Information. +Information about the Company, including the Company's Code of Conduct & Compliance, Corporate Governance Guidelines, Director Independence Standards, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, Executive Committee Charter and Governance Committee Charter, is available at its website, http://www.wolverineworldwide.com. Printed copies of the documents listed above are available by writing to the Company at 9341 Courtland Drive, N.E., Rockford, MI 49351, Attention: General Counsel. +The Company also makes available on or through its website, free of charge, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports (along with certain other Company filings with the Securities and Exchange Commission ("SEC")) as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These materials are also accessible on the SEC's website at www.sec.gov. +12 +Item 1A. Risk Factors. +Impact of consumer spending patterns. +The success of the Company's operations depends to a significant extent upon a number of factors affecting disposable consumer income, both domestic and foreign, including economic conditions and factors such as employment, business conditions, interest rates and taxation. In addition, consumer spending patterns may be affected by changes in the amount or severity of inclement weather, the acceptability of U.S. brands in international markets and the growth or decline of global footwear markets. The Company's business, results of operations and financial condition may be adversely affected by changes in consumer spending or economic conditions. +Competition and Changes in Consumer Preferences. +The Company competes with numerous other marketers of footwear, some of which are larger and have greater resources than the Company. Product performance and quality, including technological improvements, product identity, competitive pricing and the ability to adapt to style changes are all important elements of competition in the footwear industry. The footwear industry in general is subject to changes in consumer preferences with respect to the popularity of particular designs and categories of footwear. The Company strives to maintain and improve its competitive position through promotion of brand awareness, sourcing efficiencies, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. If the Company is unable to respond effectively to competitive pressures and changes in consumer spending, the Company's business, results of operations and financial condition will be adversely affected. +Inventory Management. +The Company's ability to manage its inventories properly is an important factor in its operations. Inventory shortages can impede the Company's ability to meet at-once orders and can adversely affect the timing of shipments to customers and diminish brand loyalty. Conversely, excess inventories can result in increased interest costs as well as lower gross margins due to the necessity of lowering prices in order to liquidate excess inventories. If the Company is unable to effectively manage its inventory, its business, results of operations and financial condition will be adversely affected. +Dependence on Foreign Manufacturers. +The Company currently sources most of its footwear from third party manufacturers in foreign countries, predominantly China. As is common in the industry, the Company does not have long-term contracts with its foreign footwear manufacturers. The Company is a major customer of many of the third party manufacturers from which it sources products. There can be no assurance, however, that the Company will not experience difficulties with such manufacturers, including reduction in the availability of production capacity, failure to meet production deadlines or increases in manufacturing costs. The Company's future results will depend partly on its ability to maintain positive working relationships with its third party manufacturers. +Foreign manufacturing is subject to a number of risks, including work stoppages, transportation delays and interruptions, political instability, foreign currency fluctuations, changing economic conditions, expropriation, nationalization, the imposition of tariffs, import and export controls and other +13 +non-tariff barriers and changes in governmental policies. The possibility exists that trade relations with China and other countries where the Company sources its products will worsen or that China will shift its manufacturing capacity away from footwear to other industries. Any of these events could have an adverse effect on the Company's business, results of operations and financial condition. +Changes in monetary controls and valuations of the Chinese yuan renminbi and the currencies of other countries from which the Company sources, and their relative value to the U.S. Dollar could have an adverse effect on the Company's business, results of operations and financial condition. +The Company cannot predict whether additional United States or foreign customs quotas, duties, taxes or other changes or restrictions will be imposed upon the importation of non-domestically produced products in the future or what effect such actions could have on the Company's business, financial condition or results of operations. +The European Union has initiated anti-dumping investigations regarding the importation into the European Union of leather footwear from China and Vietnam and safety footwear from China and India. The European Commission has recommended provisional measures which, if implemented, would result in additional duties of 19.4% on certain leather footwear imported into the European Union from China and 16.8% on certain leather footwear imported into the European Union from Vietnam. Analysis and discussion between the European Commission, Member States and interested parties regarding these anti-dumping investigations is continuing and the final outcome of these investigations is uncertain. The imposition of preliminary or final dumping measures could have a material impact on the Company's business, results of operations and financial condition. The Company and a number of other companies in the footwear industry are advocating against the imposition of dumping measures by the European Union. The Company is also exploring alternative sourcing options for importation in the European Union if dumping measures are imposed. +Suppliers and Service Providers. +The Company's ability to competitively price its products depends on the cost of footwear components, services, labor, equipment and raw materials, including leather and materials used in the production of outsoles. The cost of services and materials is subject to change based on the availability and market conditions that are difficult to predict. Conditions such as diseases affecting the availability of leather affect the cost of the footwear marketed by the Company. In addition, the Company's shipping costs are affected by fuel prices and numerous other factors such as the possibility of service interruptions at shipping and receiving ports. +The Company purchases pigskins for its tannery operations from a single domestic source pursuant to short-term contracts. Although this source has been a reliable and consistent supplier for over 30 years, there are no assurances that it will continue as a supplier. Failure of this source to continue to supply the Company with pigskin or to supply the Company with pigskin on less favorable terms could have a negative impact on the Company's business, results of operations and financial condition. +Customers. +The Company's financial success is directly related to the willingness of its customers to continue to purchase its products. The Company does not typically have long-term contracts with its customers. Sales to the Company's customers are generally on an order-by-order basis and are subject to rights of cancellation and rescheduling by the customers. Failure to fill customers' orders in a timely manner could harm the Company's relationships with its customers. Furthermore, if any of the Company's major +14 +customers experience a significant downturn in its business, or fails to remain committed to the Company's products or brands, then these customers may reduce or discontinue purchases from the Company, which could have an adverse effect on the Company's business, results of operations and financial condition. +The Company sells its products to wholesale customers and extends credit based on an evaluation of each customer's financial condition, usually without requiring collateral. The financial difficulties of a customer could cause the Company to stop doing business with that customer or reduce its business with that customer. The Company's inability to collect from its customers or a cessation or reduction of sales to certain customers because of credit concerns could have an adverse effect on the Company's business, results of operations and financial condition. +The recent trend toward consolidation in the retail industry could lead to customers seeking more favorable terms of purchase from the Company and could lead to a decrease in the number of stores that carry the Company's products. +The Company has been awarded a number of U.S. Department of Defense contracts that include future purchase options for Bates ® footwear. Failure to exercise these purchase options by the Department of Defense or the failure of the Company to secure future U.S. Department of Defense contracts could have an adverse effect on the Company's business, results of operations and financial condition. +The Company's products are sold in many international markets through independent licensees or distributors. Failure by the Company's licensees or distributors to meet planned annual sales goals could have an adverse effect on the Company's business, results of operations and financial condition, and it may be difficult and costly to locate an acceptable substitute distributor or licensee. If a change in distributors becomes necessary, the Company may experience increased costs, as well as substantial disruption and a resulting loss of sales and brand equity in that market. +In addition, changes in the channels of distribution such as the growth of Internet commerce and the trend toward the sale of private label products by major retailers could have an adverse effect on the Company's business, results of operations and financial condition. +Implementation of Growth Strategy. +As part of its growth strategy, the Company seeks to enhance the positioning of its brands and to extend its brands into complementary product categories and consumer groups, to expand geographically, and to improve operational performance. There can be no assurance that we will be able to successfully implement any or all of these growth strategies, which could have an adverse effect on the Company's business, results of operations and financial condition. There is no assurance that the Company will be able to successfully launch the Patagonia® footwear line in Spring 2007 and there are no assurances that the Company's expected Merrell® brand expansion into apparel in Fall 2007 will be successful. The Company is investing substantial resources into these two product launches in 2007 and the failure of either or both could have an adverse effect on the Company's business, results of operations and financial condition. +Reputational Risks. +The Company requires its independent contract manufacturers, distributors, licensees and others with which it does business to comply with the Company's standards relating to working conditions and other matters. If a party with which the Company does business is found to have violated +15 +the Company's standards, the Company could receive negative publicity that could damage its reputation and negatively affect the value of its brands. +Government/Regulation. +The Company's business is affected by changes in government and regulatory policies in the United States and on a global basis. Changes in interest rates, tax laws, duties, tariffs and quotas could have a negative impact on the Company's ability to produce and market footwear at competitive prices. +Global Political and Economic Uncertainty. +Concerns regarding acts of terrorism, the war in Iraq and subsequent events have created significant global economic and political uncertainties that may have material and adverse effects on consumer demand, foreign sourcing of footwear, shipping and transportation, product imports and exports and the sale of products in foreign markets. The Company is subject to risks in doing business in developing countries and economically volatile areas. +Currency. +Foreign currency fluctuation in valuations compared to the U.S. Dollar, changes in monetary controls and valuations, and the relative value to the U.S. dollar affect the Company's profitability. For a more detailed discussion of risk relating to foreign currency fluctuation, see Item 7A, Quantitative and Qualitative Disclosures About Market Risk. +Protection of Intellectual Property; Continuation of Licensing Agreements. +The Company invests significant resources to developing and protecting its intellectual property. The Company's ability to remain competitive is dependent upon its continued ability to secure and protect trademarks, patents and other intellectual property rights. In addition, some of the Company's branded footwear operations are operated pursuant to licensing agreements with third party trademark owners. These agreements are long-term, but are subject to early termination provisions. Early termination of any of these license agreements by the licensor could have a material adverse effect on the Company's business, results of operations and financial condition. +Integration of Newly Acquired Businesses. +The Company may make strategic acquisitions in the future and cannot assure that it will be able to successfully integrate the operations of newly-acquired businesses into the Company's current operations. The failure to integrate newly acquired businesses or the inability to make suitable strategic acquisitions in the future could have an adverse effect on the Company's business, results of operations and financial condition. +Litigation and Regulatory Proceedings. +The Company is a defendant from time to time in lawsuits and regulatory actions relating to its business. Due to the inherent uncertainties of litigation and regulatory proceedings, the Company cannot accurately predict the ultimate outcome of any such proceedings. An unfavorable outcome could have an adverse impact on the Company's business, financial condition and results of operations. In addition, regardless of the outcome of any litigation or regulatory proceedings, such proceedings are expensive and may require that the Company devote substantial resources and executive time to defend the Company. +16 +Anti-Takeover Provisions. +Provisions of the Company's certificate of incorporation, bylaws, and the Company's Rights Plan, as well as provisions of Delaware law, could discourage, delay or prevent a merger, acquisition or other change in control of the Company. These provisions are intended to protect stockholders' interests by providing the Board of Directors a means to attempt to deny coercive takeover attempts or to negotiate with a potential acquirer in order to obtain more favorable terms. Such provisions include a board of directors that is classified so that only one-third of directors stand for election each year, the authorization of "blank check" preferred stock, which the Company's Board of Directors could issue with provisions designed to prevent or delay a takeover attempt, and provisions of the Company's Rights Plan that make it more difficult to acquire the Company without negotiating with the Board of Directors. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors and take other corporate actions. +Attraction and Retention of Qualified Personnel. +The Company is dependent on the efforts and abilities of its senior executive officers, including its Chief Executive Officer and Chairman, Timothy J. O'Donovan. While the Company believes that its senior management team has significant depth, the loss of one or more members of senior executive management could have an adverse effect on the Company, its results of operations and financial condition. The Company's future success also depends on its ability to identify, attract and retain additional qualified personnel. While the Company has historically been successful in attracting and retaining key employees, competition for such employees in the footwear industry is intense and failure to retain or attract key employees could adversely impact the Company. +Item 1B. Unresolved Staff Comments . +None. +Item 2. Properties . +The Company operates its domestic administration, sales and marketing operations primarily from an owned facility of approximately 225,000 square feet in Rockford, Michigan. The Company's manufacturing and tanning operations are primarily conducted at a combination of leased and owned facilities in Arkansas, Michigan and the Dominican Republic. The Company operates its warehousing operations primarily through owned warehouses in Rockford, Michigan, totaling approximately 475,000 square feet, a leased warehouse in Cedar Springs, Michigan, of approximately 356,000 square feet and a leased warehouse in Howard City, Michigan, of approximately 460,000 square feet. +The Company also leases and owns various other offices and warehouses in the United States to meet its operational requirements. In addition, the Company's subsidiary, Hush Puppies Retail, Inc., operates retail stores through leases with various third-party landlords. International operations are conducted in Canada, the United Kingdom, and Europe through leased warehouses, offices and showrooms. The Company believes that its current facilities are suitable and adequate for its current needs. +Item 3. Legal Proceedings . +The Company is involved in litigation and various legal matters arising in the normal course of business, including certain environmental compliance activities. The Company has considered facts +17 +related to legal and regulatory matters and opinions of counsel handling these matters, and does not believe the ultimate resolution of such proceedings will have a material adverse effect on the Company's financial condition or future results of operations. +Item 4. Submission of Matters to a Vote of Security Holders . +No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report. +Supplemental Item. Executive Officers of the Registrant . +The following table lists the names and ages of the Executive Officers of the Company and the positions presently held with the Company. The information provided below the table lists the business experience of each such Executive Officer during the past five years. All Executive Officers serve at the pleasure of the Board of Directors of the Company, or if not appointed by the Board of Directors, they serve at the pleasure of management. +Name +Age +Positions held with the Company +Steven M. Duffy +53 +Retired Executive Vice President and President, +Global Operations Group +V. Dean Estes +56 +Retired Vice President and President, +Wolverine Footwear Group +Stephen L. Gulis, Jr. +48 +Executive Vice President, Chief Financial +Officer and Treasurer +Cheryl L. Johnson +44 +Vice President, Human Resources +Blake W. Krueger +52 +Chief Operating Officer and President +Timothy J. O'Donovan +60 +Chief Executive Officer and Chairman +Nicholas P. Ottenwess +43 +Vice President of Finance and Corporate +Controller +James D. Zwiers +38 +General Counsel and Secretary +Steven M. Duffy served the Company as Executive Vice President from April 1996 until his retirement in January 2006, and was also President of the Company's Global Operations Group. From 1993 to 1996 he served as Vice President. From 1989 to 1993 he served in various senior manufacturing positions. +V. Dean Estes served the Company as Vice President from 1995 until his retirement in January 2006. Mr. Estes was also President of the Wolverine Footwear Group. Since he joined the Company in 1975, Mr. Estes has served in various positions relating to the sales, marketing and product development functions of the Company's work boot and shoe related businesses. +Stephen L. Gulis, Jr., has served the Company as Executive Vice President, Chief Financial Officer and Treasurer since April 1996. From 1994 to April 1996 he served as Vice President and Chief Financial Officer. From 1993 to 1994 he served as Vice President of Finance and Corporate Controller and from 1986 to 1993 he was the Vice President of Administration and Controller for The Hush Puppies Company. +Cheryl L. Johnson has served the Company as Vice President of Human Resources since January 2006. From 2004 to 2006 she served as Human Resources Director for Whirlpool Corporation, a +18 +manufacturer and marketer of major home appliances. From 2002 to 2004 she served as Vice President of Global Human Resources, Fluid Handling Products Division for Textron, Inc., a manufacturer of centrifugal, axial flow, power, direct acting and gear pumps. During 2002 she served as Global Human Resources Director, Flooring Division, for E.I. du Pont de Nemours and Company, a chemical company, and from 1991-2002, she served as Global Human Resources Manager for that company. +Blake W. Krueger has served the Company as Chief Operating Officer and President since October 2005. From August 2004 to October 2005, he served as Executive Vice President, Secretary and President of the Heritage Brands Group. From November 2003 to August 2004 he served the Company as Executive Vice President, Secretary, and President of Caterpillar Footwear. From April 1996 to November 2003 he served the Company as Executive Vice President, General Counsel and Secretary. From 1993 to April 1996 he served as General Counsel and Secretary. From 1985 to 1996 he was a partner with the law firm of Warner Norcross & Judd LLP. +Timothy J. O'Donovan has served the Company as Chief Executive Officer and Chairman of the Board since April 2005. From April 2000 to April 2005 he served as Chief Executive Officer and President. From 1996 to April 2000 he served as Chief Operating Officer and President. From 1982 to April 1996 he served as Executive Vice President. +Nicholas P. Ottenwess has served the Company as Vice President of Finance and Corporate Controller since June 2001. From September 1997 to June 2001 he served as Corporate Controller. From 1993 to September 1997 he served as Vice President of Finance and Administration for The Hush Puppies Company. +James D. Zwiers has served the Company as General Counsel and Secretary since October 2005. From December 2003 to October 2005 he served as General Counsel and Assistant Secretary. From January 1998 to December 2003 he served the Company as Associate General Counsel and Assistant Secretary. From 1995 to 1998 he was an attorney with the law firm of Warner Norcross & Judd LLP. +PART II +Item 5. +Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +The Company's common stock is traded on the New York Stock Exchange and the Pacific Exchange under the symbol "WWW." The following table shows the high and low stock prices on the New York Stock Exchange and dividends declared by calendar quarter for 2005 and 2004. The prices and dividends shown below are adjusted to reflect the three-for-two stock split distributed on February 1, 2005. The number of stockholders of record on March 1, 2006, was 1,450. +2005 +2004 +Stock Price +High +Low +High +Low +First quarter +$ +23.65 +$ +20.04 +$ +16.10 +$ +13.40 +Second quarter +25.70 +18.90 +18.81 +15.38 +Third quarter +25.02 +20.48 +17.92 +14.27 +Fourth quarter +22.95 +19.35 +21.66 +16.18 +19 +Cash Dividends Declared Per Share +2005 +2004 +First quarter +$ +.065 +$ +.043 +Second quarter +.065 +.043 +Third quarter +.065 +.043 +Fourth quarter +.065 +.065 +A quarterly dividend of $.075 per share was declared during the first quarter of fiscal 2006. +See Item 12 for information with respect to the Company's equity compensation plans. +The following table relates information regarding the Company's purchases of its own common stock during the fourth quarter: +Issuer Purchases of Equity Securities +Period +Total +Number of +Shares +Purchased +Average +Price Paid +per Share +Total Number +of +Shares +Purchased +as Part of +Publicly +Announced +Plans or +Programs +Maximum +Number +of Shares that +May +Yet Be Purchased +Under the Plans or +Programs +Period 1 (September 11, 2005 to October 8, 2005) +Common Stock Repurchase Program (1) +- +$ +- +- +980,582 +Employee Transactions (2) +2,474 +22.73 +N/A +N/A +Period 2 (October 9, 2005 to November 5, 2005) +Common Stock Repurchase Program (1) +961,700 +$ +21.16 +961,700 +18,882 +Employee Transactions (2) +4,502 +21.43 +N/A +N/A +Period 3 (November 6, 2005 to December 3, 2005) +Common Stock Repurchase Program (1) +- +$ +- +- +18,882 +Employee Transactions (2) +850 +22.52 +N/A +N/A +Period 4 (December 4, 2005 to December 31, 2005) +Common Stock Repurchase Program (1) +- +- +- +18,882 +Employee Transactions (2) +18,755 +$ +22.33 +N/A +N/A +Total for Fourth Quarter ended December 31, 2005 +Common Stock Repurchase Program (1) +961,700 +$ +21.16 +961,700 +3,018,882 +Employee Transactions (2) +26,581 +22.22 +N/A +N/A +1. +The Company's Board of Directors approved common stock repurchase programs on December 13, 2005, and on October 5, 2004. Each program authorizes the repurchase of 3.0 million shares of common stock over a 24-month period commencing on the effective date of the program. All shares repurchased during the period covered by this report were purchased under publicly announced programs. +2. +Employee transactions include: (1) shares delivered or attested in satisfaction of the exercise price and/or tax withholding obligations by holders of employee stock options who exercised options and (2) restricted shares withheld to offset tax withholding that occurs upon vesting of +20 +restricted shares. The Company's employee stock compensation plans provides that the value of the shares delivered or attested to, or withheld, shall be the average of the high and low price of the Company's common stock on the date the relevant transaction occurs. +Item 6. Selected Financial Data . +Five-Year Operating and Financial Summary (1) +2005 +2004 +2003 +2002 +2001 +(Thousands of Dollars, Except Per Share Data) +Summary of Operations +Revenue +$ +1,060,999 +$ +991,909 +$ +888,926 +$ +827,106 +$ +720,066 +Net earnings +74,467 +65,938 +51,716 +47,912 +45,240 +Per share of common stock: +Basic net earnings (2)(3) +$ +1.33 +$ +1.15 +$ +.88 +$ +.79 +$ +.74 +Diluted net earnings (2)(3) +1.27 +1.09 +.85 +.77 +.71 +Cash dividends declared (2) +.26 +.19 +.15 +.12 +.11 +Financial Position at Year End +Total assets +$ +626,580 +$ +639,571 +$ +593,762 +$ +531,994 +$ +543,678 +Long-term debt +32,411 +43,904 +59,923 +72,915 +90,848 +Notes to Five-Year Operating and Financial Summary +1. +This summary should be read in conjunction with the consolidated financial statements and the notes thereto, which are attached as Appendix A to this Form 10-K. +2. +On December 15, 2004, the Company announced a three-for-two stock split in the form of a stock dividend on shares of common stock outstanding at January 3, 2005 that was distributed to stockholders on February 1, 2005. All per share data has been retroactively adjusted for the increased shares resulting from this stock split. Treasury shares were excluded from the stock split. +3. +Basic earnings per share are based on the weighted average number of shares of common stock outstanding during the year after adjustment for nonvested restricted common stock. Diluted earnings per share assume the exercise of dilutive stock options and the vesting of all outstanding restricted stock. +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations . +OVERVIEW +Wolverine World Wide, Inc. (the "Company") achieved record revenue and earnings during 2005. Revenue increased 7.0% to $1.061 billion. Earnings per share grew to a record $1.27 which reflected a 16.5% increase over the $1.09 reported in the prior year. The Company ended 2005 with $85.3 million in cash on hand and reduced debt to $32.4 million. For the seventh year in a row, the Company recorded positive cash generation from operating activities with 2005 cash generation reaching a record $119.7 million. Continued focus on asset management programs resulted in an 11.8% decrease in inventory levels at year end. Accounts receivable increased 3.9% on a revenue increase of 7.0%. +The Company's 2005 performance is a direct result of the execution of the Company's strategic growth plan unveiled several years ago. The key growth strategies of this plan include: +21 +• +Global Expansion Revenue from international operations represented over 30% of the Company's 2005 revenue. During 2005, the CAT® and Wolverine® businesses in Canada were acquired and converted from a non-affiliated distributor-based operation to a Company-owned wholesale operation. Additionally, non-affiliated Merrell® distributors in Sweden and Finland, as well as Sebago® businesses in the U.K. and Germany, were converted to Company-owned wholesale operations. Including the new business units, the Company experienced 15.8% growth in its European operations and 34.5% growth in its Canadian operations. The Company now does business in over 170 countries around the world, either through direct operations or in conjunction with distributors or licensees. +• +Pursuing and Delivering Product Excellence The Company introduced several innovative new products during the year. The Merrell Continuum®, Wolverine MultiShox™ and CAT® brand's iTechnology™ products drove revenue growth. Consumer acceptance of the Company's products has resulted in increased global market share. The Company plans to extend the Merrell® brand into apparel in 2007 by capitalizing on the lifestyle potential of the brand and the anticipated demand for Merrell® Apparel. +• +Strengthening Our Brand and Business Portfolio The Company's brands target different segments of the market. A broad consumer base and a strong portfolio of multi-gender brands contributed to the global success of the Company. The Company continued to diversify its product distribution and further strengthened its portfolio by recently entering into a long-term exclusive global licensing agreement for Patagonia® Footwear. A Spring 2007 product launch for Patagonia® Footwear is anticipated. The Company continued to reach consumers in 2005 through strong advertising programs, point-of-sale and shop-in-shop presentations, participation/sponsorship of grass roots consumer events and consumer-direct retail strategies. +• +Providing Service Excellence to Our Customers The Company enhanced its operating systems during 2005, achieving its goal of operating on one common global platform. Additional enhancements to the Company's core SAP® operating system were implemented to more effectively meet today's rigorous financial reporting requirements. The Company continues to upgrade and expand its operating systems' capabilities in order to meet the needs of retailers around the world. +• +Building a Strong Team and Company Culture The Company strengthened its management team to prepare for future growth. Key positions were filled with internal candidates, which is a testament to the bench strength of the management team. During the fourth quarter, Blake Krueger was promoted from Executive Vice President and President of the Heritage Brands Group to President and Chief Operating Officer of Wolverine World Wide, Inc. In addition, a seasoned Human Resources executive was recruited to strengthen the Company's global employment processes. +During the fourth quarter of 2005, the Company unveiled its new Corporate Vision -"To Excite Consumers Around the World with Innovative Footwear and Apparel that Bring Style to Purpose." The Company believes the new vision sets it apart from the competition and provides an achievable road map toward future growth and success. +The Company plans to achieve this vision and enhance shareholder value by: +• +Creating a Community of Great Global Brands The Company intends to drive its brands to worldwide leadership positions while pursuing initiatives to extend its owned brands into categories beyond footwear. +22 +• +Designing Products to Enhance the Consumer's Experience The Company will strive to design products that consumers desire and that provide exceptional performance, surpass consumers' expectations and reflect each brand's unique point-of-view. +• +Achieving Operational Excellence The Company's strong suite of business systems and processes, sourcing expertise and supply chain management should continue to offer a competitive advantage to retail customers. +• +Generating Consistent and Growing Value for Our Shareholders The Company intends to drive its future financial success with a business model based on revenue growth, expanded operating margin, improved asset turnover and cash generation. +• +Acting with a Commitment to Social Responsibility The Company intends to continue its commitment to the human needs of the communities in which it operates. +The following is a discussion of the Company's results of operations and liquidity and capital resources. This section should be read in conjunction with the consolidated financial statements and notes. All share and per share amounts in management's discussion and analysis of financial condition and results of operations have been adjusted for all periods to reflect the three-for-two stock split distributed on February 1, 2005. +RESULTS OF OPERATIONS - FISCAL 2005 COMPARED TO FISCAL 2004 +FINANCIAL SUMMARY - 2005 VERSUS 2004 +2005 +2004 +Change +$ +% +$ +% +$ +% +(Millions of Dollars, Except Per Share Data) +Revenue +Branded footwear and licensing +$ +964.5 +90.9% +$ +903.6 +91.1% +$ +60.9 +6.7% +Other business units +96.5 +9.1% +88.3 +8.9% +8.2 +9.2% +Total revenue +$ +1,061.0 +100.0% +$ +991.9 +100.0% +$ +69.1 +7.0% +Gross margin +Branded footwear and licensing +$ +369.6 +38.3% +$ +343.1 +38.0% +$ +26.5 +7.7% +Other business units +35.6 +36.9% +31.0 +35.2% +4.6 +14.7% +Total gross margin +$ +405.2 +38.2% +$ +374.1 +37.7% +$ +31.1 +8.3% +Selling and administrative expenses +$ +291.9 +27.5% +$ +274.1 +27.6% +$ +17.8 +6.5% +Interest expense-net +1.9 +0.2% +3.2 +0.3% +(1.3 +) +(41.1% +) +Other (income) expense-net +0.2 +0.0% +(.3 +) +0.0% +.5 +(149.2% +) +Earnings before income taxes and minority +interest +111.2 +10.5% +97.1 +9.8% +14.1 +14.6% +Net earnings +74.5 +7.0% +65.9 +6.6% +8.6 +12.9% +Diluted earnings per share +$ +1.27 +- +$ +1.09 +- +$ +.18 +16.5% +The Company has one reportable segment that is engaged in manufacturing, sourcing, marketing and distributing branded footwear, licensed apparel and accessories. Within the branded footwear and licensing segment, the Company has identified five operating units, consisting of the Outdoor Group (comprised of the Merrell®, Sebago® and Patagonia® Footwear brands), the Wolverine Footwear Group (comprised of the Wolverine®, HYTEST®, Bates® and Stanley® Footgear brands), the Heritage Brands Group (comprised of CAT® Footwear and Harley-Davidson® Footwear), The Hush Puppies Company, +23 +and Other Branded Footwear. The Company's other business units consist of Wolverine Retail and Wolverine® Leathers (comprised of the Tannery and Procurement operations). The following is supplemental information on total revenue: +Total Revenue +2005 +2004 +Change +$ +% +$ +% +$ +% +(Millions of Dollars) +Outdoor Group +$ +337.8 +31.8% +$ +286.6 +28.9% +$ +51.2 +17.8% +Wolverine Footwear Group +262.8 +24.8% +269.3 +27.1% +(6.5 +) +(2.4% +) +Heritage Brands Group +174.2 +16.4% +164.4 +16.6% +9.8 +5.9% +The Hush Puppies Company +163.4 +15.4% +152.8 +15.4% +10.6 +7.0% +Other Branded Footwear +26.3 +2.5% +30.5 +3.1% +(4.2 +) +(13.8% +) +Total branded footwear and licensing +revenue +$ +964.5 +90.9% +$ +903.6 +91.1% +$ +60.9 +6.7% +Other business units +96.5 +9.1% +88.3 +8.9% +8.2 +9.2% +Total revenue +$ +1,061.0 +100.0% +$ +991.9 +100.0% +$ +69.1 +7.0% +REVENUE +Revenue for 2005 increased $69.1 million over 2004. The addition of the CAT® and Wolverine® wholesale operations in Canada, as well as the transition of the Merrell® businesses in Sweden and Finland and the Sebago® operations in the U.K. and Germany from distributor-based businesses to Company-owned wholesale businesses represented $20.6 million of the revenue increase. Increases in unit volume, changes in product mix and changes in selling price for the branded footwear and licensing segment operations, as discussed below, contributed $45.0 million of the revenue increase. The impact of translating foreign denominated revenue to U.S. dollars improved revenue by $3.5 million. Both domestic and international revenue increased with international revenue accounting for 30.2% of total revenue in 2005 compared to 27.5% in 2004. +The Outdoor Group reported a 17.8% increase in revenue over 2004, its eighth year of double-digit growth. The Merrell® business achieved double-digit growth in the U.S., Canada and Europe. The brand also experienced growth with its network of international distributors. Strong sales in the multi-sport, after-sport and sports fashion categories drove the increase. The Merrell® brand presence continues to expand globally with 870 shop-in-shops and 31 Merrell® exclusive stores operated by independent retailers. The Sebago® brand experienced a 17.6% increase in revenue over the prior year. The increase was driven by sales in the international markets where distribution arrangements have been converted to Company-owned wholesale operations. +The Wolverine Footwear Group experienced a 2.4% decline in revenue for 2005. The Wolverine® and Stanley® Footgear boot businesses experienced an increase of $5.7 million during 2005 as new product and marketing initiatives drove strong retail performance. The conversion of a Canadian distributorship to a Company-owned wholesale operation accounted for approximately half of the increase. The decrease of $12.2 million in the Bates® division was primarily the result of a planned reduction in combat boot shipments. +The Heritage Brands Group experienced a 5.9% revenue increase in 2005. The CAT® Footwear increase was driven by revenue growth in Europe and with the Company's global trading partners. Positive consumer response to new product initiatives such as iTechnology™ and expanded retail distribution helped to drive the increase. The conversion of the business in Canada from a distributorship to a +24 +Company-owned wholesale operation also contributed to the increase. Revenue for the Harley-Davidson® Footwear brand remained even with the prior year. +The Hush Puppies Company's revenue increased 7.0% in 2005. The revenue growth was broad-based as increases were achieved in the U.S., Canada and Europe. Strong response to the new contemporary-styled Hush Puppies® product fueled growth both in the Company-owned wholesale operations and with the Company's global licensing partners. +Revenue for Other Branded Footwear decreased 13.8% in 2005 due to a reduction in demand from key customers for private label product. +Within the Company's other business units, Wolverine Retail reported an upper-single-digit same-store sales increase as consumers responded favorably to the Company's products. Wolverine® Leathers recorded a revenue increase driven by greater demand for sueded leather footwear. +The Company ended 2005 with an order backlog approximately 11% above 2004 year-end levels. This backlog principally reflects demand for the first half of 2006. +GROSS MARGIN +The gross margin level for 2005 of 38.2% was a 50 basis point improvement over the prior year. Benefits from favorable foreign exchange contract rates associated with the Company's foreign entity inventory purchases resulted in lower product costs which added 60 basis points to the margin. An increase in shipments of higher margin products improved margin by 40 basis points. Unfavorable manufacturing variances and increased product costs totaling 50 basis points partially offset the gross margin improvement. +SELLING AND ADMINISTRATIVE EXPENSES +Selling and administrative expenses increased $17.8 million during 2005 to $291.9 million. The addition of the CAT® and Wolverine® operations in Canada, as well as the transition of the Merrell® businesses in Sweden and Finland and the Sebago® operations in the U.K. and Germany from distributor-based businesses to Company-owned wholesale businesses, accounted for $7.3 million of the increase. The Company continues to invest in marketing and new business development which accounted for $2.7 million of the increase. The remaining increases related primarily to selling and distribution costs which vary with the increase in revenue. +INTEREST, OTHER & TAXES +The decrease in net interest expense reflected lower average outstanding amounts on senior notes and minimal borrowing under the Company's revolving credit facility, as well as increased interest income from invested cash balances. +The decrease in other income primarily related to the change in realized gains or losses on foreign denominated assets and liabilities. +The Company's effective income tax rate for 2005 was 33.1% compared to 31.8% in 2004. During the fourth quarter of 2005, the Company elected to repatriate earnings of foreign subsidiaries as provided under the American Jobs Creation Act of 2004. The Company repatriated $41.5 million of eligible earnings and, as a result, recorded tax expense of $1.4 million. The annualized effective tax rate for fiscal 2006 is estimated to range from 33.0% to 33.5%. +25 +NET EARNINGS +As a result of the revenue, gross margin and expense changes discussed above, the Company achieved net earnings of $74.5 million compared to $65.9 million in 2004, an increase of $8.6 million. +RESULTS OF OPERATIONS - FISCAL 2004 COMPARED TO FISCAL 2003 +FINANCIAL SUMMARY - 2004 VERSUS 2003 +2004 +2003 +Change +$ +% +$ +% +$ +% +(Millions of Dollars, Except Per Share Data) +Revenue +Branded footwear and licensing +$ +903.6 +91.1% +$ +812.6 +91.4% +$ +91.0 +11.2% +Other business units +88.3 +8.9% +76.3 +8.6% +12.0 +15.7% +Total revenue +$ +991.9 +100.0% +$ +888.9 +100.0% +$ +103.0 +11.6% +Gross margin +Branded footwear and licensing +$ +343.1 +38.0% +$ +300.1 +36.9% +$ +43.0 +14.3% +Other business units +31.0 +35.2% +26.5 +34.7% +4.5 +17.0% +Total gross margin +$ +374.1 +37.7% +$ +326.6 +36.7% +$ +47.5 +14.5% +Selling and administrative expenses +$ +274.1 +27.6% +$ +246.7 +27.7% +$ +27.4 +11.1% +Interest expense-net +3.2 +0.3% +5.5 +0.6% +(2.3 +) +(41.8% +) +Other income-net +(.3 +) +0.0% +(.7 +) +(0.1% +) +(.4 +) +(57.1% +) +Earnings before income taxes and minority +interest +97.1 +9.8% +75.1 +8.5% +22.0 +29.3% +Net earnings +65.9 +6.6% +51.7 +5.8% +14.2 +27.5% +Diluted earnings per share +$ +1.09 +- +$ +.85 +- +$ +.24 +28.2% +The following is supplemental information on total revenue: +Total Revenue +2004 +2003 +Change +$ +% +$ +% +$ +% +(Millions of Dollars) +Outdoor Group +$ +286.6 +28.9% +$ +223.2 +25.1% +$ +63.4 +28.4% +Wolverine Footwear Group +269.3 +27.1% +255.4 +28.7% +13.9 +5.4% +Heritage Brands Group +164.4 +16.6% +156.1 +17.5% +8.3 +5.3% +The Hush Puppies Company +152.8 +15.4% +147.2 +16.6% +5.6 +3.8% +Other Branded Footwear +30.5 +3.1% +30.7 +3.5% +(.2 +) +(0.7% +) +Total branded footwear and licensing revenue +$ +903.6 +91.1% +$ +812.6 +91.4% +$ +91.0 +11.2% +Other business units +88.3 +8.9% +76.3 +8.6% +12.0 +15.7% +Total revenue +$ +991.9 +100.0% +$ +888.9 +100.0% +$ +103.0 +11.6% +26 +REVENUE +Revenue for 2004 increased $103.0 million over 2003. A full year of revenue from Sebago® represented $26.3 million of the increase. Increases in unit volume, changes in product mix and changes in selling price for the branded footwear and licensing segment operations, as discussed below, contributed $58.5 million of the revenue increase. The impact of translating foreign denominated revenue to U.S. dollars improved revenue by $18.2 million. Both domestic and international revenue increased with international revenue accounting for 27.5% of total revenue in 2004 compared to 24.5% in 2003. +The Outdoor Group reported its seventh year of double-digit revenue growth. The Merrell® business accounted for over half of the increase. Merrell® experienced double-digit growth in the four wholesale markets that it services - U.S., Canada, U.K. and Europe. The Merrell® brand's presence continued to grow with 134 U.S. shop-in-shops in operation at year end. The Sebago® brand, in its first full year of operations, met its planned revenue goal. Approximately 60% of the Sebago® revenue was generated outside of the United States. +The Wolverine Footwear Group's revenue increase was due to the success of the Bates® division. The Bates® brand improvements were driven by increased shipments of technical boot products to the U.S. military and the civilian uniform markets. A significant portion of the sales gain resulted from accelerated demand under a combat boot contract for the Department of Defense. Wolverine® brand recorded a decline in revenue principally as a result of lower average selling prices as the business responded to consumer demand for more boot product in the $80 - $120 retail price point category. +The Heritage Brands Group recorded a mid-single-digit revenue increase for 2004. The Harley-Davidson® Footwear business recorded a slight increase for the year, with growth coming from new distribution channels. The CAT® Footwear business recorded revenue growth in the U.S., U.K., Europe and with the brand's international distributors. New product technologies introduced during the year, as well as the impact of translating foreign denominated revenue to U.S. dollars, contributed to the increase. +The Hush Puppies Company's revenue increase was generated from the U.K., Canada and the international licensing businesses. Within The Hush Puppies Company's foreign wholesale operations, Hush Puppies® U.K. reported a strong increase as a result of expanded distribution with fashion accounts. The Hush Puppies® Canada business recorded an increase in a challenging retail environment. Hush Puppies® U.S. business experienced a revenue decrease as the business continued its transition plan from mature, lower-priced product to a younger, more contemporary-styled footwear assortment. +Revenue for Other Branded Footwear decreased as the Company executed a strategy to revamp its private label footwear offerings. +Within the Company's other business units, Wolverine Retail reported a mid-single-digit same-store sales increase. Wolverine® Leathers recorded a revenue increase driven primarily by market demand for sueded leather footwear. +The Company ended 2004 with an order backlog approximately 13% above 2003 year-end levels. This backlog principally reflected demand for the first half of 2005. +GROSS MARGIN +The total gross margin level for 2004 of 37.7% was a 100 basis point improvement over the prior year. Benefits from favorable exchange rates comprised 60 basis points of the improvement. Inventory management programs, as well as a higher margin product mix, also contributed to the improvement. +27 +SELLING AND ADMINISTRATIVE EXPENSES +The increase in selling and administrative expenses included an additional $7.0 million investment in product development and marketing for the Company's branded products. The Company also recognized increases in profit sharing expense of $6.0 million. The impact of translating foreign denominated operating expense to U.S. dollars increased total expense by $4.9 million in 2004. The Company recorded a $1.2 million decrease in pension expense. The remaining increase related primarily to selling costs that are directly variable to the increase in revenue. +INTEREST, OTHER & TAXES +The net decrease in interest expense reflected lower average outstanding amounts on senior notes and lower working capital borrowings during the year, as well as interest income from invested cash. +The change in other income primarily related to the change in realized gains or losses on foreign currency transactions. +The Company's 2004 effective income tax rate was 31.8% compared to 31.0% for 2003 and was in line with the Company's estimated annualized rate. The 2003 income tax rate included the cumulative impact of research and development tax credits, while 2004 reflected only one year of credit taken. +NET EARNINGS +As a result of the revenue, gross margin and expense changes discussed above, the Company achieved 2004 net earnings of $65.9 million, an increase of $14.2 million over 2003. +LIQUIDITY AND CAPITAL RESOURCES +December 31, +January 1, +Change +2005 +2005 +$ +% +(Millions of Dollars) +Cash +$ 85.3 +$ 72.2 +$ 13.1 +18.1% +Accounts receivable +157.1 +151.2 +5.9 +3.9% +Inventories +161.3 +182.9 +(21.6 +) +(11.8% +) +Accounts payable +41.1 +50.5 +(9.4 +) +(18.6% +) +Accrued salaries and wages +17.5 +19.4 +(1.9 +) +(9.9% +) +Other accrued liabilities +34.4 +28.6 +5.8 +20.6% +Debt +32.4 +43.9 +(11.5 +) +(26.2% +) +Cash provided by operating activities +119.7 +106.4 +13.3 +12.5% +Additions to property, plant and equipment +19.2 +18.1 +1.1 +6.0% +Depreciation and amortization +20.0 +19.1 +.9 +5.1% +The Company continued to strengthen its balance sheet in 2005. Accounts receivable increased 3.9% on a 7.0% revenue gain, while reducing the accounts receivable days' sales outstanding slightly from prior year. Cash of $119.7 million was generated from operating activities in 2005, of which $15.8 million was generated from working capital improvements. Inventory levels were down 11.8% at year end as a result of focused inventory management initiatives. +The decrease in accounts payable was attributed to the timing of inventory purchases from contract suppliers. The increase in other accrued liabilities was primarily a result of a $4.2 million income tax payable recorded for year-end 2005. +28 +The majority of capital expenditures were for information system enhancements, distribution equipment and building improvements and consumer-direct initiatives. The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2023. +The Company has a long-term revolving credit agreement that expires in July 2010 and allows for borrowings up to $150.0 million. The revolving credit facility is used to support working capital requirements. No amounts were outstanding under revolving credit facilities at December 31, 2005 or January 1, 2005. The Company was in compliance with all debt covenant requirements at December 31, 2005. Proceeds from existing credit facilities and anticipated renewals, along with cash flows from operations, are expected to be sufficient to meet capital needs in the foreseeable future. Any excess cash flows from operating activities are expected to be used to purchase property, plant and equipment, pay down existing debt, fund internal and external growth initiatives, pay dividends or repurchase the Company's common stock. +The decrease in debt was the result of annual principal payments on the Company's senior notes. The Company had commercial letter-of-credit facilities outstanding of $2.9 million and $3.2 million at the end of 2005 and 2004, respectively. The total debt to total capital ratio for the Company was 6.6% in 2005 and 8.7% in 2004. +The Company's pension benefit results are based upon actuarial valuations. Inherent in these valuations are key assumptions, including discount rates and expected returns on plan assets. The Company is required to consider market conditions, including changes in interest rates, in selecting these assumptions. Pre-tax expense resulting from the Company's qualified defined benefit pension plans increased $3.1 million ($.04 per share) for 2005 when compared to 2004 as a result of the amortization of prior losses incurred due to market value declines and discount rate reductions. The Company also recorded a net change of $.6 million within the accumulated other comprehensive income component of stockholders' equity in 2005 to increase the minimum pension liability. This adjustment had no impact on the net earnings or cash flows of the Company. The Company estimates that pre-tax expense related to qualified defined benefit pension plans will remain flat in 2006 as compared to 2005. +Applying the provisions of Statement of Financial Accounting Standards (SFAS) No. 87 and SFAS No. 132, the Company's qualified pension plans (the "Plans") were overfunded by $11.1 million in 2005 and $3.5 million in 2004. Under the Employee Retirement Income Security Act of 1974, the Plans had no minimum funding requirements for 2005 and 2004. Discretionary cash contributions were made to the Plans totaling $3.1 million in 2005 and $5.0 million in 2004 to provide long-term stability to the Plans. The Company expects to contribute $3.0 million to its qualified defined benefit pension plans and $.8 million to the SERP in 2006. +In 2005, the Company elected to repatriate earnings of foreign subsidiaries as provided under the American Jobs Creation Act of 2004 (the "Act"), which provides for a tax deduction of 85% of certain foreign earnings that were repatriated in 2005. During the fourth quarter of fiscal 2005, the Company repatriated foreign earnings of $41.5 million and, as a result, recorded tax expense of $1.4 million. The amount repatriated will be used primarily for capital expenditures and research and development activities in the U.S. No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the remaining undistributed earnings of foreign subsidiaries of $89.2 million at December 31, 2005 ($96.1 million at January 1, 2005) as the Company expects such earnings will be invested overseas indefinitely. +29 +Since August 2002, the Company's Board of Directors has approved four common stock repurchase programs each authorizing the repurchase of 3.0 million shares of common stock over a 24-month period commencing on the effective dates listed below. The primary purpose of these stock repurchase programs is to increase shareholder value. The Company intends to continue to repurchase shares of its common stock in open market or privately negotiated transactions, from time-to-time, depending upon market conditions and other factors. +2005 +2004 +Cumulative +Authorization +effective date +Shares +repurchased +Market price +of shares +repurchased +Shares +repurchased +Market price +of shares +repurchased +Shares +repurchased +Market price +of shares +repurchased +December 13, 2005 +- +$ +- +- +$ +- +- +$ +- +October 5, 2004 +2,942,400 +63,682,000 +38,718 +773,000 +2,981,118 +64,455,000 +December 9, 2003 +- +- +3,000,000 +49,020,000 +3,000,000 +49,020,000 +August 19, 2002 +- +- +211,500 +3,219,000 +3,000,000 +36,529,000 +The Company declared dividends of $14.5 million in 2005, or $.26 per share, which was a 34.0% increase on a per share basis over the $11.1 million, or $.194 per share, declared in 2004. On February 15, 2006, the Company declared a quarterly cash dividend of $.075 per share of common stock, an increase of 15.4% as compared to the same period of 2005. The quarterly dividend is payable on May 1, 2006, to shareholders of record on April 3, 2006. +On June 6, 2005, the Company announced an exclusive footwear licensing agreement for Patagonia® Footwear with product introduction expected for Spring 2007. +During the second quarter of 2005, the Company purchased the remaining 5% ownership from the minority stockholder of Wolverine Europe Limited, making it a wholly-owned subsidiary. The purchase price was $2.3 million, of which $.4 million was deferred until July 1, 2006. The transaction eliminated the minority interest of $.6 million resulting in goodwill of $1.8 million. +On January 3, 2005, the Company expanded its owned Wolverine® and CAT® Footwear operations in Canada. This expansion allowed the Company to directly wholesale all major brands in Canada. Assets consisting primarily of inventory, fixed assets and amortizable intangible assets totaling $2.1 million and assumed liabilities of $.8 million were acquired from a former Wolverine® and CAT® Footwear distributor for cash of $2.3 million in cash and resulted in goodwill and intangible assets of approximately $1.0 million. Consolidated pro forma revenue and net earnings, assuming the transaction occurred at the beginning of 2005, were not materially different from reported amounts. Pursuant to SFAS No. 142, goodwill and indefinite-lived intangibles will not be amortized, but will be evaluated for impairment annually. Goodwill was assigned to the Company's branded footwear and licensing segment. The majority of the goodwill is expected to be deductible for tax purposes. The amortizable intangible assets have a weighted average useful life of approximately ten years. +On January 3, 2005, the Company expanded its owned Merrell® operations into Sweden and Finland and its Sebago® operations into the U.K. and Germany. Assets consisting primarily of inventory totaling approximately $.5 million were acquired from former distributors for cash. +On November 3, 2003, the Company acquired significant operating assets of Sebago, Inc., an international distributor of performance nautical and American-inspired footwear, consisting of accounts receivable, inventory, fixed assets, trademarks and certain amortizable intangible assets totaling $18.6 million and assumed liabilities of $2.0 million. The total purchase price of Sebago, Inc. was $16.9 +30 +million, which consisted of $14.9 million paid in cash and a note payable for $2.0 million ($1.0 million paid in 2004 and $1.0 million paid in 2005), resulting in goodwill of $.2 million. +These acquisitions are discussed further in Note 11 to the consolidated financial statements. +The European Union has initiated anti-dumping investigations regarding the importation into the European Union of leather footwear from China and Vietnam and safety footwear from China and India. The European Commission has recommended provisional measures which, if implemented, would result in additional duties of 19.4% on certain leather footwear imported into the European Union from China and 16.8% on certain leather footwear imported into the European Union from Vietnam. Analysis and discussion between the European Commission, Member States and interested parties regarding these anti-dumping investigations is continuing and the final outcome of these investigations is uncertain. The imposition of preliminary or final dumping measures could have a material impact on the Company. The Company and a number of other companies in the footwear industry are advocating against the imposition of dumping measures by the European Union. The Company is also exploring alternative sourcing options for importation into the European Union if dumping measures are imposed. +NEW ACCOUNTING STANDARDS +On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), Share-Based Payment , which would require all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated statements of operations based on their fair values, effective for public companies for fiscal years beginning after June 15, 2005. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. The Company will adopt SFAS No. 123(R) effective with its fiscal year beginning January 1, 2006 using the modified prospective method. +While the Company continues to evaluate its share-based payment strategies, it estimates the incremental pre-tax impact of SFAS No. 123(R) to approximate $3.9 million for 2006. +Further discussion on stock-based compensation can be found in Note 1 to the consolidated financial statements. +CRITICAL ACCOUNTING POLICIES +The preparation of the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates these estimates. Estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Historically, actual results have not been materially different from the Company's estimates. However, actual results may differ from these estimates under different assumptions or conditions. +The Company has identified the following critical accounting policies used in determining estimates and assumptions in the amounts reported. Management believes that an understanding of these policies is important to an overall understanding of the consolidated financial statements. +31 +REVENUE RECOGNITION +The Company's revenue consists of sales to customers, license fees and royalties. Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped and legal title has passed to the customer. Revenue generated through programs with licensees and distributors involving products bearing the Company's trademarks is recognized as earned according to stated contractual terms upon either the purchase or shipment of branded products by distributors and licensees. +The Company records provisions against gross revenue for estimated stock returns and cash discounts in the period when the related revenue is recorded. These estimates are based on factors that include, but are not limited to, historical stock returns, historical discounts taken and analysis of credit memorandum activity. The actual amount of customer returns or allowances, which is uncertain, may differ from the Company's estimates. The Company would record either an increase or decrease to net sales in the period in which it determined an adjustment to be appropriate. +ACCOUNTS RECEIVABLE +The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from its customers' inability to make required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. Historically, losses have been within the Company's expectations. Adjustments to these estimates may be required if the financial condition of the Company's customers were to change. If the Company were to determine that increases or decreases to the allowance for uncollectible accounts were appropriate, the Company would record either an increase or decrease to general and administrative expenses in the period the Company made such a determination. At December 31, 2005 and January 1, 2005, management believes that it has provided sufficient reserves to address future collection uncertainties. +INVENTORY +The Company values its inventory at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for all domestic raw materials and work-in-process inventories, and certain domestic finished goods inventories. Cost is determined using methods approximating cost under the first-in, first-out (FIFO) method for all raw materials, work-in-process and finished good inventories in foreign countries where LIFO is not permitted. The FIFO method is also used for all finished goods inventories of the Company's retail business, due to the unique nature of that operation, and for certain domestic finished goods inventories that were acquired as part of asset purchase transactions. Once elected, the Company has applied these inventory cost valuation methods consistently from year to year. The Company reduces the value of its inventories to the lower of cost or market for excess or obsolete inventories based upon assumptions about future demand and market conditions. If the Company were to determine that the estimated market value of its inventory is less than the carrying value of such inventory, the Company would provide a reserve for such difference as a charge to cost of sales. If actual market conditions are different from those projected, adjustments to those inventory reserves may be required. The adjustments would increase or decrease the Company's cost of sales and net income in the period in which they were realized or recorded. Inventory quantities are verified at various times throughout the year by performing annual physical inventory observations and perpetual inventory cycle count procedures. If the Company determines that adjustments to the inventory quantities are appropriate, an increase or decrease to the Company's cost of sales and inventory would be recorded in the period in which such determination was made. +32 +GOODWILL AND OTHER NON-AMORTIZABLE INTANGIBLES +Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually. The first step of the goodwill impairment test requires that the fair value of the applicable reporting unit be compared with its recorded value. The Company establishes fair value by calculating the present value of the expected future cash flows of the reporting unit. The Company uses assumptions about expected future operating performance in determining estimates of those cash flows, which may differ from actual cash flows. If the recorded values of these assets are not recoverable, based on this discounted cash flow analysis, management performs the next step which compares the fair value of the reporting unit calculated in step one to the fair value of the tangible and intangible assets of the reporting unit, which results in an implied fair value of goodwill. Goodwill is reduced by any shortfall of implied goodwill to its carrying value. Impairment tests for other non-amortizable intangibles require the determination of the fair value of the intangible asset. The carrying value is reduced by any excess over fair value. The Company reviewed the carrying amounts of goodwill and other non-amortizable intangible assets and there was no impairment indicated for 2005 or 2004. +INCOME TAXES +The Company operates in multiple tax jurisdictions both inside and outside the United States. Accordingly, management must determine the appropriate allocation of income in accordance with local law for each of these jurisdictions. The Company believes its tax accruals are adequate to cover exposures related to changes in income allocation between tax jurisdictions. The carrying value of the Company's deferred tax assets assumes that the Company will be able to generate sufficient taxable income in future years to utilize these deferred tax assets. If these assumptions change, the Company may be required to record valuation allowances against its gross deferred tax assets in future years, which would result in additional income tax expense in the Company's consolidated statements of operations. Management evaluates the potential for realizing gross deferred tax assets and assesses the need for valuation allowances on a quarterly basis. The Company did not record a valuation allowance in 2005 or 2004. +On a periodic basis, the Company estimates what the effective tax rate will be for the full fiscal year and records a quarterly income tax provision in accordance with the anticipated annual rate. As the fiscal year progresses, that estimate is refined based upon actual events and earnings by tax jurisdictions during the year. This continual estimation process periodically results in a change to the expected effective tax rate for the fiscal year. When this occurs, the Company adjusts the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date provision equals the expected annual rate. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +The Company faces market risk to the extent that changes in foreign currency exchange rates affect the Company's foreign assets, liabilities and inventory purchase commitments and to the extent that its long-term debt requirements are affected by changes in interest rates. The Company manages these risks by attempting to denominate contractual and other foreign arrangements in U.S. dollars and by maintaining a significant percentage of its debt on a fixed-rate basis. The Company does not believe that there has been a material change in the nature of the Company's primary market risk exposures, including the categories of market risk to which the Company is exposed and the particular markets that present the primary risk of loss to the Company. As of the date of this Annual Report, the Company does not know of or expect there to be any material change in the general nature of its primary market risk exposure in the near term. +Under the provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS Nos. 137 and 138, the Company is required to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If a +33 +derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings or recognized in accumulated other comprehensive income until the hedged item is recognized in earnings. +The Company conducts wholesale operations outside of the United States in Europe and Canada where the functional currencies are primarily the British pound, euro, and Canadian dollar. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with inventory purchases made by non-U.S. wholesale operations in foreign currencies in the normal course of business. At December 31, 2005 and January 1, 2005, the Company had outstanding forward currency exchange contracts to purchase $61.4 million and $47.0 million, respectively, of various currencies (principally U.S. dollars) with maturities ranging up to 280 days. +The Company also has production facilities in the Dominican Republic where financial statements reflect U.S. dollars as the functional currency; however, operating costs are paid in the local currency. Royalty revenue generated by the Company from third-party foreign licensees is calculated in the licensees' local currencies, but paid in U.S. dollars. Accordingly, the Company could be subject to related foreign currency remeasurement gains and losses in 2006 and beyond. +Assets and liabilities outside the United States are primarily located in the United Kingdom, Canada and The Netherlands. The Company's investments in foreign subsidiaries with a functional currency other than the U.S. dollar are generally considered long-term. Accordingly, the Company does not hedge these net investments. For the year ended December 31, 2005, the strengthening of the U.S. dollar decreased the value of these investments in net assets by $11.5 million. For the year ended January 1, 2005, the strengthening of foreign currencies increased the value of these investments in net assets by $9.7 million. These changes resulted in cumulative foreign currency translation adjustments at December 31, 2005 and January 1, 2005 of $12.2 million and $23.8 million, respectively, that are deferred and recorded as a component of accumulated other comprehensive income in stockholders' equity. +Because the Company markets, sells and licenses its products throughout the world, it could be affected by weak economic conditions in foreign markets that could reduce demand for its products. +The Company is exposed to changes in interest rates primarily as a result of its long-term debt requirements. The Company's interest rate risk management objectives are to limit the effect of interest rate changes on earnings and cash flows and to effectively manage overall borrowing costs. To achieve its objectives, the Company maintains substantially all fixed-rate debt to take advantage of lower relative interest rates currently available and finances seasonal working capital needs with variable-rate debt. The Company has not historically utilized interest rate swaps or similar hedging arrangements to fix interest rates; however, in 1998 the Company entered into an interest rate lock agreement to fix the interest rate prior to the issuance of 6.5% senior notes in the amount of $75 million. The contract was settled in 1998 and resulted in a prepayment of interest of $2.2 million that is being amortized over the term of the senior notes. The amortization of the prepayment creates an effective interest rate of 6.78% on the senior notes. +The Company does not enter into contracts for speculative or trading purposes, nor is it a party to any leveraged derivative instruments. +34 +The following table lists required principal payments and related interest rates for the Company's short- and long-term debt by fiscal year of maturity. +2005 +2004 +2006 +2007 +2008 +2009 +2010 +There- +after +Total +Fair +Value +Total +Fair +Value +(Millions of Dollars, Except Percentages) +Denominated in U.S. Dollars: +Fixed rate +$11.0 +$10.7 +$10.7 +- +- +- +$32.4 +$33.0 +$43.9 +$46.0 +Average interest rate +6.5% +6.5% +6.5% +- +- +- +6.5% +- +6.5% +- +The Company has the following payments under contractual obligations due by period: +Total +Less than +1 year +1-3 years +3-5 years +More than +5 years +(Thousands of Dollars) +Long-term debt +$ +32,384 +$ +10,956 +$ +21,428 +$ +- +$ +- +Estimated interest on long-term debt +2,104 +712 +1,392 +- +- +Capital leases +26 +16 +10 +- +- +Operating leases +75,530 +11,246 +19,301 +13,858 +31,125 +Purchase obligations (1) +190,824 +190,824 +- +- +- +Deferred compensation +2,053 +314 +609 +440 +690 +Pension (2) +3,000 +3,000 +- +- +- +SERP +13,849 +846 +1,728 +1,728 +9,547 +Dividends declared +7,731 +7,731 +- +- +- +Minimum royalties +7,082 +1,176 +2,202 +2,874 +830 +Minimum advertising +8,037 +1,514 +3,165 +3,358 +- +Total +$ +342,620 +$ +228,335 +$ +49,835 +$ +22,258 +$ +42,192 +(1) Purchase obligations primarily relate to inventory and capital expenditure commitments. +(2) Pension obligations reflect only planned pension funding as there are currently no required funding obligations under government regulation. Funding amounts are calculated on an annual basis and no required or planned funding beyond one year has been determined. +The Company had $172.3 million of additional borrowing capacity available under all of its existing credit facilities at December 31, 2005. The Company's additional borrowing capacity is summarized as follows: +Expiration of availability +Total commitments +available +Less than +1 year +1 year or +greater +(Millions of Dollars) +Revolving credit +$150.0 +$ - +$150.0 +Commercial letters of credit +20.3 +20.3 +- +Standby letters of credit +2.0 +2.0 +- +35 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk . +The response to this Item is set forth under the caption "Quantitative and Qualitative Disclosures About Market Risk" in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and is incorporated herein by reference. +Item 8. Financial Statements and Supplementary Data . +The response to this Item is set forth in Appendix A of this Annual Report on Form 10-K and is incorporated herein by reference. +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . +None. +Item 9A. Controls and Procedures . +Evaluation of Disclosure Controls and Procedures. +An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on and as of the time of such evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filings with the SEC. +Management's Report on Internal Control Over Financial Reporting. +Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2005, based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2005. +Management's assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their attestation report which is included in Appendix A and is incorporated into this Item 9A by reference. +Changes in Internal Control Over Financial Reporting. +There was no change in the Company's internal control over financial reporting that occurred during the sixteen-week period ended December 31, 2005 that has materially affected, or that is reasonably likely to materially affect, the Company's internal control over financial reporting. +36 +Item 9B. Other Information . +None. +PART III +Item 10. Directors and Executive Officers of the Registrant . +The Company's Audit Committee is comprised of four Board members, all of whom are independent under independence standards adopted by the Board and applicable regulations of the SEC and the New York Stock Exchange (including independence standards related specifically to Audit Committee membership). The Audit Committee members each have financial and business experience with companies of substantial size and complexity and have a significant understanding of generally accepted accounting principles, financial statements, internal controls and audit committee functions. The Company's Board of Directors has determined that David T. Kollat and Phillip D. Matthews are audit committee financial experts as defined by the SEC. Additional information regarding the Audit Committee is provided in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 20, 2006, under the caption "Wolverine's Board of Directors" under the subheading "Board Committees and Meetings-Audit Committee." +The Company has adopted an Accounting and Finance Code of Ethics that applies to the Company's principal executive officer, principal financial officer and principal accounting officer. The Accounting and Finance Code of Ethics is available on the Company's website, www.wolverineworldwide.com. Any waiver from or amendment to the Accounting and Finance Code of Ethics will be disclosed on the Company's website. +The information regarding directors of the Company contained under the caption "Election of Directors" and under the caption "Wolverine's Board of Directors" under the subheadings "Nominees for Terms Expiring in 2009," "Continuing Directors - Terms Expiring in 2008," and "Continuing Directors - Terms Expiring in 2007" in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 20, 2006, is incorporated herein by reference. +In addition to the directors discussed in the definitive Proxy Statement, the Company's Board of Directors currently includes Donald V. Fites (age 72), who will retire at this year's annual meeting. His term was scheduled to expire at the annual meeting in 2008. Mr. Fites is retiring after seven years of service as a director. Mr. Fites has been a director since 1999. From 1990 until his retirement in 1999, Mr. Fites was Chairman and Chief Executive Officer of Caterpillar, Inc., a manufacturer of construction, mining and agricultural machinery and engines. Mr. Fites also is a director of AK Steel Holding Corporation; Oshkosh Truck Corporation; and Unitrin, Inc. +The information regarding directors and executive officers of the Company under the caption "Related Matters" under the subheading "Section 16(a) Beneficial Ownership Reporting Compliance" in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 20, 2006, is incorporated herein by reference. Additional information regarding Executive Officers is provided in the Supplemental Item following Item 4 of Part I above. +37 +Item 11. +Executive Compensation . +The information contained under the caption "Wolverine's Board of Directors" under the subheadings "Compensation of Directors" and "Board Committees and Meetings-Compensation Committee," and under the captions "Executive Compensation," "Compensation Committee Report on Executive Compensation," "Employment Agreements and Termination of Employment and Change in Control Arrangements" and "Wolverine's Stock Price Performance" in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 20, 2006, is incorporated herein by reference. +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters . +The information contained under the caption "Ownership of Wolverine Stock" contained in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 20, 2006, is incorporated herein by reference. +The following table provides information about Wolverine's equity compensation plans as of December 31, 2005: +Equity Compensation Plan Information +Plan Category (1) +Number of +Securities to be +Issued Upon +Exercise of +Outstanding +Options, Warrants +and Rights +(a) +Weighted Average +Exercise Price of +Outstanding +Options, +Warrants and +Rights +(b) +Number of Securities +Remaining Available for +Future Issuance Under +Equity Compensation +Plans (Excluding +Securities Reflected in +Column (a)) +(c) +Equity compensation +plans approved by +security holders +5,040,712 +(2)(3) +$ +14.72 +5,674,194 +(4) +Equity compensation +plans not approved by +security holders +--- +n/a +--- +Total +5,040,712 +$ +14.72 +5,674,194 +Notes to Equity Compensation Plan Information +1. +Each plan for which aggregated information is provided contains customary anti-dilution provisions that are applicable in the event of a stock split, stock dividend or certain other changes in the Company's capitalization. +2. +Includes 4,499,984 stock options awarded to employees under the 1988 Stock Option Plan, the 1993 Stock Incentive Plan, the 1995 Stock Incentive Plan, the 1997 Stock Incentive Plan, the Stock Incentive Plan of 1999, the Stock Incentive Plan of 2001, the Stock Incentive Plan of 2003 and the Stock Incentive Plan of 2005 and 540,728 stock options awarded to non-employee +38 +directors under the Stock Incentive Plan of 2005 and the Amended and Restated Directors' Stock Option Plan approved by stockholders in 2002 and the previous Amended and Restated Directors' Stock Option Plan initially adopted in 1988. Column (a) does not include stock units credited to outside directors' fee accounts or retirement accounts under the Outside Directors' Deferred Compensation Plan. Stock units do not have an exercise price. Each stock unit credited to a director's fee account and retirement account under the Outside Directors' Deferred Compensation Plan will be converted into one share of common stock upon distribution. Column (a) also does not include shares of restricted or unrestricted common stock previously issued under the Company's equity compensation plans. +3. +All options were exercisable as of December 31, 2005. +4. +Comprised of: (i) 554,306 shares available for issuance under the Outside Directors' Deferred Compensation Plan upon the retirement of the current directors or upon a change in control; and (ii) 5,119,888 shares issuable under the various employee stock incentive plans. Of these total amounts available, the number of shares with respect to the following plans may be issued other than upon the exercise of an option, warrant or right as of December 31, 2005: +• +Outside Directors' Deferred Compensation Plan: 554,306 +• +1997 Stock Incentive Plan: 6,779 +• +Stock Incentive Plan of 1999: 73,047 +• +Stock Incentive Plan of 2001: 456,526 +• +Stock Incentive Plan of 2003: 11,692 +• +Stock Incentive Plan of 2005: 2,125,000 +The Outside Directors' Deferred Compensation Plan is a supplemental, unfunded, nonqualified deferred compensation plan for non-employee directors. Beginning in 2006, the Company will pay an annual equity retainer to non-management directors in the form of a contribution under the Outside Directors' Deferred Compensation Plan. Participation in the plan beyond the annual equity retainer is voluntary. The plan allows participating directors to receive, in lieu of some or all directors' fees, a number of stock units equal to the amount of the deferred directors' fees divided by the fair market value of the Company's common stock on the date of payment of the next cash dividend on the Company's common stock. These stock units are increased by a dividend equivalent based on dividends paid by the Company and the amount of stock units credited to the participating director's fee account and retirement account. Upon distribution, the participating directors receive a number of shares of the Company's common stock equal to the number of stock units to be distributed at that time. Distribution is triggered by termination of service as a director or by a change in control of the Company and can occur in a lump sum, in installments or on another deferred basis. Of the 554,306 shares issuable under the Outside Directors' Deferred Compensation Plan, 212,743 shares have been issued to a trust to satisfy the Company's obligations and are included in shares reported as issued and outstanding as of the record date. +The employee stock incentive plans listed above are equity-based incentive plans for officers, key employees, and, under the Stock Incentive Plan of 2005, directors. Those plans authorize awards of stock options, restricted common stock, common stock and, under certain plans, tax benefit rights, restricted stock units, deferred stock units, and/or stock appreciation rights. The Stock Incentive Plans of 2001 and 2003 specifically limit the number of shares that can be awarded as restricted or unrestricted common stock to 40% and 15%, respectively, of the shares authorized under the plan. The Stock Incentive Plan of 2005 provides that each share of restricted or +39 +unrestricted common stock, each restricted stock unit and each stock appreciation right is counted as two shares against the total number of shares authorized under the Stock Incentive Plan of 2005. The number of securities listed as remaining available in column (c) of the table assumes the grant of all stock options, which count as only one share against the total number of shares authorized under the Stock Incentive Plan of 2005. Actual shares available under the Stock Incentive Plan of 2005 will be less to the extent that awards of restricted or unrestricted common stock, restricted stock units or stock appreciation rights are issued from that plan. The numbers provided in this footnote and in column (c) will increase to the extent that options relating to the number of shares listed in column (a) of the table or other outstanding awards (e.g., shares of restricted or unrestricted stock, restricted stock units or stock appreciation rights) previously issued under a plan are canceled, surrendered, modified, exchanged for substitutes or expire or terminate prior to exercise or vesting because the number of shares underlying any such awards will again become available for issuance under the plan under which the award was granted. +Item 13. Certain Relationships and Related Transactions . +The information contained under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 20, 2006, is incorporated herein by reference. +Item 14. Principal Accountant Fees and Services . +The information contained under the caption "Selection of Auditors" in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 20, 2006, is incorporated herein by reference. +PART IV +Item 15. Exhibits and Financial Statement Schedules . +Item 15(a)(1). Financial Statements . Attached as Appendix A. +The following consolidated financial statements of Wolverine World Wide, Inc. and subsidiaries are filed as a part of this report: +• +Consolidated Balance Sheets as of December 31, 2005 and January 1, 2005. +• +Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Fiscal Years Ended December 31, 2005, January 1, 2005 and January 3, 2004. +• +Consolidated Statements of Operations for the Fiscal Years Ended December 31, 2005, January 1, 2005 and January 3, 2004. +• +Consolidated Statements of Cash Flows for the Fiscal Years Ended December 31, 2005, January 1, 2005 and January 3, 2004. +• +Notes to the Consolidated Financial Statements as of December 31, 2005. +• +Reports of Independent Registered Public Accounting Firm. +40 +Item 15(a)(2). Financial Statement Schedules . Attached as Appendix B. +The following consolidated financial statement schedule of Wolverine World Wide, Inc. and subsidiaries is filed as a part of this report: +• +Schedule II--Valuation and Qualifying Accounts of Continuing Operations. +All other schedules (I, III, IV, and V) for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and, therefore, have been omitted. +Item 15(a)(3). Exhibits . +The following exhibits are filed as part of this report: +Exhibit +Number +Document +3.1 +Certificate of Incorporation, as amended. Previously filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the period ended March 26, 2005. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.1 +Certificate of Incorporation, as amended. See Exhibit 3.1 above. +4.2 +Amended and Restated By-laws. See Exhibit 3.2 above. +4.3 +Rights Agreement dated as of April 17, 1997. Previously filed with the Company's Form 8-A filed April 12, 1997. Here incorporated by reference. +4.4 +Amendment No. 1 dated as of June 30, 2000, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.5 +Second Amendment dated as of February 11, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.6 +Third Amendment dated as of December 10, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2002. Here incorporated by reference. +4.7 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. Previously filed as Exhibit 4.7 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. Here incorporated by reference. +41 +4.8 +The Registrant has several classes of long-term debt instruments outstanding in addition to those described in Exhibits 4.7 and 4.9. The authorized amount of none of these classes of debt exceeds 10% of the Company's total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +4.9 +Credit Agreement dated as of July 22, 2005, among Wolverine World Wide, Inc. and certain of its subsidiaries, JPMorgan Chase Bank, N.A., as Administrative Agent, Harris, N.A., as Syndication Agent, Comerica Bank, Standard Federal Bank N.A. and National City Bank of the Midwest, as Documentation Agents, and certain other Banks that are parties to the Credit Agreement. Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated July 28, 2005. Here incorporated by reference. +10.1 +1988 Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed July 21, 1988, Registration No. 33-23196. Here incorporated by reference. +10.2 +1993 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed June 22, 1993, Registration No. 33-64854. Here incorporated by reference. +10.3 +1995 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed October 26, 1995, Registration No. 33-63689. Here incorporated by reference. +10.4 +1997 Stock Incentive Plan.* Previously filed as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2001. Here incorporated by reference. +10.5 +Stock Incentive Plan of 1999.* Previously filed as Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. Here incorporated by reference. +10.6 +Stock Incentive Plan of 2001.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 26, 2001. Here incorporated by reference. +10.7 +Stock Incentive Plan of 2003.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 24, 2003. Here incorporated by reference. +10.8 +Stock Incentive Plan of 2005.* Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated April 25, 2005. Here incorporated by reference. +10.9 +Amended and Restated Directors' Stock Option Plan.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 14, 2003. Here incorporated by reference. +10.10 +Amended and Restated Directors Stock Option Plan.* Previously filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +42 +10.11 +Amended and Restated Outside Directors' Deferred Compensation Plan.* Previously filed as Appendix E to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.12 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.13 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan) (Restated as amended through February 10, 2005).* +10.14 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +10.15 +Executive Severance Agreement.* Previously filed as Exhibit 10.14 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. An updated participant schedule of current executive officers who are parties to the agreement is attached as Exhibit 10.15. +10.16 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. Previously filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.17 +Benefit Trust Agreement dated May 19, 1987, and Amendments Number 1, 2, 3 and 4 thereto.* Previously filed as Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.18 +Amended and Restated Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. An updated participant schedule of current executive officers participating in the plan is attached as Exhibit 10.18. +10.19 +Employees' Pension Plan (Restated as amended through March 28, 2005).* +10.20 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.21 +Form of Non-Qualified Stock Option Agreement for Steven M. Duffy, Stephen L. Gulis, Blake W. Krueger and Timothy J. O'Donovan.* Previously filed as Exhibit 10.2 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.22 +Form of Non-Qualified Stock Option Agreement for employees other than those to whom Exhibit 10.21 applies.* Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +43 +10.23 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.24 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.25 +Form of Non-Qualified Stock Option Agreement for Steven M. Duffy, Stephen L. Gulis, Blake W. Krueger and Timothy J. O'Donovan.* Previously filed as Exhibit 10.2 to the Company's Current Report of Form 8-K dated February 15, 2006. Here incorporated by reference. +10.26 +Form of Non-Qualified Stock Option Agreement for employees other than those to whom Exhibit 10.25 applies.* Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.27 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.28 +Form of Stock Option Agreement for non-employee directors.* Previously filed as Exhibit 10.23 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. Here incorporated by reference. +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31.1 +Certification of President and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Executive Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +____________________________ +*Management contract or compensatory plan or arrangement. +The Company will furnish a copy of any exhibit listed above to any stockholder without charge upon written request to Mr. James D. Zwiers, General Counsel and Secretary, 9341 Courtland Drive, Rockford, Michigan 49351. +44 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +WOLVERINE WORLD WIDE, INC. +Dated: March 15, 2006 +By: +/s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, +Chief Financial Officer and Treasurer +(Principal Financial Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ Timothy J. O'Donovan +Timothy J. O'Donovan +Chief Executive Officer and Chairman +of the Board of Directors +(Principal Executive Officer) +March 15, 2006 +/s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, Chief +Financial Officer and Treasurer +(Principal Financial Officer) +March 15, 2006 +/s/ Nicholas P. Ottenwess +Nicholas P. Ottenwess +Vice President of Finance and +Corporate Controller +(Principal Accounting Officer) +March 15, 2006 +*/s/ Donald V. Fites +Donald V. Fites +Director +March 15, 2006 +*/s/ Alberto L. Grimoldi +Alberto L. Grimoldi +Director +March 15, 2006 +*/s/ David T. Kollat +David T. Kollat +Director +March 15, 2006 +45 +*/s/ Brenda J. Lauderback +Brenda J. Lauderback +Director +March 15, 2006 +*/s/ Phillip D. Matthews +Phillip D. Matthews +Director +March 15, 2006 +*/s/ David P. Mehney +David P. Mehney +Director +March 15, 2006 +*/s/ Shirley D. Peterson +Shirley D. Peterson +Director +March 15, 2006 +*/s/ Paul D. Schrage +Paul D. Schrage +Director +March 15, 2006 +*/s/ Michael A. Volkema +Michael A. Volkema +Director +March 15, 2006 +*By /s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Attorney-in-Fact +Executive Vice President, Chief +Financial Officer and Treasurer +(Principal Financial Officer) +March 15, 2006 +46 +APPENDIX A +Financial Statements +CONSOLIDATED BALANCE SHEETS +As of Fiscal Year End +2005 +2004 +(Thousands of Dollars) +Assets +Current assets: +Cash and cash equivalents +$ +85,258 +$ +72,172 +Accounts receivable, less allowances (2005-$8,729; 2004-$8,200) +157,119 +151,174 +Inventories: +Finished products +140,729 +161,315 +Raw materials and work-in-process +20,618 +21,609 +161,347 +182,924 +Deferred income taxes +5,411 +6,113 +Prepaid expenses and other current assets +11,613 +18,472 +Total current assets +420,748 +430,855 +Property, plant and equipment: +Land +882 +962 +Buildings and improvements +68,235 +65,246 +Machinery and equipment +140,909 +136,950 +Software +54,605 +49,686 +264,631 +252,844 +Less accumulated depreciation +171,429 +157,914 +93,202 +94,930 +Other assets: +Goodwill +35,624 +35,552 +Other non-amortizable intangibles +8,347 +8,090 +Cash surrender value of life insurance +29,257 +26,930 +Prepaid pension costs +33,735 +35,289 +Other +5,667 +7,925 +112,630 +113,786 +Total assets +$ +626,580 +$ +639,571 +Liabilities and Stockholders' Equity +Current liabilities: +Accounts payable +$ +41,107 +$ +50,521 +Salaries, wages and other compensation +17,510 +19,435 +Income taxes +4,231 +- +Taxes, other than income taxes +3,560 +4,736 +Other accrued expenses +26,657 +23,824 +Current maturities of long-term debt +10,972 +11,735 +Total current liabilities +104,037 +110,251 +Long-term debt, less current maturities +21,439 +32,169 +Deferred compensation +9,227 +8,560 +Accrued pension liabilities +19,367 +15,443 +Deferred income taxes +9,658 +14,291 +Other liabilities +531 +- +Minority interest +- +566 +Stockholders' equity: +Common stock, $1 par value: authorized 160,000,000 shares; issued, +including treasury shares: 2005-59,211,814; 2004-67,350,495 +59,212 +67,350 +Additional paid-in capital +13,203 +99,518 +Retained earnings +452,672 +437,406 +Accumulated other comprehensive income +9,398 +19,446 +Unearned compensation +(5,873 +) +(4,955 +) +Cost of shares in treasury: 2005-3,082,548 shares; 2004-9,452,361 shares +(66,291 +) +(160,474 +) +Total stockholders' equity +462,321 +458,291 +Total liabilities and stockholders' equity +$ +626,580 +$ +639,571 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +1 +CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND +COMPREHENSIVE INCOME +Fiscal Year +2005 +2004 +2003 +(Thousands of Dollars, Except Per Share Data) +Common Stock +Balance at beginning of the year +$ +67,350 +$ +66,389 +$ +65,825 +Common stock issued under stock incentive plans +(2005-1,214,857 shares; 2004-2,081,586 shares; +2003-1,234,893 shares) +1,214 +2,082 +1,235 +Impact of stock split on treasury shares +(9,352 +) +(1,121 +) +(671 +) +Balance at end of the year +59,212 +67,350 +66,389 +Additional Paid-In Capital +Balance at beginning of the year +99,518 +81,980 +71,009 +Amounts associated with common stock issued +under stock incentive plans: +Proceeds over par value +14,609 +8,878 +8,281 +Income tax benefits +3,720 +7,782 +1,710 +Impact of stock split on treasury shares +(104,726 +) +1,121 +671 +Issuance of treasury shares (2005-11,662 shares; +2004-8,924 shares; 2003-27,886 shares) +12 +87 +51 +Net change in employee notes receivable +70 +(330 +) +258 +Balance at end of the year +13,203 +99,518 +81,980 +Retained Earnings +Balance at beginning of the year +437,406 +382,603 +339,475 +Impact of stock split on treasury shares +(44,725 +) +- +- +Net earnings +74,467 +65,938 +51,716 +Cash dividends (2005-$.26 per share; +2004-$.19 per share; 2003-$.15 per share) +(14,476 +) +(11,135 +) +(8,588 +) +Balance at end of the year +452,672 +437,406 +382,603 +Accumulated Other Comprehensive Income +Balance at beginning of the year +19,446 +8,540 +(23,522 +) +Foreign currency translation adjustments +(11,544 +) +9,727 +10,922 +Change in fair value of foreign exchange contracts, net of +taxes (2005-$1,280; 2004-$174; 2003-$730) +2,085 +160 +(1,393 +) +Minimum pension liability adjustment, net of taxes +(2005-$303; 2004-$524; 2003- $11,608) +(589 +) +1,019 +22,533 +Balance at end of the year +9,398 +19,446 +8,540 +Unearned Compensation +Balance at beginning of the year +(4,955 +) +(4,138 +) +(3,833 +) +Awards under restricted stock incentive plans +(4,190 +) +(4,165 +) +(2,488 +) +Compensation expense +3,272 +3,348 +2,183 +Balance at end of the year +(5,873 +) +(4,955 +) +(4,138 +) +Cost of Shares in Treasury +Balance at beginning of the year +(160,474 +) +(105,280 +) +(79,857 +) +Common stock purchased for treasury +(2005-2,994,210 shares; 2004-2,251,972 shares; +2003-1,367,770 shares) +(64,856 +) +(55,331 +) +(25,656 +) +Issuance of treasury shares (2005-11,662 shares; +2004-8,924 shares; 2003-27,886 shares) +236 +137 +233 +Impact of stock split on treasury shares +158,803 +- +- +Balance at end of the year +(66,291 +) +(160,474 +) +(105,280 +) +Total stockholders' equity at end of the year +$ +462,321 +$ +458,291 +$ +430,094 +Comprehensive Income +Net earnings +$ +74,467 +$ +65,938 +$ +51,716 +Foreign currency translation adjustments +(11,544 +) +9,727 +10,922 +Change in fair value of foreign exchange contracts, net of taxes +2,085 +160 +(1,393 +) +Minimum pension liability adjustment, net of taxes +(589 +) +1,019 +22,533 +Total comprehensive income +$ +64,419 +$ +76,844 +$ +83,778 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +2 +CONSOLIDATED STATEMENTS OF OPERATIONS +Fiscal Year +2005 +2004 +2003 +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +1,060,999 +$ +991,909 +$ +888,926 +Cost and expenses: +Cost of products sold +655,800 +617,774 +562,338 +Selling and administrative expenses +291,891 +274,125 +246,652 +Interest expense +3,647 +4,185 +5,896 +Interest income +(1,736 +) +(940 +) +(422 +) +Other (income) expense +150 +(305 +) +(686 +) +949,752 +894,839 +813,778 +Earnings before income taxes and minority interest +111,247 +97,070 +75,148 +Income taxes +36,780 +30,879 +23,262 +Earnings before minority interest +74,467 +66,191 +51,886 +Minority interest +- +253 +170 +Net earnings +$ +74,467 +$ +65,938 +$ +51,716 +Net earnings per share: +Basic +$ +1.33 +$ +1.15 +$ +.88 +Diluted +1.27 +1.09 +.85 +See accompanying notes to consolidated financial statements. +3 +CONSOLIDATED STATEMENTS OF CASH FLOWS +Fiscal Year +2005 +2004 +2003 +(Thousands of Dollars) +Operating Activities +Net earnings +$ +74,467 +$ +65,938 +$ +51,716 +Adjustments necessary to reconcile net earnings +to net cash provided by operating activities: +Depreciation +19,470 +18,683 +17,664 +Amortization +570 +388 +283 +Deferred income taxes (credit) +(4,908 +) +1,179 +(902 +) +Unearned compensation +3,272 +3,348 +2,183 +Pension +5,927 +1,249 +(2,456 +) +Other +5,011 +3,376 +(1,265 +) +Changes in operating assets and liabilities: +Accounts receivable +(7,739 +) +(2,332 +) +15,534 +Inventories +19,375 +(15,833 +) +17,069 +Other operating assets +11,221 +(2,776 +) +529 +Accounts payable +(4,862 +) +21,229 +(5,820 +) +Other operating liabilities +(2,153 +) +11,912 +7,668 +Net cash provided by operating activities +119,651 +106,361 +102,203 +Investing Activities +Business acquisitions, net of cash acquired +(4,602 +) +- +(14,780 +) +Additions to property, plant and equipment +(19,160 +) +(18,080 +) +(16,015 +) +Other +513 +(104 +) +58 +Net cash used in investing activities +(23,249 +) +(18,184 +) +(30,737 +) +Financing Activities +Proceeds from long-term borrowings +69,972 +44,385 +66,194 +Payments of long-term debt +(81,465 +) +(60,404 +) +(81,176 +) +Cash dividends paid +(14,814 +) +(11,135 +) +(8,588 +) +Purchase of common stock for treasury +(64,856 +) +(55,331 +) +(25,656 +) +Proceeds from shares issued under stock incentive plans +11,951 +6,688 +7,570 +Net cash used in financing activities +(79,212 +) +(75,797 +) +(41,656 +) +Effect of foreign exchange rate changes +(4,104 +) +4,436 +(1,532 +) +Increase in cash and cash equivalents +13,086 +16,816 +28,278 +Cash and cash equivalents at beginning of the year +72,172 +55,356 +27,078 +Cash and cash equivalents at end of the year +$ +85,258 +$ +72,172 +$ +55,356 +Other Cash Flow Information +Interest paid +$ +3,171 +$ +4,056 +$ +5,461 +Net income taxes paid +27,207 +23,868 +22,725 +( ) Denotes reduction in cash and cash equivalents. +See accompanying notes to consolidated financial statements. +4 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. Summary of Significant Accounting Policies +NATURE OF OPERATIONS +Wolverine World Wide, Inc. (NYSE: WWW) is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, performance outdoor footwear, work shoes and boots, uniform shoes and boots, constructed slippers and moccasins. The Company's global portfolio of owned and licensed brands includes: Bates®, CAT® Footwear, Harley-Davidson® Footwear, Hush Puppies®, HYTEST®, Merrell®, Patagonia® Footwear, Sebago®, Stanley® Footgear and Wolverine®. Apparel and licensing programs are utilized to extend the Company's owned brands into product categories beyond footwear. The Company also operates a retail division to showcase its brands and branded footwear from other manufacturers, a tannery that produces Wolverine Performance Leathers™ and a pigskin procurement operation. +PRINCIPLES OF CONSOLIDATION +The consolidated financial statements include the accounts of Wolverine World Wide, Inc. and its wholly and majority owned subsidiaries (collectively, the "Company"). All intercompany accounts and transactions have been eliminated in consolidation. +FISCAL YEAR +The Company's fiscal year is the 52- or 53-week period that ends on the Saturday nearest to December 31. Fiscal years presented in this report include the 52-week periods ended December 31, 2005 and January 1, 2005 and the 53-week period ended January 3, 2004. +USE OF ESTIMATES +The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. +REVENUE RECOGNITION +Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped, legal title has passed to the customer and collectibility is reasonably assured. Revenue generated through programs with licensees and distributors involving products bearing the Company's trademarks is recognized as earned according to stated contractual terms upon either the purchase or shipment of branded products by licensees and distributors. +The Company records provisions against gross revenue for estimated stock returns and cash discounts in the period when the related revenue is recorded. These estimates are based on factors that include, but are not limited to, historical stock returns, historical discounts taken and analysis of credit memorandum activity. +COST OF PRODUCTS SOLD +Cost of products sold for the Company's operations include the actual product costs, including inbound freight charges, purchasing, sourcing, inspection and receiving costs. Warehousing costs are included in selling and administrative expenses. +5 +SHIPPING AND HANDLING COSTS +Shipping and handling costs that are charged to and reimbursed by the customer are recognized as revenue, while the related expenses incurred by the Company are recorded as cost of products sold in the consolidated statements of operations. +CASH EQUIVALENTS +All short-term investments with a maturity of three months or less when purchased are considered cash equivalents. +ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS +The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from its customers' inability to make required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. Adjustments to these estimates may be required if the financial condition of the Company's customers were to change. The Company does not require collateral or other security on trade accounts receivable. +INVENTORIES +Inventories are valued at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for all domestic raw materials and work-in-process inventories, and certain domestic finished goods inventories. Cost is determined using methods approximating cost under the first-in, first-out (FIFO) method for all raw materials, work-in-process and finished goods inventories in foreign countries where LIFO is not permitted. The FIFO method is also used for all finished goods inventories of the Company's retail business, due to the unique nature of that operation, and for certain domestic finished goods inventories that were acquired as part of asset purchase transactions. Once elected, the Company has applied these inventory cost valuation methods consistently from year to year. +PROPERTY, PLANT AND EQUIPMENT +Property, plant and equipment are stated on the basis of cost and include expenditures for new facilities, major renewals, betterments and software. Normal repairs and maintenance are expensed as incurred. +Depreciation of property, plant and equipment is computed using the straight-line method. The depreciable lives range from five to forty years for buildings and improvements and from three to ten years for machinery, equipment and software. Leasehold improvements are depreciated at the lesser of the estimated useful life or lease term, including reasonably assured lease renewals as determined at lease inception. +GOODWILL AND OTHER INTANGIBLES +Goodwill represents the excess of the purchase price over the fair value of net tangible and identifiable intangible assets of acquired businesses. Other intangibles consist primarily of trademarks, brand names, patents and customer relationships. Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets . The Company reviews the carrying amounts of goodwill and other non-amortizable intangible assets annually by reporting unit to determine if such assets may be impaired. If the carrying amounts of these assets are not recoverable based upon a discounted cash flow analysis, such assets are reduced by the estimated shortfall of fair value to recorded value. Other amortizable intangible assets (principally patents) are amortized using the straight-line method over their estimated useful lives (periods ranging from two to fifteen years). Other amortizable intangible assets are included in other assets on the consolidated balance sheets and have net carrying amounts of $2,318,000 and $1,492,000 for 2005 and 2004, respectively, and accumulated amortization of $1,610,000 and $1,159,000 for 2005 and 2004, respectively. Estimated +6 +aggregate amortization expense for such intangibles for each of the five fiscal years subsequent to 2005 is as follows: 2006-$673,000; 2007-$583,000; 2008-$447,000; 2009-$244,000; 2010-$101,000. +The Company has performed the required annual impairment tests and has determined that there was no impairment indicated for recorded goodwill and other non-amortizable intangibles. +The changes in the carrying amount of goodwill and other non-amortizable intangibles for the years ended December 31, 2005 and January 1, 2005 are as follows: +Goodwill +Trademarks +Total +(Thousands of Dollars) +Balance at January 3, 2004 +$ +34,391 +$ +7,739 +$ +42,130 +Intangibles acquired +- +351 +351 +Purchase accounting adjustments +(613 +) +- +(613 +) +Foreign currency translation effects +1,774 +- +1,774 +Balance at January 1, 2005 +35,552 +8,090 +43,642 +Intangibles acquired +2,489 +257 +2,746 +Purchase accounting adjustments +313 +- +313 +Foreign currency translation effects +(2,730 +) +- +(2,730 +) +Balance at December 31, 2005 +$ +35,624 +$ +8,347 +$ +43,971 +IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS +The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or an asset group may not be recoverable. Each impairment test is based on a comparison of the carrying amount of the asset or asset group to the future undiscounted net cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment amount to be recognized is the amount by which the carrying value of the assets exceeds their fair value. +STOCK-BASED COMPENSATION +The Company has elected to follow Accounting Principles Board (APB) Opinion No. 25 , Accounting for Stock Issued to Employees , and related interpretations, in accounting for its stock incentive awards. Under APB Opinion No. 25, compensation expense is recognized when the market price of the stock underlying an award on the date of grant exceeds any related exercise price. +Where compensation expense has been determined by APB Opinion No. 25, pro forma information regarding net earnings and earnings per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its stock awards using the fair value method. The fair value of these awards was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: risk-free interest rate of 3.7% (3.4% in 2004 and 2.9% in 2003); dividend yield of 1.1% (1.0% in 2004 and 1.3% in 2003); expected market price volatility factor of.239 (.317 in 2004 and.386 in 2003); and an expected option life of four years. +The estimated weighted-average fair value for each option granted was $5.10 in 2005, $4.68 in 2004 and $3.30 in 2003. +For purposes of pro forma disclosures, the estimated fair values of stock options are amortized to expense over the related vesting periods and awards subject to acceleration of vesting upon retirement are currently recognized over the explicit service period up to the date of actual retirement. Upon adoption of SFAS No. 123(R), service beyond the eligible retirement date will be considered non-substantive. The Company +7 +recognizes compensation cost for fixed awards with pro rata vesting using the straight-line attribution method. The Company's pro forma information under SFAS No. 123 is as follows: +2005 +2004 +2003 +(Thousands of Dollars, Except Per Share Data) +Net earnings, as reported +$ +74,467 +$ +65,938 +$ +51,716 +Add: +Total stock-based employee compensation +expense included in reported net income, net of +related tax effects +3,272 +3,374 +2,326 +Deduct: +Total stock-based employee compensation +expense determined under fair value +method for all awards, net of related tax effects +7,266 +8,330 +5,456 +Pro forma net earnings +$ +70,473 +$ +60,982 +$ +48,586 +Net earnings per share: +Basic-as reported +$ +1.33 +$ +1.15 +$ +.88 +Basic-pro forma +1.26 +1.06 +.83 +Diluted-as reported +1.27 +1.09 +.85 +Diluted-pro forma +1.20 +1.01 +.79 +On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), Share-Based Payment , which would require all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated statements of operations based on their fair values, effective for public companies for fiscal years beginning after June 15, 2005. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. The Company intends to adopt SFAS No. 123(R) effective with its fiscal year beginning January 1, 2006 using the modified prospective method. +Effective December 13, 2005, the Board of Directors accelerated the vesting of unvested stock options previously granted to employees and officers of the Company under various stock option plans. As a result of this action, options to purchase approximately 1,003,000 shares of common stock that otherwise would have vested in 2006, 2007 and 2008 became fully vested and an additional $4,407,000 of pro forma stock-based employee compensation expense was recognized in the quarter ended December 31, 2005. Accordingly, compensation costs of $2,185,000, $1,495,000 and $727,000 in 2006, 2007 and 2008, respectively, that would have been recognized in each year after the adoption of SFAS No. 123(R) will not be recognized due to the modification. The decision to accelerate the vesting of these options, which the Company believes to be in the best interest of its stockholders, was made primarily to reduce non-cash compensation expense that would have been recorded in future periods following the Company's adoption of SFAS No. 123(R). While the Company continues to evaluate its share based payment strategies, it estimates the incremental pre-tax impact of SFAS No. 123 (R), after the impact of the acceleration of vesting discussed above, to approximate $3.9 million for 2006. +ADVERTISING COSTS +Advertising costs are expensed as incurred and customer specific advertising dollars are expensed when earned by customers. Total advertising expense was $40,059,000 in 2005, $38,611,000 in 2004 and $35,254,000 in 2003, and includes customer specific advertising dollars of $6,445,000 in 2005, $9,689,000 in 2004 and $9,652,000 in 2003. The Company provides sales incentives to certain retail customers in the form of a cooperative advertising program and accounts for this in accordance with EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the +8 +Vendor's Products) . Under this program, customers are reimbursed for Company-approved advertising expenditures where the value to the Company is objectively verifiable. +INCOME TAXES +The provision for income taxes is based on the earnings reported in the consolidated financial statements. A deferred income tax asset or liability is determined by applying currently enacted tax laws and rates to the cumulative temporary differences between the carrying values of assets and liabilities for financial statement and income tax purposes. +EARNINGS PER SHARE +Basic earnings per share is computed based on weighted average shares of common stock outstanding during each year after adjustment for nonvested common stock issued under restricted stock incentive plans. Diluted earnings per share assumes the exercise of dilutive stock options and the vesting of all common stock under restricted stock programs. +The following table sets forth the reconciliation of weighted average shares used in the computation of basic and diluted earnings per share: +2005 +2004 +2003 +Weighted average shares outstanding during the year +57,241,893 +58,498,042 +59,846,151 +Adjustment for nonvested common stock +(1,098,177 +) +(1,099,677 +) +(1,081,869 +) +Denominator for basic earnings per share +56,143,716 +57,398,365 +58,764,282 +Effect of dilutive stock options +1,742,344 +2,265,984 +1,570,782 +Adjustment for nonvested common stock - treasury method +789,065 +809,708 +746,343 +Denominator for diluted earnings per share +58,675,125 +60,474,057 +61,081,407 +Options to purchase 516,335 shares of common stock in 2005, 588,978 shares in 2004 and 988,601 shares in 2003 have not been included in the denominator for the computation of diluted earnings per share because the related exercise prices were greater than the average market price for the period and, therefore, they were antidilutive. +STOCK SPLIT +On December 15, 2004, the Company announced a three-for-two stock split in the form of a stock dividend on shares of common stock outstanding at January 3, 2005 that was distributed to stockholders on February 1, 2005. All share and per share amounts in the consolidated financial statements and related notes have been adjusted for all periods to reflect the stock split. Treasury shares were excluded from the stock split. +FOREIGN CURRENCY +For the Company's international subsidiaries, the local currency is the functional currency. Assets and liabilities of these subsidiaries are translated into U.S. dollars at the year-end exchange rate. Operating statement amounts are translated at average exchange rates for the period. The cumulative translation adjustments resulting from changes in exchange rates are included in the consolidated balance sheets as a component of accumulated other comprehensive income in stockholders' equity. Transaction gains and losses are included in the consolidated statements of operations and were not material. +FINANCIAL INSTRUMENTS AND RISK MANAGEMENT +The Company's financial instruments consist of cash and cash equivalents, accounts and notes receivable, accounts and notes payable and long-term debt. Except for fixed rate long-term debt with a carrying value of $32,385,000 and a fair value of $32,975,000 at December 31, 2005 and a carrying value of $43,857,000 and a fair value of $45,996,000 at January 1, 2005, the Company's estimate of the fair values of these financial instruments approximates their carrying amounts for the respective years. Fair value +9 +was determined using discounted cash flow analyses and current interest rates for similar instruments. The Company does not hold or issue financial instruments for trading purposes. +The Company follows SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS Nos. 137 and 138, which requires that all derivative instruments be recorded on the consolidated balance sheets at fair value and establishes criteria for designation and effectiveness of hedging relationships. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with foreign currency inventory purchases made by non-U.S. wholesale operations in the normal course of business. At December 31, 2005 and January 1, 2005, foreign exchange contracts with a notional value of $61,404,000 and $46,974,500, respectively, were outstanding to purchase various currencies (principally U.S. dollars) with maturities ranging up to 280 days. These contracts have been designated as cash flow hedges. As of December 31, 2005 and January 1, 2005, an asset of $715,000 and a liability of $1,821,000, respectively, have been recognized for the fair value of the foreign currency forward exchange contracts. +The fair value of the foreign currency forward exchange contracts represents the estimated receipts or payments necessary to terminate the contracts. Hedge effectiveness is evaluated by the hypothetical derivative method. Any hedge ineffectiveness is reported within the cost of products sold caption of the consolidated statements of operations. Hedge ineffectiveness was not material in 2005 or 2004. If, in the future, the foreign exchange contracts are determined to be ineffective hedges or terminated before their contractual termination dates, the Company would be required to reclassify into earnings all or a portion of the unrealized amounts related to the cash flow hedges that are currently included in accumulated other comprehensive income within stockholders' equity. +COMPREHENSIVE INCOME +Comprehensive income represents net earnings and any revenue, expenses, gains and losses that, under accounting principles generally accepted in the United States, are excluded from net earnings and recognized directly as a component of stockholders' equity. +Ending accumulated other comprehensive income is as follows: +2005 +2004 +(Thousands of Dollars) +Foreign currency translation adjustments +$ +12,243 +$ +23,787 +Foreign currency cash flow hedge adjustments, net of taxes +(2005 - $287; 2004 - $993) +608 +(1,477 +) +Minimum pension liability adjustments, net of taxes +(2005 - $1,779; 2004 - $1,476) +(3,453 +) +(2,864 +) +Accumulated other comprehensive income +$ +9,398 +$ +19,446 +RECLASSIFICATIONS +Certain amounts previously reported in 2004 and 2003 have been reclassified to conform with the presentation used in 2005. +2. Inventories +Inventories of $72,546,000 at December 31, 2005 and $81,771,000 at January 1, 2005 have been valued using the LIFO method. If the FIFO method had been used, inventories would have been $8,858,000 and $8,053,000 higher than reported at December 31, 2005 and January 1, 2005, respectively. +10 +3. Debt +Long-term debt consists of the following obligations: +2005 +2004 +(Thousands of Dollars) +6.5% senior notes payable +$ +32,385 +$ +42,857 +Other +26 +1,047 +32,411 +43,904 +Less current maturities +10,972 +11,735 +$ +21,439 +$ +32,169 +The 6.5% unsecured senior notes payable require annual principal payments of $10,714,000 due through the maturity date of December 8, 2008. In connection with the issuance of these senior notes, the Company entered into an interest rate lock agreement with a bank that was settled in 1998 and resulted in a prepayment of interest of $2,200,000. This prepayment is being amortized over the remaining term of the notes using the effective interest method. +The Company has an unsecured revolving credit agreement that allows for borrowings up to $150,000,000, subject to increase or decrease as specified in the credit agreement. This agreement, which expires July 2010, requires that interest be paid at a variable rate based on one of the following options elected by the Company: prime, LIBOR or money market rate plus applicable spread. No amounts were outstanding under revolving credit facilities at December 31, 2005 or January 1, 2005. +The Company had commercial letters of credit outstanding of $2,936,000 and $3,175,000 at December 31, 2005 and January 1, 2005, respectively. +The long-term loan agreements contain restrictive covenants that, among other things, require the Company to maintain certain financial ratios and minimum levels of consolidated net worth. At December 31, 2005, the Company was in compliance with all restrictive covenants. The agreements also impose restrictions on securing additional debt, sale and merger transactions and the disposition of significant assets. +Principal maturities of long-term debt subsequent to 2006 are as follows: 2007-$10,721,000; 2008-$10,718,000. +Interest costs of $208,000 in 2005, $408,000 in 2004 and $235,000 in 2003 were capitalized in connection with various capital improvement and computer hardware and software installation projects. +4. Leases +The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2023. Certain leases contain renewal provisions and generally require the Company to pay utilities, insurance, taxes and other operating expenses. At December 31, 2005, minimum rental payments due under all noncancelable leases were as follows: 2006-$11,246,000; 2007-$10,092,000; 2008-$9,209,000; 2009-$7,883,000; 2010-$5,975,000; thereafter-$31,125,000. +Rental expense under all operating leases consisted primarily of minimum rentals and totaled $12,403,000 in 2005, $11,542,000 in 2004 and $11,614,000 in 2003. +5. Capital Stock +The Company has 2,000,000 authorized shares of $1 par value preferred stock, of which none is issued or outstanding. +11 +The Company has a preferred stock rights plan that is designed to protect stockholder interests in the event the Company is confronted with coercive or unfair takeover tactics. Two-thirds of one right is associated with each share of common stock currently outstanding. The rights trade with the common stock and become exercisable only upon the occurrence of certain triggering events. Each right, when exercisable, will entitle the holder to purchase one one-hundredth of a share of Series B junior participating preferred stock for $120. The Company has designated 500,000 shares of preferred stock as Series B junior participating preferred stock for possible future issuance under the Company's preferred stock rights plan. Upon issuance for reasons other than liquidation, each share of Series B junior participating preferred stock will have 100 votes and a preferential quarterly dividend equal to the greater of $21 per share or 100 times the dividend declared on common stock. +If, after a triggering event, the Company is a party to a merger or other business combination, regardless of whether the Company is the surviving corporation, right holders other than the party to the merger will be entitled to receive common stock of the surviving corporation worth twice the exercise price of the rights. The plan also provides for protection against self-dealing transactions by certain 15% stockholders or the activities of an adverse person (as defined in the plan). The Company may redeem the rights for $.01 each at any time prior to a person being designated as an adverse person or fifteen days after a triggering event. Unless redeemed earlier, all rights expire on May 7, 2007. The Board of Directors can elect to exclude certain transactions from triggering the exercise of preferred stock rights and other actions under the plan. +The Company has stock incentive plans under which options to purchase shares of common stock may be granted to officers, other key employees and non-employee directors. Options granted are exercisable over no more than ten years and generally vest over three years. All unexercised options are available for future grant upon their cancellation. +A summary of the transactions under the stock option plans is as follows: +Shares Under +Option +Weighted-Average +Option Price +Outstanding at December 28, 2002 +6,618,297 +9.93 +Granted +1,208,001 +10.81 +Exercised +(1,127,250 +) +7.96 +Cancelled +(66,084 +) +13.45 +Outstanding at January 3, 2004 +6,632,964 +10.41 +Granted +1,938,069 +17.75 +Exercised +(2,880,498 +) +9.90 +Cancelled +(108,186 +) +13.60 +Outstanding at January 1, 2005 +5,582,349 +13.14 +Granted +643,695 +22.89 +Exercised +(1,166,838 +) +11.62 +Cancelled +(18,494 +) +16.30 +Outstanding at December 31, 2005 +5,040,712 +$ +14.72 +Shares available for grant under the stock option plans were 5,119,888 at December 31, 2005, 2,067,445 at January 1, 2005 and 3,147,514 at January 3, 2004. +12 +The exercise prices of options outstanding at December 31, 2005 range from $6.46 to $24.57. A summary of stock options outstanding and options exercisable at December 31, 2005 is as follows: +Options Outstanding +Options Exercisable +Range of +Exercise +Price +Number +Weighted- +Average +Exercise Price +Average +Remaining +Contractual Life +Number +Weighted- +Average +Exercise Price +Less than $10 +662,089 +$ +7.38 +3.3 years +662,089 +$ +7.38 +$10 to $15 +1,696,300 +10.56 +5.8 years +1,696,300 +10.56 +Greater than $15 +2,682,323 +19.16 +6.1 years +2,682,323 +19.16 +5,040,712 +$ +14.72 +5.6 years +5,040,712 +$ +14.72 +The number of options exercisable at January 1, 2005 and January 3, 2004 totaled 4,342,966 and 5,273,376, respectively, with weighted-average exercise prices of $13.25 and $10.40, respectively. +The Company also has stock award plans for officers and other key employees. Common stock issued under these plans is subject to certain restrictions, including a prohibition against any sale, transfer or other disposition by the officer or employee (except for certain transfers for estate planning purposes for certain officers), a requirement to forfeit all or a certain portion of the award upon certain terminations of employment or upon failure to achieve performance criteria in certain instances. These restrictions lapse over a three- to five-year period from the date of the award. Shares aggregating 188,150 in 2005, 294,120 in 2004 and 242,850 in 2003 were awarded under these plans. The weighted-average grant date fair value was $23.03 in 2005, $15.37 in 2004 and $10.57 in 2003 for the shares awarded. There were no awards cancelled in 2005 and 2003. There were 13,734 awards cancelled in 2004. The market value of the shares awarded without performance criteria is recognized as unearned compensation in the consolidated statements of stockholders' equity and is amortized to operations over the vesting period. Awards based on performance criteria are amortized to operations over the combined performance and vesting period. +6. Retirement Plans +The Company has noncontributory, defined benefit pension plans covering a majority of its domestic employees. The Company's principal defined benefit pension plan provides benefits based on the employees' years of service and final average earnings (as defined in the plan), while the other plan provides benefits at a fixed rate per year of service. The Company intends to annually contribute amounts deemed necessary to maintain the plans on a sound actuarial basis. +The Company has a Supplemental Executive Retirement Plan ("SERP") for certain current and former employees that entitles them to receive payments from the Company following retirement based on the employees' years of service and final average earnings (as defined in the SERP). Under the SERP, the employees can elect early retirement with a corresponding reduction in benefits. The Company also has individual deferred compensation agreements with certain former employees that entitle them to receive payments from the Company for a period of fifteen to eighteen years following retirement. The Company maintains life insurance policies with a cash surrender value of $28,557,000 at December 31, 2005 and $26,245,000 at January 1, 2005 that are intended to fund deferred compensation benefits under the SERP and deferred compensation agreements. +The Company has a defined contribution money accumulation plan covering substantially all domestic employees that provides for Company contributions based on earnings. This plan is combined with the principal defined benefit pension plan for funding purposes to the extent allowable under applicable regulations. The Company recognized expense for the money accumulation plan of $2,031,000 in 2005, $1,788,000 in 2004 and $1,620,000 in 2003. The Company also has certain defined contribution plans at +13 +foreign subsidiaries. Contributions to these plans were $962,000 in 2005, $832,000 in 2004 and $662,000 in 2003. +The Company uses a September 30 measurement date for its defined benefit plans. The following summarizes the status of and changes in the Company's pension assets and related obligations for its pension plans (which include the Company's defined benefit pension plans and the SERP) as of: +September 30 +2005 +2004 +(Thousands of Dollars) +Change in projected benefit obligations: +Projected benefit obligations at beginning of the year +$ +156,868 +$ +146,486 +Service cost pertaining to benefits earned during the year +4,272 +3,983 +Interest cost on projected benefit obligations +9,444 +8,991 +Effect of changes in actuarial assumptions +- +37 +Actuarial losses +4,108 +4,176 +Benefits paid to plan participants +(7,061 +) +(6,805 +) +Projected benefit obligations at end of the year +$ +167,631 +$ +156,868 +Change in fair value of pension assets: +Fair value of pension assets at beginning of the year +$ +144,272 +$ +127,854 +Actual return on plan assets +17,442 +17,559 +Company contributions +3,754 +5,664 +Benefits paid to plan participants +(7,061 +) +(6,805 +) +Fair value of pension assets at end of the year +$ +158,407 +$ +144,272 +Funded status +$ +(9,224 +) +$ +(12,596 +) +Unrecognized prior service costs +2,600 +3,253 +Unrecognized net actuarial losses +26,649 +35,118 +Net amount recognized +$ +20,025 +$ +25,775 +Amounts recognized in the consolidated balance sheets: +Prepaid benefit cost +$ +34,183 +$ +36,416 +Accrued benefit cost +(20,016 +) +(16,778 +) +Intangible assets +626 +1,797 +Accumulated other comprehensive loss +5,232 +4,340 +Net amount recognized +$ +20,025 +$ +25,775 +Funded status of pension plans and SERP (supplemental): +Funded status of qualified defined benefit plans and SERP +$ +(9,224 +) +$ +(12,596 +) +Nonqualified trust assets (cash surrender value of life insurance) recorded +in other assets and intended to satisfy the projected benefit obligation +of unfunded supplemental employee retirement plans +26,212 +23,631 +Net funded status of pension plans and SERP (supplemental) +$ +16,988 +$ +11,035 +14 +The Company made contributions of $178,000 and $159,000 subsequent to the measurement date and before the fiscal years ended 2005 and 2004, respectively. +Information for pension plans with an accumulated benefit obligation in excess of plan assets: +September 30 +2005 +2004 +(Thousands of Dollars) +Projected benefit obligations +$ +24,216 +$ +28,381 +Accumulated benefit obligations +22,815 +27,295 +Fair value of plan assets +2,799 +10,517 +The accumulated benefit obligations for all defined benefit pension plans and the SERP were $157,931,000 and $147,933,000 at September 30, 2005 and 2004, respectively. +The following is a summary of net pension and SERP cost recognized by the Company: +2005 +2004 +2003 +(Thousands of Dollars) +Service cost pertaining to benefits earned during the year +$ +(4,272 +) +$ +(3,983 +) +$ +(3,243 +) +Interest cost on projected benefit obligations +(9,444 +) +(8,991 +) +(8,634 +) +Expected return on pension assets +12,013 +11,906 +10,175 +Net amortization loss +(7,800 +) +(5,548 +) +(5,491 +) +Net pension cost +$ +(9,503 +) +$ +(6,616 +) +$ +(7,193 +) +Expense for qualified defined benefit pension plans was $7,916,000 in 2005, $4,825,000 in 2004 and $6,014,000 in 2003. +2005 +2004 +Weighted average assumptions used to determine benefit obligations at September 30: +Discount rate +6.00% +5.98% +Rate of compensation increase +3.50% +3.50% +Weighted average assumptions used to determine net periodic benefit cost for the years ended: +Discount rate +5.98% +6.11% +Expected long-term rate of return on plan assets +8.75% +8.75% +Rate of compensation increase +3.50% +3.50% +Unrecognized net experience losses exceeding certain corridors are amortized over a five-year period, unless the minimum amortization method based on average remaining service periods produces a higher amortization. +The long-term rate of return is based on overall market expectations for a balanced portfolio with an asset mix similar to the Company's, utilizing historic returns for broad market and fixed income indices. +2005 +2004 +Weighted average asset allocations at September 30 by asset category are as follows: +Equity securities +74.4% +72.3% +Fixed income investments +19.7% +22.7% +Cash and money market investments +5.9% +5.0% +100.0% +100.0% +15 +The Company's investment policy for plan assets uses a blended approach of U.S. and foreign equities combined with U.S. fixed income investments. Policy guidelines indicate that total equities should not exceed 80% and fixed income securities should not exceed 50%. Within the equity and fixed income classifications, the investments are diversified. +The Company expects to contribute $3,000,000 to its qualified defined benefit pension plans and $846,000 to the SERP in 2006. +Expected benefit payments for the five years subsequent to 2005 and the sum of the five years following those are as follows: 2006 - $7,717,000; 2007 - $8,002,000; 2008 - $8,207,000; 2009 - $8,448,000; 2010 - $9,010,000; and 2011 through 2015 - $52,118,000. +7. Income Taxes +The provisions for income taxes consist of the following: +2005 +2004 +2003 +(Thousands of Dollars) +Currently payable: +Federal +$ +30,458 +$ +23,096 +$ +19,818 +State and foreign +11,230 +6,604 +4,346 +Deferred (credit) expense +(4,908 +) +1,179 +(902 +) +$ +36,780 +$ +30,879 +$ +23,262 +A reconciliation of the Company's total income tax expense and the amount computed by applying the statutory federal income tax rate of 35% to earnings before income taxes is as follows: +2005 +2004 +2003 +(Thousands of Dollars) +Income taxes at statutory rate +$ +38,937 +$ +33,975 +$ +26,302 +State income taxes, net of federal income tax reduction +314 +343 +183 +Nontaxable earnings of foreign affiliates +(1,625 +) +(2,186 +) +(1,605 +) +Research and development credits +(740 +) +(550 +) +(1,870 +) +Repatriation of earnings of foreign subsidiaries +1,400 +- +- +Foreign earnings taxed at rates differing from +the U.S. statutory rate +(853 +) +(313 +) +718 +Other +(653 +) +(390 +) +(466 +) +$ +36,780 +$ +30,879 +$ +23,262 +16 +Significant components of the Company's deferred income tax assets and liabilities as of the end of 2005 and 2004 are as follows: +2005 +2004 +(Thousands of Dollars) +Deferred income tax assets: +Accounts receivable and inventory valuation allowances +$ +2,541 +$ +2,444 +Deferred compensation accruals +2,019 +2,163 +Future benefit of foreign net operating losses +254 +254 +Accrued pension costs +1,779 +1,476 +Other amounts not deductible until paid +5,623 +6,470 +Total deferred income tax assets +12,216 +12,807 +Deferred income tax liabilities: +Tax over book depreciation +(8,131 +) +(10,336 +) +Prepaid pension costs +(6,821 +) +(9,250 +) +Other +(1,511 +) +(1,399 +) +Total deferred income tax liabilities +(16,463 +) +(20,985 +) +Net deferred income tax liabilities +$ +(4,247 +) +$ +(8,178 +) +In 2005, the Company elected to repatriate earnings of foreign subsidiaries as provided under the American Jobs Creation Act of 2004 (the "Act"), which was enacted on October 22, 2004. The Act provides for a tax deduction of 85% of certain foreign earnings that are repatriated in 2005. During the fourth quarter of fiscal 2005, the Company repatriated $41,547,000 of eligible foreign earnings for this deduction and as a result recorded tax expense of $1,400,000. +No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the remaining undistributed earnings of foreign subsidiaries of $89,239,000 at December 31, 2005 as the Company expects such earnings will be reinvested overseas indefinitely. (At January 1, 2005, undistributed foreign earnings were $96,052,000.) +8. Litigation and Contingencies +The Company is involved in various environmental claims and other legal actions arising in the normal course of business. The environmental claims include sites where the Environmental Protection Agency has notified the Company that it is a potentially responsible party with respect to environmental remediation. These remediation claims are subject to ongoing environmental impact studies, assessment of remediation alternatives, allocation of costs between responsible parties and concurrence by regulatory authorities and have not yet advanced to a stage where the Company's liability is fixed. However, after taking into consideration legal counsel's evaluation of all actions and claims against the Company, management is currently of the opinion that their outcome will not have a material effect on the Company's consolidated financial position or future results of operations. +Pursuant to certain of the Company's lease agreements, the Company has provided financial guarantees to third parties in the form of indemnification provisions. These provisions indemnify and reimburse the third parties for costs, including but not limited to adverse judgments in lawsuits, taxes and operating costs. The terms of the guarantees are equal to the terms of the related lease agreements. The Company is not able to calculate the maximum potential amount of future payments it could be required to make under these guarantees, as the potential payment is dependent upon the occurrence of future unknown events. +The Company has future minimum royalty obligations due under the terms of certain licenses held by the Company. These minimum future obligations are as follows: +17 +2006 +2007 +2008 +2009 +2010 +(Thousands of Dollars) +Minimum royalties +$1,176 +$1,139 +$1,063 +$1,329 +$1,545 +Minimum royalties are based on both fixed obligations and assumptions regarding the consumer price index. Royalty obligations in excess of minimum requirements are based upon future sales levels. In accordance with these agreements, the Company incurred royalty expense of $3,145,000, $3,083,000 and $3,132,000 for 2005, 2004 and 2003, respectively. +The terms of certain license agreements also require advertising expenditures based on the level of sales. In accordance with these agreements, the Company's advertising obligations, based on actual sales, totaled $1,906,000, $1,982,000 and $2,915,000 for 2005, 2004 and 2003, respectively. +9. Business Segments +The Company has one reportable segment that is engaged in manufacturing, sourcing, marketing, licensing and distributing branded footwear and licensed apparel and accessories to the retail sector, including casual shoes, dress shoes, performance outdoor footwear, boots, uniform shoes, work shoes, slippers, moccasins and apparel and accessories. Revenue of this segment is derived from the sale of branded footwear to external customers as well as royalty income from the licensing of the Company's trademarks and brand names to licensees and distributors. The business units comprising the branded footwear and licensing segment manufacture or source, market and distribute products in a similar manner. Branded footwear and licensed products are distributed through wholesale channels and under licensing and distributor arrangements. +The other business units in the following tables consist of the Company's retail, tannery and pigskin procurement operations. The Company operated 76 domestic retail stores and 5 consumer-direct internet sites at December 31, 2005 that sell Company-manufactured and sourced products, as well as footwear manufactured by unaffiliated companies. The other business units distribute products through retail and wholesale channels. +The Company measures segment profits as earnings before income taxes and minority interest. The accounting policies used to determine profitability and total assets of the branded products and other business segments are the same as disclosed in Note 1. +Business segment information is as follows: +2005 +Branded +Footwear +and Licensing +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +964,522 +$ +96,477 +$ +- +$ +1,060,999 +Intersegment sales +36,232 +3,437 +- +39,669 +Interest (income) expense - net +9,706 +1,009 +(8,804 +) +1,911 +Depreciation expense +7,845 +3,735 +7,890 +19,470 +Earnings (loss) before income taxes +120,668 +5,847 +(15,268 +) +111,247 +Total assets +406,024 +41,600 +178,956 +626,580 +Additions to property, plant and equipment +7,975 +4,721 +6,464 +19,160 +18 +2004 +Branded +Footwear +and Licensing +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +903,611 +$ +88,298 +$ +- +$ +991,909 +Intersegment sales +30,750 +2,939 +- +33,689 +Interest (income) expense - net +9,266 +968 +(6,989 +) +3,245 +Depreciation expense +6,585 +3,215 +8,883 +18,683 +Earnings (loss) before income taxes +and minority interest +111,261 +4,226 +(18,417 +) +97,070 +Total assets +453,522 +39,260 +146,789 +639,571 +Additions to property, plant and equipment +8,920 +3,890 +5,270 +18,080 +2003 +Branded +Footwear +and Licensing +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +812,590 +$ +76,336 +$ +- +$ +888,926 +Intersegment sales +27,288 +2,471 +- +29,759 +Interest (income) expense - net +9,314 +1,059 +(4,899 +) +5,474 +Depreciation expense +5,667 +2,587 +9,410 +17,664 +Earnings (loss) before income taxes +and minority interest +85,294 +1,357 +(11,503 +) +75,148 +Total assets +399,276 +36,594 +157,922 +593,792 +Additions to property, plant and equipment +6,229 +3,355 +6,431 +16,015 +Geographic information, based on shipping destination, related to revenue from external customers included in the consolidated statements of operations is as follows: +2005 +2004 +2003 +(Thousands of Dollars) +United States +$ +740,442 +$ +718,674 +$ +674,794 +Foreign countries: +Europe and Russia +219,085 +193,461 +150,643 +Canada +66,955 +49,797 +45,422 +Central and South America +12,131 +9,084 +6,639 +Asia +13,960 +11,990 +8,132 +Middle East/Africa +8,426 +8,903 +3,296 +Total foreign countries revenue +320,557 +273,235 +214,132 +$ +1,060,999 +$ +991,909 +$ +888,926 +19 +The Company's long-lived assets (primarily property, plant and equipment and intangible assets) are as follows: +2005 +2004 +2003 +(Thousands of Dollars) +United States +$ +131,820 +$ +132,651 +$ +135,914 +Foreign countries +40,277 +40,776 +36,880 +The Company does not believe that it is dependent upon any single customer, since none accounts for more than 10% of consolidated revenue. +The Company sources approximately 90% (based on pairs) of its footwear products from unrelated suppliers primarily located in Asia. The remainder is produced in Company-owned manufacturing facilities in the United States and the Dominican Republic. All licensed apparel and accessories are sourced from unrelated suppliers. While changes in suppliers could cause delays in manufacturing and a possible loss of sales, management believes that other suppliers could provide similar products on comparable terms. +Revenue derived from the branded footwear and licensing segment accounted for approximately 91% of revenue in 2005, 2004 and 2003. No other product groups account for more than 10% of consolidated revenue. +Approximately 14% of the Company's employees are subject to bargaining unit contracts extending through various dates ranging from 2006 through 2009. +10. Quarterly Results of Operations (unaudited) +The Company reports its quarterly results of operations on the basis of 12-week periods for each of the first three quarters and a 16- or 17-week period for the fourth quarter. The fourth quarters of 2005 and 2004 include 16 weeks. +The Company's unaudited quarterly results of operations are as follows: +2005 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +245,175 +$ +215,706 +$ +279,116 +$ +321,002 +Gross margin +96,406 +84,454 +108,661 +115,678 +Net earnings +16,133 +13,257 +24,634 +20,443 +Net earnings per share: +Basic +$ +.28 +$ +.23 +$ +.44 +$ +.37 +Diluted +.27 +.22 +.42 +.36 +20 +2004 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +224,871 +$ +198,774 +$ +260,897 +$ +307,367 +Gross margin +85,441 +75,514 +98,177 +115,003 +Net earnings +12,299 +10,985 +21,946 +20,708 +Net earnings per share: +Basic +$ +.21 +$ +.19 +$ +.38 +$ +.37 +Diluted +.20 +.18 +.37 +.34 +Adjustments in the fourth quarter resulted in a decrease in net earnings of $890,000 ($.02 per share) in 2005 and were immaterial in 2004. These adjustments related primarily to inventories. +11. Business Acquisitions +During the second quarter of 2005, the Company purchased the remaining 5% ownership from the minority stockholder of Wolverine Europe Limited, making it a wholly-owned subsidiary. The purchase price was $2,322,000 of which $407,000 was deferred until July 1, 2006. The transaction eliminated the minority interest of $566,000 and resulted in goodwill of $1,756,000. +On January 3, 2005, the Company converted its CAT® and Wolverine® businesses in Canada from a non-affiliated distributor-based operation to a Company-owned wholesale operation. This expansion allowed the Company to directly wholesale all major brands in Canada. Assets consisting primarily of inventory, fixed assets and amortizable intangible assets totaling $2,117,000 and assumed liabilities of $883,000 were acquired from a former Wolverine® and CAT® Footwear distributor for cash of $2,280,000 and resulted in goodwill and intangible assets of $1,046,000. Consolidated pro forma revenue and net earnings, assuming the transaction occurred at the beginning of 2005, were not materially different from reported amounts. Pursuant to SFAS No. 142, goodwill and indefinite-lived intangibles will not be amortized, but will be evaluated for impairment annually. Goodwill was assigned to the Company's branded footwear and licensing segment. The majority of the goodwill is expected to be deductible for tax purposes. The amortizable intangible assets have a weighted average useful life of approximately ten years. +On January 3, 2005, the Company converted its Merrell® operations in Sweden and Finland and its Sebago® operations in the United Kingdom and Germany from a non-affiliated distributor-based operation to a Company-owned wholesale operation. Assets consisting primarily of inventory totaling $544,000 were acquired from former distributors for cash. +On November 3, 2003, the Company acquired significant operating assets of Sebago, Inc., an international distributor of performance nautical and American-inspired footwear, consisting of accounts receivable, inventory, fixed assets, trademarks and certain amortizable intangible assets totaling $18,627,000 and assumed liabilities of $1,987,000. The total purchase price of Sebago, Inc. was $16,886,000, which consisted of $14,886,000 paid in cash and a note payable for $2,000,000 ($1,000,000 paid in 2004 and $1,000,000 paid in 2005), resulting in goodwill of $246,000 after allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. The acquisition has been accounted for using the purchase method of accounting and, accordingly, the results of operations since November 3, 2003 are included in the Company's consolidated statements of operations. +21 +An independent valuation of the Sebago trademarks was performed as of the date of the acquisition, which totaled $4,904,000. Pursuant to SFAS No. 142, goodwill and indefinite-lived intangibles will not be amortized, but will be evaluated for impairment annually. Goodwill was assigned to the Company's branded footwear and licensing segment. The majority of the goodwill is expected to be deductible for tax purposes. The amortizable intangible assets have a weighted average useful life of approximately nine years. +The following table sets forth the unaudited pro forma information for the Company as if the Sebago acquisition had occurred as of the beginning of 2003 utilizing the Company's effective tax rate. The unaudited pro forma financial information is provided for informational purposes only and does not purport to be indicative of the Company's results of operations that would actually have been achieved had the acquisition been completed at the beginning of the periods presented or that may be achieved in the future. The unaudited pro forma financial information was derived from the annual financial statements of the acquired company and does not give effect to any operational synergies or integration costs that may occur as a result of or following the acquisition. +2003 +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +921,944 +Net earnings +53,460 +Basic earnings per share +$ +.91 +Diluted earnings per share +.87 +Immediately after the acquisition was consummated, management of the Company began to implement an integration plan for the Sebago acquisition. In conjunction with the integration plan, the Company recorded additional liabilities of $1,792,000, which were included in the acquisition cost allocation in accordance with Emerging Issues Task Force Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination . The additional liabilities include severance and related costs for approximately 100 manufacturing and administrative employees in Maine, and exit costs for specific product lines of Sebago, Inc. +The following table is a summary of the activity in the reserves by category: +Employee +Severance +Exit Costs +Total +(Thousands of Dollars) +Amounts recognized as charges in 2003 and accrued at +January 3, 2004 +$ +1,496 +$ +296 +$ +1,792 +Payments +(1,187 +) +(282 +) +(1,469 +) +Adjustments +(309 +) +- +(309 +) +Balance at January 1, 2005 +$ +- +$ +14 +$ +14 +Payments +- +(14 +) +(14 +) +Balance at December 31, 2005 +$ +- +$ +- +$ +- +22 +Report of Independent Registered Public Accounting Firm +The Board of Directors and Shareholders +Wolverine World Wide, Inc. +We have audited the accompanying consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of December 31, 2005 and January 1, 2005, and the related consolidated statements of stockholders' equity and comprehensive income, operations, and cash flows for each of the three fiscal years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Wolverine World Wide, Inc. and subsidiaries at December 31, 2005 and January 1, 2005, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Wolverine World Wide, Inc.'s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 16, 2006 expressed an unqualified opinion thereon. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +February 16, 2006 +23 +Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting +Board of Directors and Stockholders +Wolverine World Wide, Inc. +We have audited management's assessment, included in the accompanying management's report on internal control over financial reporting, that Wolverine World Wide, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Wolverine World Wide, Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, management's assessment that Wolverine World Wide, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Wolverine World Wide, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2005 consolidated financial statements of Wolverine World Wide, Inc. and our report dated February 16, 2006 expressed an unqualified opinion thereon. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +February 16, 2006 +24 +APPENDIX B +Schedule II - Valuation and Qualifying Accounts of Continuing Operations +Wolverine World Wide, Inc. and Subsidiaries +Column A +Column B +Column C +Column D +Column E +Additions +(1) +(2) +Description +Balance at +Beginning of +Period +Charged to +Costs and +Expenses +Charged to +Other +Accounts +(Describe) +Deductions +(Describe) +Balance at +End of +Period +Fiscal year ended December 31, 2005 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +4,834,000 +$ +1,706,000 +$ +1,884,000 +(A) +$ +4,656,000 +Allowance for sales returns +1,786,000 +28,405,000 +27,651,000 +(B) +2,540,000 +Allowance for cash discounts +1,580,000 +13,023,000 +13,070,000 +(C) +1,533,000 +Inventory valuation allowances +5,844,000 +10,941,000 +10,329,000 +(D) +6,456,000 +$ +14,044,000 +$ +54,075,000 +$ +52,934,000 +$ +15,185,000 +Fiscal year ended January 1, 2005 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +7,335,000 +$ +3,638,000 +$ +6,139,000 +(A) +$ +4,834,000 +Allowance for sales returns +1,997,000 +23,611,000 +23,822,000 +(B) +1,786,000 +Allowance for cash discounts +1,130,000 +13,539,000 +13,089,000 +(C) +1,580,000 +Inventory valuation allowances +6,355,000 +8,385,000 +8,896,000 +(D) +5,844,000 +$ +16,817,000 +$ +49,173,000 +$ +51,946,000 +$ +14,044,000 +Fiscal year ended January 3, 2004 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +7,387,000 +$ +4,962,000 +$ +5,014,000 +(A) +$ +7,335,000 +Allowance for sales returns +1,587,000 +26,610,000 +26,200,000 +(B) +1,997,000 +Allowance for cash discounts +1,217,000 +12,632,000 +12,719,000 +(C) +1,130,000 +Inventory valuation allowances +4,751,000 +12,011,000 +10,407,000 +(D) +6,355,000 +$ +14,942,000 +$ +56,215,000 +$ +54,340,000 +$ +16,817,000 +(A) Accounts charged off, net of recoveries. +(B) Actual customer returns. +(C) Discounts given to customers. +(D) Adjustment upon disposal of related inventories. +Commission File No. 001-6024 +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +EXHIBITS +TO +FORM 10-K +For the Fiscal Year Ended +December 31, 2005 +Wolverine World Wide, Inc. +9341 Courtland Drive +Rockford, Michigan 49351 +EXHIBIT INDEX +Exhibit +Number +Document +3.1 +Certificate of Incorporation, as amended. Previously filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the period ended March 26, 2005. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. +4.1 +Certificate of Incorporation, as amended. See Exhibit 3.1 above. +4.2 +Amended and Restated By-laws. See Exhibit 3.2 above. +4.3 +Rights Agreement dated as of April 17, 1997. Previously filed with the Company's Form 8-A filed April 12, 1997. Here incorporated by reference. +4.4 +Amendment No. 1 dated as of June 30, 2000, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +4.5 +Second Amendment dated as of February 11, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the period ended March 23, 2002. Here incorporated by reference. +4.6 +Third Amendment dated as of December 10, 2002, to the Rights Agreement dated as of April 17, 1997. Previously filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2002. Here incorporated by reference. +4.7 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. Previously filed as Exhibit 4.7 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. Here incorporated by reference. +4.8 +The Registrant has several classes of long-term debt instruments outstanding in addition to those described in Exhibits 4.7 and 4.9. The authorized amount of none of these classes of debt exceeds 10% of the Company's total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +4.9 +Credit Agreement dated as of July 22, 2005, among Wolverine World Wide, Inc. and certain of its subsidiaries, JPMorgan Chase Bank, N.A., as Administrative Agent, Harris, N.A., as Syndication Agent, Comerica Bank, Standard Federal Bank N.A. and National City Bank of the Midwest, as Documentation Agents, and certain other Banks that are parties to the Credit Agreement. Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated July 28, 2005. Here incorporated by reference. +10.1 +1988 Stock Option Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed July 21, 1988, Registration No. 33-23196. Here incorporated by reference. +i +10.2 +1993 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed June 22, 1993, Registration No. 33-64854. Here incorporated by reference. +10.3 +1995 Stock Incentive Plan.* Previously filed as an exhibit to the Company's registration statement on Form S-8, filed October 26, 1995, Registration No. 33-63689. Here incorporated by reference. +10.4 +1997 Stock Incentive Plan.* Previously filed as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2001. Here incorporated by reference. +10.5 +Stock Incentive Plan of 1999.* Previously filed as Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. Here incorporated by reference. +10.6 +Stock Incentive Plan of 2001.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 26, 2001. Here incorporated by reference. +10.7 +Stock Incentive Plan of 2003.* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 24, 2003. Here incorporated by reference. +10.8 +Stock Incentive Plan of 2005.* Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated April 25, 2005. Here incorporated by reference. +10.9 +Amended and Restated Directors' Stock Option Plan.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 14, 2003. Here incorporated by reference. +10.10 +Amended and Restated Directors Stock Option Plan.* Previously filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.11 +Amended and Restated Outside Directors' Deferred Compensation Plan.* Previously filed as Appendix E to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.12 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Appendix B to the Company's Definitive Proxy Statement with respect to the Company's Annual Meeting of Stockholders held on April 25, 2002. Here incorporated by reference. +10.13 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan) (Restated as amended through February 10, 2005).* +10.14 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 7, 2002. Here incorporated by reference. Here incorporated by reference. +ii +10.15 +Executive Severance Agreement.* Previously filed as Exhibit 10.14 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. An updated participant schedule of current executive officers who are parties to the agreement is attached as Exhibit 10.15. Here incorporated by reference. +10.16 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. Previously filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. Here incorporated by reference. +10.17 +Benefit Trust Agreement dated May 19, 1987, and Amendments Number 1, 2, 3 and 4 thereto.* Previously filed as Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. Here incorporated by reference. +10.18 +Amended and Restated Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2000. An updated participant schedule of current executive officers participating in the plan is attached as Exhibit 10.18. Here incorporated by reference. +10.19 +Employees' Pension Plan (Restated as amended through March 28, 2005).* +10.20 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.21 +Form of Non-Qualified Stock Option Agreement for Steven M. Duffy, Stephen L. Gulis, Blake W. Krueger and Timothy J. O'Donovan.* Previously filed as Exhibit 10.2 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.22 +Form of Non-Qualified Stock Option Agreement for employees other than those to whom Exhibit 10.21 applies.* Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.23 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.24 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.25 +Form of Non-Qualified Stock Option Agreement for Steven M. Duffy, Stephen L. Gulis, Blake W. Krueger and Timothy J. O'Donovan.* Previously filed as Exhibit 10.2 to the Company's Current Report of Form 8-K dated February 15, 2006. Here incorporated by reference. +10.26 +Form of Non-Qualified Stock Option Agreement for employees other than those to whom Exhibit 10.25 applies.* Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.27 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.28 +Form of Stock Option Agreement for non-employee directors.* Previously filed as Exhibit 10.23 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. Here incorporated by reference. +iii +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31.1 +Certification of President and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Executive Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +____________________________ +*Management contract or compensatory plan or arrangement. +iv \ No newline at end of file diff --git a/raw/filings/0000110471/2005/0000905729-06-000156/filing_metadata.csv b/raw/filings/0000110471/2005/0000905729-06-000156/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..789e6f884d3482419d5affa8b6e7fa61535fc63f --- /dev/null +++ b/raw/filings/0000110471/2005/0000905729-06-000156/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000110471,WWW,WOLVERINE WORLD WIDE INC /DE/,10-K,2006-03-15,2005-12-31,2006-03-15T19:41:53.000Z,0000905729-06-000156,www10k_031506.htm,WOLVERINE WORLD WIDE FORM 10-K (YE 12/31/05),1264810,0,0,https://www.sec.gov/Archives/edgar/data/110471/000090572906000156/www10k_031506.htm,https://www.sec.gov/Archives/edgar/data/110471/000090572906000156/,2005,2005,1 diff --git a/raw/filings/0000110471/2005/0000905729-06-000156/item1.txt b/raw/filings/0000110471/2005/0000905729-06-000156/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..f7b9d65046a0fc7b55dc4fc4267cd398de08de54 --- /dev/null +++ b/raw/filings/0000110471/2005/0000905729-06-000156/item1.txt @@ -0,0 +1,93 @@ +Item 1. Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear, and constructed slippers and moccasins. The Company, a Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +The Company sold approximately 44 million pairs of Company branded footwear during fiscal 2005, making the Company a global leader among footwear companies in the marketing of branded casual, work and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort and performance. The products are marketed throughout the world under widely recognized brand names, including Bates ® , CAT ® , Harley-Davidson ® , Hush Puppies ® , HyTest ® , Merrell ® , Sebago ®, Stanley ® and Wolverine ® and, beginning with the expected product launch in Spring 2007, Patagonia ® footwear. The Company believes that its primary competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary designs and comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. For 2005, the Company's footwear products were organized under five operating units: (i) the Wolverine Footwear Group, focusing on the Bates ®, HyTest ®, Stanley ® and Wolverine ® product lines of work, outdoor, uniform and lifestyle boots and shoes, (ii) the Outdoor Group, currently focusing on the Sebago ® and Merrell ® product lines of performance and lifestyle footwear, and, beginning with anticipated product launches in fiscal 2007, Merrell ® brand apparel and Patagonia ® brand footwear (iii) the Heritage Brands Group, focusing on the CAT ® product lines of work and lifestyle footwear and the Harley-Davidson ® lines of lifestyle and performance footwear, (iv) The Hush Puppies Company, focusing on the Hush Puppies ® brand of comfortable casual and dress footwear and slippers, and (v) Other Branded Footwear, focusing on the design and manufacture of private label footwear. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, gloves, handbags and plush toys. +The Company's Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support for the various Company brands. The Company's footwear is distributed domestically through 76 Company-owned retail stores and to numerous accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of the +3 +retailers to which Wolverine distributes operate multiple storefront locations. The Company's products are marketed worldwide in over 170 markets through licensees and distributors. +The Company, through its Wolverine Leathers Division, operates a tannery which is one of the premier tanners of quality pigskin leather for the shoe and leather goods industries. Pigskin leather tanned by the Company is used in a significant portion of the footwear marketed by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of footwear. In addition, Wolverine Procurement, Inc., a Company-owned subsidiary, performs skinning operations and purchases raw pigskins which it then cures and sells to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company and the notes thereto, which are attached as Appendix A to this Form 10-K. The Company has one reportable segment, Branded Footwear and Licensing. The Branded Footwear and Licensing segment is engaged in manufacturing, sourcing, licensing, marketing and distributing branded footwear, including casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes, work shoes and performance outdoor footwear. The Company's Other Business units consist of its retail stores, tannery and pigskin procurement operations. Financial information regarding the Company's business segments and financial information about geographic areas is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Form 10-K. +Branded Footwear and Licensing. +The Company sources and markets a broad range of footwear styles including shoes, boots, slippers, moccasins and sandals under many recognizable brand names including Bates ® , CAT ® , Harley-Davidson ® , Hush Puppies ® , HyTest ® , Merrell ® , Sebago ® , Stanley ® and Wolverine ® and, with the expected product launch in Spring 2007, Patagonia ® footwear. The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications at both Company-owned and independent manufacturing facilities. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, handbags and plush toys. Current significant licensing programs include Hush Puppies ® apparel, eyewear, watches and plush toys, and Wolverine ® brand apparel, gloves and eyewear. +The Company's five branded footwear and licensing operating units are described below. +1. The Outdoor Group . The Outdoor Group consists of Merrell ®, Sebago ®, and, with its expected launch in Spring 2007, Patagonia ® footwear and includes performance outdoor, hiking and nautical footwear as well as casual and after-sport footwear. +Merrell ® Footwear. The Merrell ® product line consists primarily of technical hiking, rugged outdoor and outdoor-inspired casual footwear designed for backpacking, day hiking and everyday use. The Merrell ® product line also includes the "After-Sport" category, incorporating Merrell ® footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers™ and other technical materials to create footwear with unique styling, performance and comfort features. In spring of 2005, the Outdoor Group launched its tightly-focused Merrell ® Continuum ® product offering, featuring four product categories that are organized by end use (Hiking, Active Speed, Multi-Sport, and Aqua Sport). In addition to footwear, the Outdoor Group markets a line of Merrell ® packs, bags and luggage. The Outdoor Group also intends to launch a line of Merrell ® brand apparel in fiscal 2007. Merrell ® products are sold primarily through outdoor +4 +specialty retailers, department stores and catalogs. Merrell ® footwear is marketed in over 125 countries worldwide. +Sebago ® Footwear. The Sebago ® product line consists primarily of performance nautical and American-inspired casual footwear for men and women such as boat shoes and handsewn loafers that have been manufactured and distributed since 1946. Highly recognized Sebago ® line extensions include Sebago Docksides ® , Drysides™ , Campsides™ and Athletic Marine. The Sebago ® product line is distributed in over 80 countries worldwide. The Sebago ® manufacturing and design tradition of quality componentry, durability, comfort and "Americana" heritage is further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. +Patagonia® Footwear. In 2005, the Company entered into a license agreement providing the Company with exclusive worldwide rights to manufacture, market, distribute and sell footwear under the Patagonia®, Water Girl® and other trademarks. The Outdoor Group anticipates the launch of its Patagonia® Footwear line for Spring 2007. +2. Wolverine Footwear Group . The Wolverine Footwear Group encompasses footwear primarily under the Wolverine ® , Bates ® , HyTest ® and Stanley ® brands and markets footwear designed with performance and comfort features to serve a variety of work, outdoor and lifestyle functions. +Wolverine ® Work and Industrial Footwear . The Wolverine ® brand has built its reputation by offering high quality work boots and shoes that incorporate innovative technologies to deliver comfort and durability. The Wolverine ® brand, which has been in existence for 123 years, markets work and outdoor footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® technology and, in 2004, Wolverine MultiShox™ technology, has allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The Wolverine Fusion ® , DuraShocks SR™ and Wolverine Compressor™ technologies represent the Company's tradition of comfortable work and industrial footwear, a tradition that is continued and enhanced with the development of the Wolverine MultiShox™ Individual Comfort System. The Wolverine ® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female industrial and farm workers. The Wolverine ® rugged casual and outdoor sport product lines incorporate DuraShocks ® technology and other comfort features into products designed for casual and outdoor sport use. The rugged casual line targets active lifestyles and includes trail shoes, rugged casuals and outdoor sandals. The outdoor sport line is designed to meet the demands of hunters, fishermen and other active outdoor sportsmen and women. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® and Thinsulate ® brand fabrics, the Company's performance leathers and patented DuraShocks ® technologies. In addition, the Wolverine ® brand is licensed for use on apparel, eyewear, watches and gloves. +Bates ® Uniform Footwear . The Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes DuraShocks ® , DuraShocks SR ™ , CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and +5 +oxfords including the Bates ®, Enforcer Series ® and Special Ops ™ footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and the militaries of several foreign countries to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial occupations. Bates Uniform Footwear Division's products are also distributed through specialty retailers and catalogs. +HyTest ® Safety Footwear . The HyTest ® product line consists primarily of high-quality work boots and shoes designed to protect male and female industrial workers from foot injuries. HyTest ® footwear incorporates various specialty safety features into its product lines, including steel toe, composite toe, metatarsal guards, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology to provide comfort together with safety for working men and women. HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company's occupational and work footwear brands to workers at industrial facilities and also through direct sales arrangements with large industrial customers. +Stanley ® Footgear . Pursuant to a license arrangement with The Stanley Works, the Company has exclusive rights to manufacture, market, distribute and sell footwear under the Stanley ® brand. The Stanley ® Footgear line is designed primarily for and marketed in the value-priced work footwear market. Stanley ® Footgear is currently sold in Payless ShoeSource, Inc. stores throughout the United States. +3. The Heritage Brands Group . The Heritage Brands Group consists of Caterpillar ® Footwear and Harley-Davidson ® Footwear . +Caterpillar ® Footwear. Pursuant to a license arrangement with Caterpillar Inc., the Company has exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ® , CAT & Design ® , Walking Machines ® and other trademarks. The Company believes the association with CAT ® equipment enhances the reputation of its footwear for quality, ruggedness and durability. CAT ® brand footwear products include work boots and shoes, sport boots, rugged casuals and lifestyle footwear, including lines of work and casual footwear featuring CAT ® iTechnology™ and Hidden Tracks ® comfort features. In addition, the Company also manufactures and markets CAT ® Marine Power ® footwear, designed for industrial and recreational marine uses. CAT ® footwear products target work and industrial users and active lifestyle users. CAT ® footwear is marketed in over 150 countries worldwide. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson ® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a network of independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. +4. The Hush Puppies Company . Since 1958, the Hush Puppies ® brand has been a leader in the casual footwear market. The brand offers shoes and boots for men, women and children, and is sold in over 120 countries. The modern styling is complemented by a variety of +6 +comfort features and proprietary technologies that have earned the brand its reputation for comfort. In addition, the Hush Puppies ® brand is licensed for use on apparel, eyewear, handbags and plush toys. +5. Other Branded Footwear . The Company designs and manufactures constructed slippers, aftersport footwear, moccasins and children's footwear on a private label basis according to customer specifications. The styling of the Company's footwear reflects consumer demand for the "rugged indoor" look by using natural leathers such as moosehide, shearling and suede in constructed slipper and indoor and outdoor moccasin designs. In addition to its traditional line of private label products, the Company has developed a College Clogs™ program for the sale of licensed collegiate slipper products. +Other Businesses. +In addition to manufacturing, sourcing, marketing and distributing the Company's footwear products as reported in the Branded Footwear and Licensing segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly-owned subsidiary Wolverine Procurement, Inc., and (iii) operates 76 domestic retail footwear stores. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces pigskin leathers primarily for use in the footwear industry. Wolverine Leathers® brand products are primarily manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes these leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof and stain resistant leathers are featured in many of the Company's domestic footwear lines and many products offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +3. Wolverine Retail . The Company operates 76 domestic retail shoe stores as of February 2006. These stores are under the Hush Puppies ®, Hush Puppies and Family SM , Track'N Trail® and Rockford Footwear Depot SM names. The Company expects to open new stores under both the Hush Puppies ® and Track'N Trail® formats in 2006. Both retail formats carry a large selection of Company branded footwear featuring such brands as Wolverine® , Merrell® , Hush Puppies® , CAT® , Sebago® and Harley-Davidson® . The Company also operates direct-to-customer retail websites, including www.upfootgear.com , www.trackandtrail.com , www.catfootwear.com , www.hushpuppies.com and www.sebago.com . +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States and international markets to foster a differentiated and consistent image for each of the Company's core footwear brands. Each footwear brand group has its own marketing personnel who develop the marketing strategy for products within that group. Marketing campaigns and strategies vary by brand and may target accounts and/or end users as they strive to +7 +increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's footwear. Components of the brand-specific plans vary and may include print, radio and television advertising, event sponsorships, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's footwear brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance that may be provided by the Company to its licensees and distributors are (i) direction on the categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting on retail store layout and design. The Company believes its footwear brand names provide a competitive advantage and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution. +The Company uses a wide variety of distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses the following distribution strategies. +• +Traditional wholesale distribution is used to service department stores, large footwear chains, specialty retailers, catalogs, independent retailers and uniform outlets. A dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide branded and private label footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchant and government customers. +• +A network of independent Shoemobile ® distribution outlets is used to distribute the Company's work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and enters bids for contracts to supply specific footwear products. Such contracts typically contain future purchase options that are not required to be exercised. +In addition to its wholesale activities, the Company also operates a domestic retail operation as described above. The Company continues to develop various programs, both independently and with its retail customers, for the distribution of its products. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's revenue in fiscal 2005. +The Company experiences moderate fluctuations in sales volume during the year as reflected in quarterly revenue (and taking into consideration the 16 weeks or 17 weeks included in the fourth accounting period versus the 12 weeks included in the first three accounting periods). The Company also experiences some fluctuation in its levels of working capital, typically including an increase in working capital requirements near the end of the third quarter. The Company provides working capital for such +8 +fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects current seasonal sales patterns to continue in future years. +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of sales of branded footwear products generated from the Company's owned operations in Canada, the United Kingdom, Austria, Finland, France, Germany, The Netherlands, Spain, Sweden and Switzerland and from royalty income through a network of independent licensees and distributors. The Company's owned operations include Hush Puppies (UK) Ltd., Merrell Europe B.V., Merrell (Europe) Limited, Wolverine Europe Limited and Wolverine World Wide Corporation, Inc. (formerly known as Hush Puppies Canada Footwear, Ltd.). In addition, in January 2005, the Company's Canadian subsidiary, Wolverine World Wide Corporation, Inc., purchased selected assets of the Canadian CAT and Wolverine footwear businesses from the Company's former independent distributor, Wolverine Canada, Inc.; and also acquired the assets of the Company's Merrell Canada division to centralize its Canadian operations. The Company also acquired selected assets of its Merrell distributors in Sweden and Finland and began direct distribution of Sebago ® brand products to retailers in the U.K. and Germany. The Company's owned operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of products (primarily Company footwear) bearing the Hush Puppies ® , Wolverine ® , Bates ® , HyTest ® , Merrell ®, Sebago ® and other trademarks by independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the CAT ® , and Harley-Davidson ® trademarks through foreign distributors. License and distribution arrangements enable the Company to develop sales in international markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent with the global brand position. Independent licensees and distributors purchase goods from either the Company or authorized third-party manufacturers pursuant to distribution agreements or manufacture branded products consistent with Company standards pursuant to license agreements. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and manufacture of approximately 77% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the pairs controlled by the Company, approximately 90% are purchased or sourced from third parties, with the remainder produced at Company-operated facilities. Footwear produced by the Company is manufactured at Company-operated facilities in several domestic and certain affiliated foreign facilities located in Michigan, Arkansas, and the Dominican Republic. For some of the Company-produced footwear, a "twin plant" concept is utilized whereby a majority of the labor intensive cutting and fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Dominican Republic and Arkansas, and the technology intensive construction, or "bottoming," is performed primarily at the Company's Michigan facilities. +The Company's factories each have the flexibility to produce a variety of footwear, which departs from the industry's historical practice of dedicating a given facility to production of specific footwear +9 +products. This flexibility allows the Company to quickly respond to changes in market preference and demand. The Company currently produces slippers, military footwear and work, casual and dress casual footwear in its owned facilities. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, Central and South America, India and Europe. The Company maintains technical offices in the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In addition, the Company has adopted "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +The Company's domestic manufacturing operations allow the Company to (i) reduce its production lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and (iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (i) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (ii) source the highest quality raw materials from around the world, and (iii) avoid additional capital expenditures necessary for owned factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company the flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates a pigskin tannery through its Wolverine Leathers Division, which is one of the premier tanners of quality leather for the footwear industry. The Company and its licensees receive virtually all of their pigskin leather requirements from the tannery. The Company believes the tannery provides a strategic advantage for the Company by producing pigskin leather using proprietary technology at prices below those available from other sources. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of common upper materials and specialty leathers eliminates any reliance by the Company upon a sole supplier. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over 30 years. Alternative sources of pigskin are available; however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas, tariffs and duties, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could have an adverse impact on the Company's operations and financial condition. +10 +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear products. The owned trademarks that are most widely used by the Company include Hush Puppies ® , Wolverine ® , Bates ® , Wolverine Fusion ® , DuraShocks ® , Wolverine MultiShox TM , Wolverine Compressor TM , Hidden Tracks ® , iTechnology TM , Bounce ® , Comfort Curve ® , HyTest ® , Merrell ® , Continuum ® , Sebago ® , and Track'N Trail ® . The Company has obtained license rights to manufacture, market and distribute footwear throughout the world under the CAT ® , Harley-Davidson ® and Patagonia ® trademarks, and the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark, all pursuant to license arrangements with the respective trademark owners. The CAT ®, Harley-Davidson ®, Patagonia ® and Stanley ® licenses are long-term and extend for five or more years with conditional renewal options and are subject to early termination for breach. Pigskin leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers ® , Wolverine Warrior Leather ® , Weather Tight ® and All Season Weather Leathers ™. +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of ownership of its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever possible and to vigorously defend its trademarks against infringement or other threats to the greatest extent practicable under the laws of the United States and other countries. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent practicable under applicable laws. +Order Backlog. +At March 11, 2006, the Company had an order backlog of approximately $357 million compared with an order backlog of approximately $318 million at March 12, 2005, determined on a basis consistent with the current year. Substantially all of the backlog relates to demand for products expected to be shipped in 2006. Orders in backlog are subject to cancellation by customers and to changes in planned customer demand or at-once orders. The backlog at a particular time is affected by a number of factors, including seasonality, retail conditions, expected customer demand, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments. +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States and Europe. The Company has at least ten major competitors in connection with the sale of its work shoes and boots, at least ten major competitors in connection with the sale of its sport boots, and at least thirty major competitors in connection with the sale of its casual, work and outdoor shoes. Product performance and quality, including technological improvements, product identity, competitive pricing and ability to control costs, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing and sourcing efficiencies, its tannery operations, and the style, comfort and +11 +value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and no one company has a dominant market position. +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to the development of new production techniques and to improving the function, performance, reliability and quality of its branded footwear and other products. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, such as Bounce ® , DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company uses and generates certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites and other regulatory issues. +Employees. +As of December 31, 2005, the Company had approximately 4,502 domestic and foreign production, office and sales employees. Approximately 614 employees were covered by three union contracts expiring at various dates through March 31, 2007. The Company presently considers its employee relations to be good. +Available Information. +Information about the Company, including the Company's Code of Conduct & Compliance, Corporate Governance Guidelines, Director Independence Standards, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, Executive Committee Charter and Governance Committee Charter, is available at its website, http://www.wolverineworldwide.com. Printed copies of the documents listed above are available by writing to the Company at 9341 Courtland Drive, N.E., Rockford, MI 49351, Attention: General Counsel. +The Company also makes available on or through its website, free of charge, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports (along with certain other Company filings with the Securities and Exchange Commission ("SEC")) as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These materials are also accessible on the SEC's website at www.sec.gov. +12 \ No newline at end of file diff --git a/raw/filings/0000110471/2005/0000905729-06-000156/item13.txt b/raw/filings/0000110471/2005/0000905729-06-000156/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..5057ba70d146c702ed450e064c489dfc031d7966 --- /dev/null +++ b/raw/filings/0000110471/2005/0000905729-06-000156/item13.txt @@ -0,0 +1,2 @@ +Item 13. Certain Relationships and Related Transactions . +The information contained under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 20, 2006, is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000110471/2005/0000905729-06-000156/item9a.txt b/raw/filings/0000110471/2005/0000905729-06-000156/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..6b865cc75bbdde056c91c3a66a8e5fda8a9a4cbf --- /dev/null +++ b/raw/filings/0000110471/2005/0000905729-06-000156/item9a.txt @@ -0,0 +1,9 @@ +Item 9A. Controls and Procedures . +Evaluation of Disclosure Controls and Procedures. +An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on and as of the time of such evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filings with the SEC. +Management's Report on Internal Control Over Financial Reporting. +Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2005, based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2005. +Management's assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their attestation report which is included in Appendix A and is incorporated into this Item 9A by reference. +Changes in Internal Control Over Financial Reporting. +There was no change in the Company's internal control over financial reporting that occurred during the sixteen-week period ended December 31, 2005 that has materially affected, or that is reasonably likely to materially affect, the Company's internal control over financial reporting. +36 \ No newline at end of file diff --git a/raw/filings/0000110471/2005/0000905729-06-000156/rp_note.txt b/raw/filings/0000110471/2005/0000905729-06-000156/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000110471/2005/0000905729-06-000156/rpt_disclosure.txt b/raw/filings/0000110471/2005/0000905729-06-000156/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..ce3a61c5fa592af76868569713819c8afdfd0074 --- /dev/null +++ b/raw/filings/0000110471/2005/0000905729-06-000156/rpt_disclosure.txt @@ -0,0 +1,64 @@ +related person transactions. Such policies and procedures +require the Governance Committee to review and either approve or +disapprove of entry into any Interested Transactions (defined +below). If advance approval of the Interested Transaction is not +feasible, then it must be considered and, if the Governance +Committee determines it to be appropriate, ratified at the +Governance Committee’s next meeting. +47 +An Interested Transaction is any transaction, arrangement or +relationship or series of similar transactions, arrangements or +relationships (including any indebtedness or guarantee of +indebtedness) in which (1) the aggregate amount involved +will or may be expected to exceed $100,000 in any calendar year, +(2) Wolverine is a participant, and (3) any Related +Person (defined below) has or will have a direct or indirect +interest (other than solely as a result of being a director or +less than ten percent beneficial owner of another entity). A +Related Person is, any (a) person who is or was at any +point during the last fiscal year for which Wolverine filed a +Form 10-K +and proxy statement, an executive officer, director or nominee +for election as a director, (b) greater than five percent +beneficial owner of Wolverine’s common stock, or +(c) immediate family member of any of the foregoing. +Immediate family member includes a person’s spouse, +parents, stepparents, children, stepchildren, siblings, mothers- +and +fathers-in-law, +sons- and +daughters-in-law, +and brothers- and +sisters-in-law +and anyone residing in such person’s home (other than a +tenant or employee). +In determining whether to approve or ratify an Interested +Transaction, the Governance Committee will take into account +whether the Interested Transaction is on terms no less favorable +than terms generally available to an unaffiliated third-party +under the same or similar circumstances, the extent of the +Related Person’s interest in the transaction and other +factors that it deems relevant. No director shall participate in +any discussion or approval of an Interested Transaction for +which he or she is a Related Person, except to provide all +material information to the Governance Committee. The following +Interested Transactions are pre-approved under the policies and +procedures: +• +any transaction with another company at which a Related +Person’s only relationship is as an employee, director or +beneficial owner of less than ten percent of that company’s +shares, if the aggregate amount involved does not exceed the +greater of $1,000,000, or two percent of that company’s +total revenues. +• +any charitable contribution by Wolverine to a charitable +organization where a Related Person is an employee, if the +aggregate amount involved does not exceed the lesser of +$100,000, or two percent of the charitable organization’s +total annual receipts. +Wolverine’s policies and procedures for related party +transactions were adopted in December 2006. All of the +transactions described above were previously considered by the +Governance Committee under Wolverine’s Director +Independence Standards. \ No newline at end of file diff --git a/raw/filings/0000110471/2007/0000905729-08-000096/filing.txt b/raw/filings/0000110471/2007/0000905729-08-000096/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..3b22f9deb925c6226c65f8cc39187eb5b25dbd4e --- /dev/null +++ b/raw/filings/0000110471/2007/0000905729-08-000096/filing.txt @@ -0,0 +1,3727 @@ +10-K +1 +www10k_022608.htm +WOLVERINE WORLD WIDE FORM 10-K - 02-26-08 +Wolverine World Wide Form 10-K - 02/26/08 +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +___________________ +FORM 10-K +[X] +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 29, 2007 +[ ] +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: 001-6024 +WOLVERINE WORLD WIDE, INC. +(Exact name of registrant as specified in its charter) +Delaware +(State or other jurisdiction of +incorporation or organization) +38-1185150 +(I.R.S. Employer Identification No.) +9341 Courtland Drive, Rockford, Michigan +(Address of principal executive offices) +49351 +(Zip Code) +Registrant's telephone number, including area code: (616) 866-5500 +Securities registered pursuant to Section 12(b) of the Securities Exchange Act: +Title of each class +Name of each exchange on which registered +Common Stock, $1 Par Value +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes +X +No +Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. +Yes +No +X +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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X +Indicate by check mark whether the registrant is a large accelerated filer (as defined in Exchange Act Rule 12b-2), an accelerated filer (as defined in Exchange Act Rule 12b-2), a non-accelerated filer, or a smaller reporting company (as defined in Exchange Act Rule 12b-2). +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 Exchange Act Rule 12b-2). +Yes +No +X +The aggregate market value of the registrant's voting stock held by non-affiliates of the registrant based on the closing price on the New York Stock Exchange on June 15, 2007, the last business day of the registrant's most recently completed second fiscal quarter: $1,469,385,282. +Number of shares outstanding of the registrant's Common Stock, $1 par value (excluding shares of treasury stock) as of February 22, 2008: 50,333,597. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the definitive proxy statement for the registrant's annual stockholders' meeting to be held April 17, 2008, are incorporated by reference into Part III of this report. +FORWARD-LOOKING STATEMENTS +This Report on Form 10-K contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the footwear business, worldwide economics and the Company itself. Statements, including without limitation, those related to: future revenue, earnings, margins, growth, cash flows, operating measurements, tax rates and tax benefits; expected economic returns; projected 2008 operating results and dividend rates; future share repurchase activity; the effect of new accounting rules and guidance; future strength of the Company; future brand positioning; seasonal sales patterns and capital requirements; ability to arrange adequate alternative sources of supply; the outcome of litigation; achievement of the Company vision; future pension expenses, contributions and costs; future marketing investments; the ability to successfully extend into new lines or categories of products, including Merrell ® Apparel and Patagonia ® Footwear; future growth or success in specific countries, categories or market sectors; liquidity; capital resources and market risk are forward-looking statements. In addition, words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "predicts," "projects," "should," "will," variations of such words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("Risk Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. +Risk Factors include, but are not limited to, uncertainties relating to changes in demand for the Company's products; changes in consumer preferences or spending patterns; the cost and availability of inventories, services, labor and equipment furnished to the Company; the cost and availability of contract manufacturers; the cost and availability of raw materials, including leather and petroleum based materials; changes in planned consumer demand or at-once orders; customer order cancellations; the impact of competition and pricing by the Company's competitors; changes in government and regulatory policies; foreign currency fluctuation in valuations compared to the U.S. dollar; changes in monetary controls and valuations of the Chinese yuan renminbi and the relative value to the U.S. dollar; changes in duty structures in countries of import and export; changes in interest rates, tax laws, duties, tariffs, quotas or applicable assessments; technological developments; changes in local, domestic or international economic and market conditions; the size and growth of footwear markets; service interruptions at shipping and receiving ports; changes in the amount or severity of inclement weather; changes due to the growth of Internet commerce; popularity of particular designs and categories of footwear; the ability of the Company to manage and forecast its growth and inventories; the ability to secure and protect trademarks, patents and other intellectual property; integration of operations of newly acquired businesses; changes in business strategy or development plans; the Company's ability to adapt and compete in global apparel and accessory markets; the success of new business initiatives, including Patagonia ® Footwear and Merrell ® Apparel; the ability to attract and retain qualified personnel; the ability to retain rights to brands licensed by the Company; loss of significant customers; relationships with international distributors and licensees; the Company's ability to meet at-once orders; the exercise of future purchase options by the U.S. Department of Defense on previously awarded contracts; the risk of doing business in developing countries and economically volatile areas; retail buying patterns; consolidation in the retail sector; and the acceptability of U.S. brands in international markets. Additionally, concerns regarding acts of terrorism, the war in Iraq and subsequent events have created significant global economic and political uncertainties that may have material and adverse effects on consumer demand, foreign sourcing of footwear, shipping and transportation, product imports and exports and the sale of products in foreign markets. These matters are representative of the Risk Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement. Historical operating results are not necessarily indicative of the results that may be expected in the future. The Risk Factors included here are not exhaustive. Other Risk +2 +Factors exist, and new Risk Factors emerge from time-to-time, that may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. Furthermore, the Company undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. +PART I +Item 1. +Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear. The Company, a Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Approximately 47.5 million pairs of Company branded footwear were sold during fiscal 2007, making the Company a global leader among footwear companies in the marketing of branded casual, work and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort and performance. The products are marketed throughout the world under widely recognized brand names, including Bates ®, Cat ® Footwear, Harley-Davidson ® Footwear, Hush Puppies ®, HyTest ®, Merrell ®, Patagonia ® Footwear, Sebago ® and Wolverine ®. The Company believes that its primary competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary designs and comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. Cat ® is a registered trademark of Caterpillar Inc., Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. and Patagonia ® is a registered trademark of Patagonia, Inc. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. The Company's footwear products are organized under four operating units: (i) the Wolverine Footwear Group, focusing primarily on the Bates ®, HyTest ® and Wolverine ® product lines of work, outdoor, uniform and lifestyle boots and shoes, and Wolverine ® brand apparel, (ii) the Outdoor Group, currently focusing on Patagonia ® and Merrell ® product lines of performance and lifestyle footwear, and Merrell ® brand apparel, (iii) the Heritage Brands Group, focusing on the Cat ® product lines of work and lifestyle footwear, the Harley-Davidson ® lines of lifestyle and performance footwear, and the Sebago ® lines of lifestyle and performance footwear, and (iv) The Hush Puppies Company, focusing on the Hush Puppies ® brand of comfortable casual and dress footwear. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, gloves, handbags and plush toys. +The Company's Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support for the various Company brands. The Company's footwear is distributed domestically through 90 Company-owned retail stores and to numerous accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of the retailers to which Wolverine distributes operate multiple storefront locations. The Company's products are marketed worldwide in nearly 200 countries and territories through Company-owned wholesale operations, licensees and distributors. +3 +The Company, through its Wolverine Leathers Division, operates a tannery which tans pigskin leather for the shoe and leather goods industries. A significant portion of the pigskin leather tanned by the Company is used in the footwear marketed by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of footwear. In addition, Wolverine Procurement, Inc., a Company-owned subsidiary, performs skinning operations and purchases raw pigskins which it then cures and sells to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company and the notes thereto, which are attached as Appendix A to this Form 10-K. The Company has one reportable segment, Branded Footwear and Licensing. The Branded Footwear and Licensing segment is engaged in manufacturing, sourcing, licensing, marketing and distributing branded footwear and apparel, including casual shoes and apparel, dress shoes, boots, uniform shoes, work shoes and rugged outdoor footwear and apparel. The Company's Other Business units consist of its retail stores, tannery and pigskin procurement operations. Financial information regarding the Company's business segments and financial information about geographic areas is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Form 10-K. +Branded Footwear, Apparel and Licensing. +The Company sources and markets a broad range of footwear styles including shoes, boots and sandals under many recognizable brand names including Bates ®, Cat ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Patagonia ®, Sebago ® and Wolverine ®. The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications at both Company-owned and independent manufacturing facilities. The Company also markets Merrell ® and Wolverine ® brand apparel and licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, handbags and plush toys. Current significant licensing programs include Hush Puppies ® apparel, eyewear, watches, socks, handbags and plush toys, and Wolverine ® brand gloves, eyewear, socks and headwear. +The Company's four branded apparel, footwear and licensing operating units are described below. +1. The Outdoor Group . The Outdoor Group consists of Merrell ® and Patagonia ® Footwear and Merrell ® Apparel. Outdoor Group products include performance outdoor and hiking footwear, casual and after-sport footwear and performance and casual Merrell ® Apparel. +Merrell ® Footwear. The Merrell ® footwear line consists primarily of technical hiking, rugged outdoor and outdoor-inspired casual footwear designed for backpacking, day hiking and everyday use. The Merrell ® footwear line also includes the "After-Sport" category, incorporating Merrell ® footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers ™ and other technical materials to create footwear with unique styling, performance and comfort features. Merrell ® footwear products are sold primarily through outdoor specialty retailers, department stores and catalogs. Merrell ® footwear is marketed in approximately 160 countries and territories worldwide. +Merrell ® Apparel. The Merrell ® Apparel line consists primarily of technical outdoor and outdoor-inspired casual apparel. In addition to Merrell ® Apparel, the Outdoor Group markets Merrell ® packs, bags and luggage. +4 +Patagonia® Footwear. In 2005, the Company entered into a license agreement providing the Company with exclusive worldwide rights to manufacture, market, distribute and sell footwear under the Patagonia ® , Water Girl ® and other trademarks. The Outdoor Group launched its Patagonia ® Footwear line in Spring 2007. +2. Wolverine Footwear Group . The Wolverine Footwear Group encompasses footwear primarily under the Wolverine ®, Bates ®, and HyTest ® brands and markets footwear designed with performance and comfort features to serve a variety of work, outdoor and lifestyle functions. The Wolverine Footwear Group also markets Wolverine ® brand apparel. +Wolverine ® Work and Industrial Footwear . The Wolverine ® brand has built its reputation by offering high quality work boots and shoes that incorporate innovative technologies to deliver comfort and durability. The Wolverine ® brand, which has been in existence for 125 years, markets work and outdoor footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® technology and MultiShox ® technology, has allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The Wolverine Fusion ®, DuraShocks SR ™ and Wolverine Compressor ® technologies represent the Company's tradition of comfortable work and industrial footwear, a tradition that is continued and enhanced with the development of the MultiShox ® Individual Comfort System and the new Contour Welt ™ product line. The Wolverine ® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female industrial and farm workers. The Wolverine ® rugged casual and outdoor sport product lines incorporate DuraShocks ® technology and other comfort features into products designed for casual and outdoor sport use. The rugged casual line targets active lifestyles and includes trail shoes, rugged casuals and outdoor sandals. The outdoor sport line is designed to meet the demands of hunters, fishermen and other active outdoor sportsmen and women. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® (a registered trademark of W.L. Gore & Associates, Inc.) and Thinsulate ® (a registered trademark of Minnesota Mining and Manufacturing Company) brand fabrics, the Company's performance leathers and patented DuraShocks ® technologies. +Wolverine ® Apparel and Licensing . The Wolverine Footwear Group markets a line of work and rugged casual Wolverine ® brand apparel. In addition, the Wolverine ® brand is licensed for use on eyewear, headwear, gloves and socks. +Bates ® Uniform Footwear . The Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes DuraShocks ®, DuraShocks SR ™, CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and oxfords including the Bates ®, Enforcer Series ® and Special Ops ™ footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and the militaries of several foreign countries to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial occupations. Bates Uniform Footwear Division's products are also distributed through specialty retailers and catalogs. +HyTest ® Safety Footwear . The HyTest ® product line consists primarily of high-quality work boots and shoes designed to protect industrial workers from foot injuries. HyTest ® footwear incorporates various specialty safety features into its product lines, +5 +including steel toe, composite toe, metatarsal guards, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology to provide comfort together with safety for working men and women. HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company's occupational and work footwear brands to workers at industrial facilities and also through direct sales arrangements with large industrial customers. +3. The Heritage Brands Group . The Heritage Brands Group consists of Caterpillar ® Footwear, Harley-Davidson ® Footwear and Sebago ® Footwear. Sebago ® Footwear was recently added to the Heritage Brands Group. +Caterpillar ® Footwear. Pursuant to a license arrangement with Caterpillar Inc., the Company has exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ®, Cat & Design ®, Walking Machines ® and other trademarks. The Company believes the association with Cat ® equipment enhances the reputation of its footwear for quality, ruggedness and durability. Cat ® brand footwear products include work boots and shoes, sport boots, rugged casuals and lifestyle footwear, including lines of work and casual footwear featuring iTechnology ™ and Hidden Tracks ® comfort features. In addition, the Company also manufactures and markets Cat ® Marine Power ® footwear, designed for industrial and recreational marine uses. Cat ® footwear products target work and industrial users and active lifestyle users. Cat ® footwear is marketed in approximately 135 countries and territories worldwide. Cat ®, Caterpillar ®, Cat & Design ®, Walking Machines ® and Marine Power ® are registered trademarks of Caterpillar Inc. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson ® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a network of independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. +Sebago® Footwear. The Sebago ® product line consists primarily of performance nautical and American-inspired casual footwear for men and women such as boat shoes and handsewn loafers that have been manufactured and distributed since 1946. Highly recognized Sebago ® line extensions include Sebago Docksides ®, Sebago Drysides ™, Sebago Campsides ™ and Athletic Marine. The Sebago ® product line is marketed in approximately 110 countries and territories worldwide. The Sebago ® manufacturing and design tradition of quality componentry, durability, comfort and "Americana" heritage is further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. +4. The Hush Puppies Company . Since 1958, the Hush Puppies ® brand has been a leader in the casual footwear market. The brand offers shoes and boots for men, women and children, and is marketed in approximately 130 countries and territories. The modern styling is complemented by a variety of comfort features and proprietary technologies that have earned the +6 +brand its reputation for comfort. In addition, the Hush Puppies ® brand is licensed for use on apparel, eyewear, handbags, socks, watches and plush toys. +Other Businesses. +In addition to manufacturing, sourcing, marketing and distributing the Company's footwear and apparel products as reported in the Branded Footwear and Licensing segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly-owned subsidiary Wolverine Procurement, Inc., and (iii) operates 90 domestic retail footwear stores. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces and markets pigskin leathers primarily for use in the footwear industry. Wolverine Leathers & Design ® brand products are primarily manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes pigskin leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof and stain resistant leathers are featured in some of the Company's domestic footwear lines and many products offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +3. Wolverine Retail . The Company operates 90 domestic retail shoe stores as of February 2008. These stores are under the Hush Puppies ®, Hush Puppies and Family SM , Track'N Trail ®, Rockford Footwear Depot ® and Merrell ® names. Both the Rockford Footwear Depot ® and Track'N Trail ® retail formats carry a large selection of Company branded footwear featuring such brands as Wolverine ®, Merrell ®, Hush Puppies ®, Cat ®, Patagonia ® , Sebago ® and Harley-Davidson ®. The Company also operates direct-to-customer retail websites, including www.upfootgear.com , www.trackandtrail.com , www.catfootwear.com , www.hushpuppies.com, www.sebago.com and www.merrell.com . +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States and international markets to foster a differentiated and consistent image for each of the Company's core brands. Each brand group has its own marketing personnel who develop the marketing strategy for products within that group. Marketing campaigns and strategies vary by brand and may target accounts and/or end users as they strive to increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's products. Components of the brand-specific plans vary and may include print, radio and television advertising, event sponsorships, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance that may be provided by the Company to its licensees and distributors are (i) direction on the +7 +categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation specifications, blueprints and packaging, (v) sales materials, and (vi) consulting on retail store layout and design. The Company believes its brand names provide a competitive advantage and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution. +The Company uses a wide variety of domestic distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses the following distribution strategies. +• +Traditional wholesale distribution is used to service department stores, large footwear chains, specialty retailers, catalogs, independent retailers and uniform outlets. A dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchant and government customers. +• +A network of independent Shoemobile ® distribution outlets is used to distribute the Company's work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and enters bids for contracts to supply specific footwear products. Such contracts typically contain future purchase options that are not required to be exercised. +In addition to its wholesale activities, the Company also operates a domestic retail operation as described above. The Company continues to develop various programs, both independently and with its retail customers, for the distribution of its products. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's revenue in fiscal 2007. +The Company experiences moderate fluctuations in sales volume during the year as reflected in quarterly revenue (and taking into consideration the 16 weeks or 17 weeks included in the fourth accounting period versus the 12 weeks included in the first three accounting periods). The Company also experiences some fluctuation in its levels of working capital, typically including an increase in working capital requirements near the end of the third quarter. The Company provides working capital for such fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects current seasonal sales patterns to continue in future years. +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of (i) sales of branded footwear products generated from the Company's owned operations in Canada, the United Kingdom, Austria, Finland, France, Germany, Italy, The Netherlands, Spain, Sweden and Switzerland and from sales to international distributors for certain markets and businesses, and (ii) from royalty income through a network of independent licensees and distributors. The Company's owned operations include Hush +8 +Puppies (UK) Ltd., Wolverine Europe B.V. (formerly known as Merrell Europe B.V.), Merrell (Europe) Limited, Wolverine Europe Limited and Wolverine World Wide Corporation, Inc. (formerly known as Hush Puppies Canada Footwear, Ltd.). The Company's owned operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of products (primarily Company footwear) bearing the Hush Puppies ®, Wolverine ®, Bates ®, Merrell ®, Sebago ® and other trademarks by independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the Cat ® and Harley-Davidson ® trademarks through foreign distributors. License and distribution arrangements enable the Company to develop sales in international markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent with the global brand position. Independent licensees and distributors purchase goods from either the Company or authorized third-party manufacturers pursuant to distribution agreements or manufacture branded products consistent with Company standards pursuant to license agreements. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and/or manufacture of approximately 73% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the pairs purchased by the Company, approximately 89% are purchased or sourced from third parties, with the remainder produced at Company-operated facilities. Footwear produced by the Company is manufactured at Company-operated facilities in several domestic and certain affiliated foreign facilities located in Michigan, Arkansas, and the Dominican Republic. For some of the Company-produced footwear, a "twin plant" concept is utilized whereby a majority of the labor intensive cutting and fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Dominican Republic and Arkansas, and the technology intensive construction, or "bottoming," is performed primarily at the Company's Michigan facilities. +The Company's factories each have the flexibility to produce a variety of footwear, which departs from the industry's historical practice of dedicating a given facility to production of specific footwear products. This flexibility allows the Company to quickly respond to changes in market preference and demand. The Company currently produces military footwear and work, casual and dress casual footwear in its owned facilities. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, South America and India. The Company maintains technical offices in the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In addition, the Company has adopted "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +9 +The Company's owned manufacturing operations allow the Company to (i) reduce its production lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and (iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (a) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (b) source the highest quality raw materials from around the world, and (c) avoid additional capital expenditures necessary for owned factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company the flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates a pigskin tannery through its Wolverine Leathers Division. The Company and its licensees receive a majority of their pigskin leather requirements from the tannery. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of common upper materials and specialty leathers eliminates any reliance by the Company upon a sole supplier. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over 30 years. Alternative sources of pigskin are available; however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas, tariffs and duties, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could have an adverse impact on the Company's operations and financial condition. +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear and apparel products. The owned trademarks that are most widely used by the Company include Hush Puppies ®, Wolverine ®, Bates ®, Wolverine Fusion ®, DuraShocks ®, MultiShox ®, Wolverine Compressor ®, Hidden Tracks ®, iTechnology TM , Bounce ®, Comfort Curve ®, HyTest ®, Merrell ®, Continuum ®, Sebago ®, Q-Form ® and Track 'N Trail ®. Pigskin leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers & Design ®, Wolverine Warrior Leather ®, Weather Tight ® and All Season Weather Leathers ™. The Company has obtained license rights to manufacture, market and distribute footwear throughout the world under the Cat ®, Harley-Davidson ® and Patagonia ® trademarks, and the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark, all pursuant to license arrangements with the respective trademark owners. The Company's license agreement for Stanley ® footgear will terminate effective June 30, 2008. The Cat ® footwear license has a current term extending through December 2011. The Harley-Davidson ® footwear license is long term and extends for more than five years. The Patagonia ® Footwear license extends for more than five years and also includes conditional renewal options. All of these license agreements are subject to early termination provisions. +10 +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of ownership of its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever practicable and to vigorously defend its trademarks against infringement or other threats. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company vigorously protects its proprietary rights under applicable laws. +Order Backlog. +At February 16, 2008, the Company had an order backlog of approximately $389 million compared with an order backlog of approximately $354 million at February 17, 2007, determined on a basis consistent with the current year. Substantially all of the backlog relates to demand for products expected to be shipped in 2008. Orders in backlog are subject to cancellation by customers and to changes in planned customer demand or at-once orders. The backlog at a particular time is affected by a number of factors, including seasonality, retail conditions, expected customer demand, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments. +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States and Europe. The Company has at least thirty major competitors in connection with the sale of its casual, work and outdoor footwear. Product performance and quality, including technological improvements, product identity, competitive pricing and ability to control costs, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing and sourcing efficiencies, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and no one company has a dominant market position. +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to the development of new production techniques and to improving the function, performance, reliability and quality of its branded footwear and other products. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, such as Bounce ®, DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. +11 +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company uses and generates certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites and other regulatory issues. +Employees. +As of December 29, 2007, the Company had approximately 4,651 domestic and foreign production, office and sales employees. Approximately 667 employees were covered by four union contracts expiring at various dates through April 30, 2009. The Company presently considers its employee relations to be good. +Available Information. +Information about the Company, including the Company's Code of Conduct & Compliance, Corporate Governance Guidelines, Director Independence Standards, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, and Governance Committee Charter, is available at its website, www.wolverineworldwide.com. Printed copies of the documents listed above are available, without charge, by writing to the Company at 9341 Courtland Drive, N.E., Rockford, Michigan 49351, Attention: General Counsel. +The Company also makes available on or through its website, free of charge, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports (along with certain other Company filings with the Securities and Exchange Commission ("SEC")) as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These materials are also accessible on the SEC's website at www.sec.gov. +Item 1A. +Risk Factors . +Impact of Consumer Spending Patterns. +The success of the Company's operations depends to a significant extent upon a number of factors affecting disposable consumer income, both domestic and foreign, including economic conditions and factors such as employment, business conditions, interest rates and taxation. In addition, consumer spending patterns may be affected by changes in the amount or severity of inclement weather, the acceptability of U.S. brands in international markets and the growth or decline of global footwear markets. The Company's business, results of operations and financial condition may be adversely affected by changes in consumer spending or economic conditions. +Competition and Changes in Consumer Preferences. +The Company competes with numerous other marketers of footwear, some of which are larger and have greater resources than the Company. Product performance and quality, including technological +12 +improvements, product identity, competitive pricing and the ability to adapt to style changes are all important elements of competition in the footwear industry. The footwear industry in general is subject to changes in consumer preferences with respect to the popularity of particular designs and categories of footwear. The Company strives to maintain and improve its competitive position through promotion of brand awareness, sourcing efficiencies, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. If the Company is unable to respond effectively to competitive pressures and changes in consumer spending, the Company's business, results of operations and financial condition will be adversely affected. +Inventory Management. +The Company's ability to manage its inventories properly is an important factor in its operations. Inventory shortages can impede the Company's ability to meet at-once orders and can adversely affect the timing of shipments to customers and diminish brand loyalty. Conversely, excess inventories can result in increased interest costs as well as lower gross margins due to the necessity of lowering prices in order to liquidate excess inventories. If the Company is unable to effectively manage its inventory, its business, results of operations and financial condition will be adversely affected. +Dependence on Foreign Manufacturers. +The Company currently sources most of its footwear from third party manufacturers in foreign countries, predominantly China. As is common in the industry, the Company does not have long-term contracts with its foreign footwear manufacturers. The Company is a major customer of many of the third party manufacturers from which it sources products. There can be no assurance, however, that the Company will not experience difficulties with such manufacturers, including reduction in the availability of production capacity, failure to meet production deadlines or increases in manufacturing costs. The Company's future results will depend partly on its ability to maintain positive working relationships with its third party manufacturers. +Foreign manufacturing is subject to a number of risks, including work stoppages, transportation delays and interruptions, political instability, foreign currency fluctuations, changing economic conditions, expropriation, nationalization, the imposition of tariffs, import and export controls and other non-tariff barriers and changes in governmental policies. The possibility exists that trade relations with China and other countries where the Company sources its products will worsen or that China will shift its manufacturing capacity away from footwear to other industries. Any of these events could have an adverse effect on the Company's business, results of operations and financial condition. +Changes in monetary controls and valuations of the Chinese yuan renminbi and the currencies of other countries from which the Company sources, and their relative value to the U.S. Dollar could have an adverse effect on the Company's business, results of operations and financial condition. +The Company cannot predict whether additional United States or foreign customs quotas, duties, taxes or other changes or restrictions will be imposed upon the importation of non-domestically produced products in the future or what effect such actions could have on the Company's business, financial condition or results of operations. +13 +Suppliers and Service Providers. +The Company's ability to competitively price its products depends on the cost of footwear components, services, labor, equipment and raw materials, including leather and materials used in the production of outsoles. The cost of services and materials is subject to change based on the availability and market conditions that are difficult to predict. Conditions such as diseases affecting the availability of leather affect the cost of the footwear marketed by the Company. In addition, the Company's shipping costs are affected by fuel prices and numerous other factors such as the possibility of service interruptions at shipping and receiving ports. +The Company purchases pigskins for its tannery operations from a single domestic source pursuant to short-term contracts. Although this source has been a reliable and consistent supplier for over 30 years, there are no assurances that it will continue as a supplier. Failure of this source to continue to supply the Company with pigskin or to supply the Company with pigskin on less favorable terms could have a negative impact on the Company's business, results of operations and financial condition. +Customers. +The Company's financial success is directly related to the willingness of its customers to continue to purchase its products. The Company does not typically have long-term contracts with its customers. Sales to the Company's customers are generally on an order-by-order basis and are subject to rights of cancellation and rescheduling by the customers. Failure to fill customers' orders in a timely manner could harm the Company's relationships with its customers. Furthermore, if any of the Company's major customers experience a significant downturn in its business, or fails to remain committed to the Company's products or brands, then these customers may reduce or discontinue purchases from the Company, which could have an adverse effect on the Company's business, results of operations and financial condition. +The Company sells its products to wholesale customers and extends credit based on an evaluation of each customer's financial condition, usually without requiring collateral. The financial difficulties of a customer could cause the Company to stop doing business with that customer or reduce its business with that customer. The Company's inability to collect from its customers or a cessation or reduction of sales to certain customers because of credit concerns could have an adverse effect on the Company's business, results of operations and financial condition. +The recent trend toward consolidation in the retail industry could lead to customers seeking more favorable terms of purchase from the Company and could lead to a decrease in the number of stores that carry the Company's products. +The Company has been awarded a number of U.S. Department of Defense contracts that include future purchase options for Bates ® footwear. Failure to exercise these purchase options by the Department of Defense or the failure of the Company to secure future U.S. Department of Defense contracts could have an adverse effect on the Company's business, results of operations and financial condition. +The Company's products are sold in many international markets through independent licensees or distributors. Failure by the Company's licensees or distributors to meet planned annual sales goals could have an adverse effect on the Company's business, results of operations and financial condition, and it may be difficult and costly to locate an acceptable substitute distributor or licensee. If a change in distributors becomes necessary, the Company may experience increased costs, as well as substantial disruption and a resulting loss of sales and brand equity in that market. +14 +In addition, changes in the channels of distribution such as the growth of Internet commerce and the trend toward the sale of private label products by major retailers could have an adverse effect on the Company's business, results of operations and financial condition. +Implementation of Growth Strategy. +As part of its growth strategy, the Company seeks to enhance the positioning of its brands and to extend its brands into complementary product categories and consumer groups, to expand geographically, and to improve operational performance. There can be no assurance that we will be able to successfully implement any or all of these growth strategies, which could have an adverse effect on the Company's business, results of operations and financial condition. There is no assurance that the Patagonia ® Footwear initiative and the Company's expansion into apparel will be successful. The Company has invested substantial resources into these two product launches and the failure of either or both could have an adverse effect on the Company's business, results of operations and financial condition. +Reputational Risks. +The Company requires its independent contract manufacturers, distributors, licensees and others with which it does business to comply with the Company's standards relating to working conditions and other matters. If a party with which the Company does business is found to have violated the Company's standards, the Company could receive negative publicity that could damage its reputation and negatively affect the value of its brands. +Information Technology. +The Company's technology systems are critical to the operations of its business. Any interruption, impairment or loss of data integrity or malfunction of these systems could severely impact the Company's business, including delays in product fulfillment and reduced efficiency in operations. In addition, costs and potential problems and interruptions associated with the implementation of new or upgraded systems or with maintenance or adequate support of existing systems could also disrupt or reduce the efficiency of our operations. +Government/Regulation. +The Company's business is affected by changes in government and regulatory policies in the United States and on a global basis. Changes in interest rates, tax laws, duties, tariffs and quotas could have a negative impact on the Company's ability to produce and market footwear at competitive prices. +Global Political and Economic Uncertainty. +Concerns regarding acts of terrorism, the war in Iraq and subsequent events have created significant global economic and political uncertainties that may have material and adverse effects on consumer demand, foreign sourcing of footwear, shipping and transportation, product imports and exports and the sale of products in foreign markets. The Company is subject to risks in doing business in developing countries and economically volatile areas. +Currency. +Foreign currency fluctuation in valuations compared to the U.S. Dollar, changes in monetary controls and valuations, and the relative value to the U.S. dollar affect the Company's profitability. For a +15 +more detailed discussion of risk relating to foreign currency fluctuation, see Item 7A, Quantitative and Qualitative Disclosures About Market Risk. +Protection of Intellectual Property; Continuation of Licensing Agreements. +The Company invests significant resources to develop and protect its intellectual property. The Company's ability to remain competitive is dependent upon its continued ability to secure and protect trademarks, patents and other intellectual property rights. In addition, some of the Company's branded footwear operations are operated pursuant to licensing agreements with third party trademark owners. These agreements are subject to early termination for breach. Expiration or early termination of any of these license agreements by the licensor could have a material adverse effect on the Company's business, results of operations and financial condition. +Integration of Newly Acquired Businesses. +The Company may make strategic acquisitions in the future and cannot assure that it will be able to successfully integrate the operations of newly-acquired businesses into the Company's current operations. The failure to integrate newly acquired businesses or the inability to make suitable strategic acquisitions in the future could have an adverse effect on the Company's business, results of operations and financial condition. +Litigation and Regulatory Proceedings. +The Company is a defendant from time to time in lawsuits and regulatory actions relating to its business. Due to the inherent uncertainties of litigation and regulatory proceedings, the Company cannot accurately predict the ultimate outcome of any such proceedings. An unfavorable outcome could have an adverse impact on the Company's business, financial condition and results of operations. In addition, regardless of the outcome of any litigation or regulatory proceedings, such proceedings are expensive and may require that the Company devote substantial resources and executive time to defend the Company. +Anti-Takeover Provisions. +Provisions of the Company's certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay or prevent a merger, acquisition or other change in control of the Company. These provisions are intended to protect stockholders' interests by providing the Board of Directors a means to attempt to deny coercive takeover attempts or to negotiate with a potential acquirer in order to obtain more favorable terms. Such provisions include a board of directors that is classified so that only one-third of directors stand for election each year. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors and take other corporate actions. +Attraction and Retention of Qualified Personnel. +The Company is dependent on the efforts and abilities of its senior executive officers. While the Company believes that its senior management team has significant depth and that appropriate senior management succession plans are in place, the loss of one or more members of senior executive management or the failure to successfully implement succession planning could have an adverse effect on the Company, its results of operations and financial condition. The Company's future success also depends on its ability to identify, attract and retain additional qualified personnel. While the Company has historically been successful in attracting and retaining key employees, competition for such employees in +16 +the footwear industry is intense and failure to retain or attract key employees could adversely impact the Company. +Item 1B. +Unresolved Staff Comments . +None. +Item 2. +Properties . +The Company operates its domestic administration, sales and marketing operations primarily from an owned facility of approximately 225,000 square feet in Rockford, Michigan. The Company's manufacturing and tanning operations are primarily conducted at a combination of leased and owned facilities in Arkansas, Michigan and the Dominican Republic. The Company operates its warehousing operations primarily through owned warehouses in Rockford, Michigan, totaling approximately 475,000 square feet, a leased warehouse in Cedar Springs, Michigan, of approximately 356,000 square feet and a leased warehouse in Howard City, Michigan, of approximately 460,000 square feet. +The Company also leases and owns various other offices and warehouses in the United States to meet its operational requirements. In addition, the Company's subsidiary, Hush Puppies Retail, Inc., operates retail stores through leases with various third-party landlords. International operations are conducted in Canada, the United Kingdom, and Europe through leased warehouses, offices and showrooms. The Company believes that its current facilities are suitable and adequate for its current needs. +Item 3. +Legal Proceedings . +The Company is involved in litigation and various legal matters arising in the normal course of business, including certain environmental compliance activities. The Company has considered facts related to legal and regulatory matters and opinions of counsel handling these matters, and does not believe the ultimate resolution of such proceedings will have a material adverse effect on the Company's financial condition or future results of operations. +Item 4. +Submission of Matters to a Vote of Security Holders . +No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report. +Supplemental Item. Executive Officers of the Registrant . +The following table lists the names and ages of the Executive Officers of the Company and the positions presently held with the Company. The information provided below the table lists the business experience of each such Executive Officer during the past five years. All Executive Officers serve at the pleasure of the Board of Directors of the Company, or if not appointed by the Board of Directors, they serve at the pleasure of management. +17 +Name +Age +Positions held with the Company +Kenneth A. Grady +51 +General Counsel and Secretary +Stephen L. Gulis, Jr. +50 +Executive Vice President, Chief Financial Officer and Treasurer +Blake W. Krueger +54 +Chief Executive Officer and President +Pamela L. Linton +58 +Senior Vice President of Human Resources +Nicholas P. Ottenwess +45 +Vice President of Finance and Corporate Controller +James D. Zwiers +40 +Senior Vice President +Kenneth A. Grady has served the Company as General Counsel and Secretary since October 2006. During 2006, he was President and shareholder of the law firm K.A. Grady PC. During 2005, he served as Vice President, General Counsel and Secretary of PC Connection, Inc., a direct marketer of information technology products and solutions. From 2004 to 2005, Mr. Grady served as Executive Vice President of Administration, General Counsel and Secretary of KB Toys, Inc., a specialty toy retailer. From 2001 to 2004, he served as Vice President, General Counsel and Secretary of KB Toys, Inc. +Stephen L. Gulis, Jr., has served the Company as Executive Vice President, Chief Financial Officer and Treasurer since April 1996. Mr. Gulis will be taking on the role of Executive Vice President and President of the Company's Global Operations Group upon the appointment and integration of a new Chief Financial Officer. From 1994 to April 1996 he served as Vice President and Chief Financial Officer. From 1993 to 1994 he served as Vice President of Finance and Corporate Controller and from 1986 to 1993 he was the Vice President of Administration and Controller for The Hush Puppies Company. +Blake W. Krueger has served the Company as Chief Executive Officer and President since April 2007. From October 2005 to April 2007 he served as Chief Operating Officer and President. From August 2004 to October 2005, he served as Executive Vice President and Secretary of the Company and President of the Heritage Brands Group. From November 2003 to August 2004 he served the Company as Executive Vice President, Secretary, and President of Caterpillar Footwear. From April 1996 to November 2003 he served the Company as Executive Vice President, General Counsel and Secretary. From 1993 to April 1996 he served as General Counsel and Secretary. From 1985 to 1996 he was a partner with the law firm of Warner Norcross & Judd LLP. +Pamela L. Linton has served the Company as Senior Vice President of Human Resources since December 2007. From 2005 to 2007 she was an independent consultant. From 2001 to 2005 she was Senior Vice President, Global Human Resources of American Greetings Corporation, a greeting card and gift wrap company. +Nicholas P. Ottenwess has served the Company as Vice President of Finance and Corporate Controller since June 2001. Mr. Ottenwess will be taking on the new role of Senior Vice President - Operations of the Outdoor Group in early 2008. From September 1997 to June 2001 he served as Corporate Controller. From 1993 to September 1997 he served as Vice President of Finance and Administration for The Hush Puppies Company. +James D. Zwiers has served the Company as Senior Vice President since January 2008. From October 2006 to December 2007 he served as President of the Company's Hush Puppies U.S. Division. From October 2005 to October 2006 he served as the Company's General Counsel and Secretary. From December 2003 to October 2005 he served as General Counsel and Assistant Secretary. From January +18 +1998 to December 2003 he served the Company as Associate General Counsel and Assistant Secretary. From 1995 to 1998 he was an attorney with the law firm of Warner Norcross & Judd LLP. +PART II +Item 5. +Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities . +The Company's common stock is traded on the New York Stock Exchange under the symbol "WWW." The following table shows the high and low stock prices on the New York Stock Exchange and dividends declared by calendar quarter for 2007 and 2006. The number of stockholders of record on February 22, 2008, was 1,301. +2007 +2006 +Stock Price +High +Low +High +Low +First quarter +$ +31.08 +$ +26.78 +$ +24.21 +$ +20.96 +Second quarter +30.80 +27.30 +25.18 +20.26 +Third quarter +29.22 +24.55 +26.46 +22.27 +Fourth quarter +29.60 +23.38 +30.20 +25.41 +Cash Dividends Declared Per Share +2007 +2006 +First quarter +$ +.09 +$ +.075 +Second quarter +.09 +.075 +Third quarter +.09 +.075 +Fourth quarter +.09 +.075 +A quarterly dividend of $.11 per share was declared during the first quarter of fiscal 2008. +See Item 12 for information with respect to the Company's equity compensation plans. +19 +Stock Performance Graph +The following graph compares the cumulative total stockholder return on Wolverine common stock to the Standard & Poor's Small Cap 600 Index and the Standard & Poor's 600 Footwear Index, assuming an investment of $100.00 at the beginning of the period indicated. Wolverine is part of the Standard & Poor's Small Cap 600 Index and the Standard & Poor's Footwear Index. This Stock Performance Graph shall not be deemed to be incorporated by reference into the Company's SEC filings and shall not constitute soliciting material or otherwise be considered filed under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended. +20 +The following table relates information regarding the Company's purchases of its own common stock during the fourth quarter of fiscal 2007: +Issuer Purchases of Equity Securities +Period +Total +Number of +Shares +Purchased +Average +Price Paid +per Share +Total Number +of Shares +Purchased +as Part of +Publicly +Announced +Plans or +Programs +Maximum +Number +of Shares that +May Yet +Be Purchased +Under the Plans +or Programs +Period 1 (September 9, 2007 to October 6, 2007) +Common Stock Repurchase Program (1) +-- +$ +-- +-- +4,646,282 +Employee Transactions (2) +-- +-- +N/A +N/A +Period 2 (October 7, 2007 to November 3, 2007) +Common Stock Repurchase Program (1) +802,817 +$ +25.51 +802,817 +3,843,465 +Employee Transactions (2) +-- +-- +N/A +N/A +Period 3 (November 4, 2007 to December 1, 2007) +Common Stock Repurchase Program (1) +393,000 +$ +24.61 +393,000 +3,450,465 +Employee Transactions (2) +-- +-- +N/A +N/A +Period 4 (December 2, 2007 to December 29, 2007) +Common Stock Repurchase Program (1) +-- +-- +-- +3,450,465 +Employee Transactions (2) +225 +$ +25.80 +N/A +N/A +Total for Fourth Quarter ended December 29, 2007 +Common Stock Repurchase Program (1) +1,195,817 +$ +25.21 +1,195,817 +3,450,465 +Employee Transactions (2) +225 +25.80 +N/A +N/A +(1) +The Company's Board of Directors approved common stock repurchase programs on December 13, 2005 and April 19, 2007. These programs authorize the repurchase of 3.0 million and 7.0 million shares of common stock over a 24-month and 36-month period, respectively, commencing on the effective date of the program. All shares repurchased during the period covered by this report were purchased under publicly announced programs. +(2) +Employee transactions include: (1) shares delivered or attested in satisfaction of the exercise price and/or tax withholding obligations by holders of employee stock options who exercised options, and (2) restricted shares withheld to offset tax withholding that occurs upon vesting of restricted shares. The Company's employee stock compensation plans currently provide that the value of the shares delivered or attested to, or withheld, shall be the closing price of the Company's common stock on the date the relevant transaction occurs. +21 +Item 6. +Selected Financial Data . +Five-Year Operating and Financial Summary (1) +2007 +2006 +2005 +2004 +2003 +(Thousands of Dollars, Except Per Share Data) +Summary of Operations +Revenue +$ +1,198,972 +$ +1,141,887 +$ +1,060,999 +$ +991,909 +$ +888,926 +Net earnings +92,886 +83,647 +74,467 +65,938 +51,716 +Per share of common stock: +Basic net earnings (2)(3) +$ +1.77 +$ +1.52 +$ +1.33 +$ +1.15 +$ +.88 +Diluted net earnings (2)(3) +1.70 +1.47 +1.27 +1.09 +.85 +Cash dividends declared (2) +.36 +.30 +.26 +.19 +.15 +Financial Position at Year End +Total assets +$ +638,378 +$ +671,092 +$ +626,580 +$ +639,571 +$ +593,762 +Long-term debt +10,731 +21,471 +32,411 +43,904 +59,923 +Notes to Five-Year Operating and Financial Summary +(1) +This summary should be read in conjunction with the consolidated financial statements and the notes thereto, which are attached as Appendix A to this Form 10-K. +(2) +On December 15, 2004, the Company announced a three-for-two stock split in the form of a stock dividend on shares of common stock outstanding at January 3, 2005 that was distributed to stockholders on February 1, 2005. All per share data has been retroactively adjusted for the increased shares resulting from this stock split. Treasury shares were excluded from the stock split. +(3) +Basic earnings per share are based on the weighted average number of shares of common stock outstanding during the year after adjustment for nonvested restricted common stock. Diluted earnings per share assume the exercise of dilutive stock options and the vesting of all outstanding restricted stock. +Item 7. +Management's Discussion and Analysis of Financial Condition and Results of Operations . +OVERVIEW +Wolverine World Wide, Inc. (the "Company") continues to evolve from a leading global marketer of branded footwear into a global multi-branded footwear and apparel company. The Company's goal is articulated in its strategic vision - "To Excite Consumers Around the World with Innovative Footwear and Apparel that Bring Style to Purpose." The Company intends to achieve this goal by extending key brands beyond footwear, strengthening the global brand portfolio, pursuing product excellence, leveraging global supply chain management and managing its brands' presence at retail. The Company is focused on delivering its long-term financial objectives of mid-to-upper single digit average annual revenue growth, annual double digit earnings per share increases, improved asset utilization and strong cash generation. +The following financial performance highlights of 2007 are a result of the execution of these strategies: +• +Eighth consecutive year of revenue growth with revenue increasing 5.0% to an all-time record level of $1.199 billion +• +Earnings per share achieved an all-time record level of $1.70 per share, an increase of 15.6% over the $1.47 reported in the prior year, which marks the fifth consecutive year of double-digit growth +• +Accounts receivable increased 17.9% resulting from the timing of deliveries to large international customers and increased shipments +22 +• +Inventory decreased 10.0% primarily due to the successful execution of inventory reduction programs +• +Cash provided from operating activities for 2007 reached $123.3 million, marking the fifth consecutive year of cash generation in excess of $100.0 million +• +The Company's cash position remained strong at the end of 2007 with $76.1 million of cash on hand and debt outstanding of $10.7 million +• +New business initiatives were implemented as Patagonia ® Footwear and Wolverine ® Apparel completed their first full year of business in 2007 and Merrell ® Apparel was launched in the second half of the year +The following is a discussion of the Company's results of operations and liquidity and capital resources. This section should be read in conjunction with the consolidated financial statements and notes. All share and per share amounts in Management's Discussion and Analysis of Financial Condition and Results of Operations have been adjusted for all periods to reflect the three-for-two stock split distributed on February 1, 2005. +RESULTS OF OPERATIONS - FISCAL 2007 COMPARED TO FISCAL 2006 +FINANCIAL SUMMARY - 2007 VERSUS 2006 +2007 +2006 +Change +$ +% +$ +% +$ +% +(Millions of Dollars, Except Per Share Data) +Revenue +Branded footwear, apparel and +licensing +$ +1,099.2 +91.7% +$ +1,036.9 +90.8% +$ +62.3 +6.0% +Other business units +99.8 +8.3% +105.0 +9.2% +(5.2 +) +(4.9% +) +Total revenue +$ +1,199.0 +100.0% +$ +1,141.9 +100.0% +$ +57.1 +5.0% +Gross margin +Branded footwear, apparel and +licensing +$ +434.6 +39.5% +$ +402.3 +38.8% +$ +32.3 +8.0% +Other business units +37.3 +37.4% +39.2 +37.4% +(1.9 +) +(4.9% +) +Total gross margin +$ +471.9 +39.4% +$ +441.5 +38.7% +$ +30.4 +6.9% +Selling and administrative +expenses +$ +333.2 +27.8% +$ +318.2 +27.9% +$ +15.0 +4.7% +Interest income - net +(.7 +) +(.1% +) +(.2 +) +.0% +(.5 +) +(227.1% +) +Other expense - net +.8 +.1% +1.2 +.1% +(.4 +) +(27.6% +) +Earnings before income taxes +138.6 +11.6% +122.3 +10.7% +16.3 +13.3% +Net earnings +92.9 +7.7% +83.6 +7.3% +9.3 +11.0% +Diluted earnings per share +$ +1.70 +- +$ +1.47 +- +$ +.23 +15.6% +23 +The Company has one reportable segment that is engaged in manufacturing, sourcing, marketing, licensing and distributing branded footwear, apparel and accessories. Within the branded footwear, apparel and licensing segment, the Company has identified five operating units, consisting of the Outdoor Group (comprised of the Merrell ®, Patagonia ® Footwear, and Sebago ® brands), the Wolverine Footwear Group (comprised of the Wolverine ®, HyTest ®, Bates ® and Stanley ® Footgear brands and certain private label branded products), the Heritage Brands Group (comprised of Cat ® Footwear and Harley-Davidson ® Footwear), The Hush Puppies Company, and Other Branded Footwear. The Company's other business units consist of Wolverine Retail and Wolverine Leathers (comprised of the tannery and procurement operations). The following is supplemental information on total revenue: +TOTAL REVENUE +2007 +2006 +Change +$ +% +$ +% +$ +% +(Millions of Dollars) +Outdoor Group +$ +458.3 +38.2% +$ +393.3 +34.4% +$ +65.0 +16.5% +Wolverine Footwear Group +256.6 +21.4% +275.8 +24.2% +(19.2 +) +(6.9% +) +Heritage Brands Group +199.4 +16.7% +192.3 +16.8% +7.1 +3.7% +The Hush Puppies Company +174.1 +14.5% +169.9 +14.9% +4.2 +2.4% +Other Branded Footwear +10.8 +.9% +5.6 +.5% +5.2 +92.5% +Total branded footwear, +apparel and licensing +revenue +$ +1,099.2 +91.7% +$ +1,036.9 +90.8% +$ +62.3 +6.0% +Other business units +99.8 +8.3% +105.0 +9.2% +(5.2 +) +(4.9% +) +Total revenue +$ +1,199.0 +100.0% +$ +1,141.9 +100.0% +$ +57.1 +5.0% +REVENUE +Revenue for 2007 increased $57.1 million over 2006. Increases in unit volume, changes in product mix and changes in selling price for the branded footwear, apparel and licensing segment operations, as discussed below, contributed $39.5 million of the revenue increase. The impact of translating foreign denominated revenue to U.S. dollars improved revenue by $22.8 million. The other business units' revenue decreased $5.2 million. Both domestic and international revenue increased, with international revenue accounting for 39.1% of total revenue in 2007 compared to 36.8% in 2006. +The Outdoor Group reported an increase in revenue of $65.0 million over 2006, its tenth year of double-digit growth. The Merrell ® footwear business realized a $41.8 million increase over the prior year as revenue increases were achieved across all geographic locations. Strong sales in the multi-sport and trail running categories along with strong reorders of the women's casual product drove the majority of the increase. The brand also continued to experience growth with its network of international distributors. The Merrell ® Apparel division, which launched in the second half of 2007, contributed $4.6 million in revenue. The Sebago ® brand experienced an increase in revenue of $7.1 million during 2007 due to strong consumer and retail response across all categories including marine, dress casual, sandals and kids. In the first full year of business, Patagonia ® experienced strong sell-through, especially in men's product, and contributed approximately $11.5 million to the increase. +The Wolverine Footwear Group recorded a $19.2 million decrease in revenue for 2007, as compared to 2006. The Wolverine ® business experienced an increase of $5.2 million during 2007 due to higher demand in the mobile distribution channel, strong reorder activity on the MultiShox ® comfort technology product, the successful introduction of the Contour Welt TM technology and the launch of the Wolverine ® Apparel business. The Bates ® division recognized a decrease in revenue from 2006 of $7.2 million due to a planned reduction in demand from the U.S. Department of Defense. Planned lower sales due to the +24 +phase out of Stanley ® Footgear and private label businesses decreased revenue by $5.2 million and $12.0 million, respectively. +The Heritage Brands Group experienced a $7.1 million revenue increase in 2007, as compared to 2006. Cat ® Footwear's revenue increased $7.4 million driven by strong revenue growth in the U.S. and globally through the international distribution network. Positive momentum has been driven through continued focus on strong integrated product marketing concepts including the Legendary Raw Collection and iTechnology ™ collection. The Harley-Davidson ® Footwear brand experienced a $.3 million revenue decrease in 2007 as the brand refocuses its distribution in the U.S. +The Hush Puppies Company's revenue increased $4.2 million in 2007. The majority of the revenue growth was driven by increased wholesale shipments in the Canadian and European markets, as well as higher royalty income generated by international licensees. Strong response to the Hush Puppies ® product fueled a revenue increase of $2.3 million in Canada and an increase of $8.7 million in Europe. Revenue for the U.S. market decreased $6.5 million from 2006 due to the internal reorganization of the SoftStyle ® business, a weak spring sandal season and reducing inventories to limit retail risk. A $3.9 million revenue decrease in the slipper operations was experienced as the Company decided to phase out of the slipper business. International licensing revenue increased $3.6 million in 2007 as global demand for Hush Puppies ® product continued to grow. +Within the Company's other business units, Wolverine Retail reported a $4.8 million increase in revenue as a result of a mid-single digit same-store revenue increase, as well as the net addition of eight stores as compared to 2006. The Wolverine Leathers operation reported a $10.0 million revenue decrease primarily due to decreased demand for the Company's proprietary sueded products. +The Company ended 2007 with an increase in order backlog of nearly 10% above 2006 year-end levels. This backlog principally reflects demand for the first half of 2008. +GROSS MARGIN +The gross margin level for 2007 of 39.4% was a 70 basis point increase over the prior year. Increased initial pricing margins, strong inventory reduction programs, and improvements in sourcing and manufacturing operations increased margin by 110 basis points. Offsetting a portion of this improvement were inventory reserve increases associated with apparel inventory and domestically produced footwear. Benefits from favorable foreign exchange contract rates associated with the Company's foreign entity inventory purchases added 60 basis points. These improvements were partially offset by a reduction of 20 basis points due to increased product costs on the European operations related to the levying of dumping duties on products sourced from China and Vietnam and increased shipments to lower gross margin international distributors, which decreased gross margin by 80 basis points. +SELLING AND ADMINISTRATIVE EXPENSES +Selling and administrative expenses of $333.2 million for 2007 increased $15.0 million from $318.2 million in 2006. Selling and administrative expenses as a percentage of revenue decreased 10 basis points as compared to the prior year reflecting improvements in overall distribution costs and reductions in employee benefit expenses of $7.0 million. The Company invested an additional $9.4 million in product development, selling, advertising and administrative costs on the Merrell ® Apparel and Patagonia ® Footwear initiatives in 2007 compared to 2006. Additional brand development initiatives during the year increased selling and advertising costs by $9.5 million. The remaining increases related primarily to selling and distribution costs that vary with the increase in revenue. +25 +INTEREST, OTHER & TAXES +The change in net interest reflected lower average outstanding amounts on senior notes. +The decrease in other expense primarily related to the change in realized gains or losses on foreign denominated assets and liabilities. +The Company's effective income tax rate for 2007 was 33.0% compared to 31.6% in 2006. In the fourth quarter of 2006, the Company recognized a one-time net income tax benefit of $1.5 million resulting from the closure of prior year income tax audits. The annualized effective tax rate for fiscal 2008 is estimated to range from 32.5% to 33.5%. +NET EARNINGS +As a result of the revenue, gross margin and expense changes discussed above, the Company achieved net earnings of $92.9 million compared to $83.6 million in 2006, an increase of $9.3 million. +RESULTS OF OPERATIONS - FISCAL 2006 COMPARED TO FISCAL 2005 +FINANCIAL SUMMARY - 2006 VERSUS 2005 +2006 +2005 +Change +$ +% +$ +% +$ +% +(Millions of Dollars, Except Per Share Data) +Revenue +Branded footwear, apparel and +licensing +$ +1,036.9 +90.8% +$ +964.5 +90.9% +$ +72.4 +7.5% +Other business units +105.0 +9.2% +96.5 +9.1% +8.5 +8.8% +Total revenue +$ +1,141.9 +100.0% +$ +1,061.0 +100.0% +$ +80.9 +7.6% +Gross margin +Branded footwear, apparel and +licensing +$ +402.3 +38.8% +$ +369.6 +38.3% +$ +32.7 +8.9% +Other business units +39.2 +37.4% +35.6 +36.9% +3.6 +10.1% +Total gross margin +441.5 +38.7% +$ +405.2 +38.2% +$ +36.3 +9.0% +Selling and administrative +expenses +$ +318.2 +27.9% +$ +291.9 +27.5% +$ +26.3 +9.0% +Interest (income) expense - net +(.2 +) +.0% +1.9 +.2% +(2.1 +) +(110.6% +) +Other expense - net +1.2 +.1% +.2 +.0% +1.0 +698.7% +Earnings before income taxes +122.3 +10.7% +111.2 +10.5% +11.1 +9.9% +Net earnings +83.6 +7.3% +74.5 +7.0% +9.1 +12.3% +Diluted earnings per share +$ +1.47 +- +$ +1.27 +- +$ +.20 +15.7% +26 +The following is supplemental information on total revenue: +TOTAL REVENUE +2006 +2005 +Change +$ +% +$ +% +$ +% +(Millions of Dollars) +Outdoor Group +$ +393.3 +34.4% +$ +337.8 +31.8% +$ +55.5 +16.5% +Wolverine Footwear Group +275.8 +24.2% +285.5 +26.9% +(9.7 +) +(3.4% +) +Heritage Brands Group +192.3 +16.8% +174.2 +16.4% +18.1 +10.4% +The Hush Puppies Company +169.9 +14.9% +163.4 +15.4% +6.5 +4.0% +Other Branded Footwear +5.6 +.5% +3.6 +.4% +2.0 +57.8% +Total branded footwear, +apparel and licensing +revenue +$ +1,036.9 +90.8% +$ +964.5 +90.9% +$ +72.4 +7.5% +Other business units +105.0 +9.2% +96.5 +9.1% +8.5 +8.8% +Total revenue +$ +1,141.9 +100.0% +$ +1,061.0 +100.0% +$ +80.9 +7.6% +REVENUE +Revenue for 2006 increased $80.9 million over 2005. Increases in unit volume, changes in product mix and changes in selling price for the branded footwear, apparel and licensing segment operations, as discussed below, contributed $66.8 million of the revenue increase. Of the $66.8 million revenue increase, $19.2 million was attributed to increased shipments to an international distributor and the conversion of this distributor from a royalty arrangement to a wholesale operation, which required recognition of sales and cost of products sold. The impact of translating foreign denominated revenue to U.S. dollars improved revenue by $5.6 million. The other business units contributed $8.5 million to the increase. Both domestic and international revenue increased, with international revenue accounting for 36.8% of total revenue in 2006 compared to 30.2% in 2005. +The Outdoor Group reported an increase in revenue of $55.5 million over 2005, its ninth year of double-digit growth. The Merrell ® business realized a $54.8 million increase over the prior year as revenue increases were achieved across all geographic locations. The brand also continued to experience growth with its network of international distributors. Strong sales in the multi-sport, after-sport and sports fashion categories drove the majority of the increase. The Sebago ® brand experienced a slight decrease in revenue from the prior year. The decrease was primarily a result of lower than anticipated shipments in the U.S. The growth and change in the international distributor arrangement mentioned above contributed $11.8 million to the increase for the Outdoor Group. The first shipments of the Patagonia ® product contributed approximately $.8 million to the increase. +The Wolverine Footwear Group recorded a $9.7 million decrease in revenue for 2006, as compared to 2005. The Wolverine ® boot business experienced an increase of $3.8 million during 2006 due to strong customer demand and reorder activity on the MultiShox ® comfort technology product. A decrease of $6.0 million in the Bates ® division was primarily the result of a planned reduction of Department of Defense contract shipments. The Stanley ® Footgear and private label businesses realized $3.6 million and $3.9 million revenue decreases, respectively, due to reduced customer demand. +The Heritage Brands Group experienced an $18.1 million revenue increase in 2006 as compared to 2005. Cat ® Footwear's revenue increased $16.1 million driven by strong revenue growth in the U.S., Canada, continental Europe and globally through the international distribution network. Improved sell-through results were experienced through the introduction of expanded product campaigns including the Legendary Raw Collection and iTechnology ™ collection. Increased shipments to the Harley-Davidson ® +27 +dealer network resulted in a $2.0 million revenue increase for the Harley-Davidson ® Footwear brand in 2006. The growth and change in the international distributor arrangement mentioned above contributed $7.4 million to the increase for the Heritage Brands Group. +The Hush Puppies Company's revenue increased $6.5 million in 2006. The majority of the revenue growth was driven by increased wholesale shipments in the Canadian and European markets, as well as higher royalty income generated by international licensees. Strong response to the Hush Puppies ® product fueled a revenue increase of $4.6 million in Canada, an increase of $2.6 million in Europe and a slight increase in the U.S. A $2.1 million revenue decrease in the slipper product was experienced as the Company has decided to phase out of the slipper business. International licensing revenue increased $1.2 million in 2006 as global demand for Hush Puppies ® product continued to grow. +Within the Company's other business units, Wolverine Retail reported a $4.5 million increase in revenue as a result of a mid-single digit same-store revenue increase, as well as the net addition of six stores as compared to 2005. The Wolverine Leathers operation reported a $4.0 million increase primarily due to increased demand for the Company's proprietary sueded products. +The Company ended 2006 with an increase in order backlog of over 10% above 2005 year-end levels. This backlog principally reflects demand for the first half of 2007. +GROSS MARGIN +The gross margin level for 2006 of 38.7% was a 50 basis point increase over the prior year. A change in business mix contributed an increase of 40 basis points, favorable product costs increased margin by 30 basis points and benefits from favorable foreign exchange contract rates associated with the Company's foreign entity inventory purchases added 10 basis points. These improvements were partially offset by a reduction of 30 basis points due to increased product costs on the European operations related to the levying of dumping duties on products sourced from China and Vietnam. +SELLING AND ADMINISTRATIVE EXPENSES +Selling and administrative expenses increased $26.3 million during 2006 to $318.2 million. The Company invested approximately $6.1 million in product development and selling and administrative costs on the Merrell ® Apparel and Patagonia ® Footwear initiatives in 2006. Incremental stock-based compensation costs increased the selling and administrative expenses by $2.7 million as a result of the adoption of Statement of Financial Accounting Standards (SFAS) No. 123(R). The remaining increases related primarily to selling and distribution costs that vary with the increase in revenue. +INTEREST, OTHER & TAXES +The change in net interest reflected increased interest income from invested cash balances, as well as lower average outstanding amounts on senior notes and minimal borrowing under the Company's revolving credit facility. +The increase in other expense primarily related to the change in realized gains or losses on foreign denominated assets and liabilities. +The Company's effective income tax rate for 2006 was 31.6%, compared to 33.1% in 2005. In the fourth quarter of 2006, the Company recognized a one-time net income tax benefit of $1.5 million resulting from the closure of prior year income tax audits. The 2005 income tax rate reflected additional income tax expense of $1.4 million due to the Company's repatriation of earnings of foreign subsidiaries of $41.5 million as provided under the American Jobs Creation Act of 2004. +28 +NET EARNINGS +As a result of the revenue, gross margin and expense changes discussed above, the Company achieved net earnings of $83.6 million compared to $74.5 million in 2005, an increase of $9.1 million. +LIQUIDITY AND CAPITAL RESOURCES +December 29, +December 30, +Change +2007 +2006 +$ +% +(Millions of Dollars) +Cash and cash equivalents +$ 76.1 +$ 124.7 +$ (48.6 +) +(39.0% +) +Accounts receivable +179.9 +152.6 +27.3 +17.9% +Inventories +165.9 +184.3 +(18.4 +) +(10.0% +) +Accounts payable +51.6 +47.4 +4.2 +8.7% +Accrued salaries and wages +18.5 +19.3 +(.8 +) +(4.0% +) +Other accrued liabilities +41.9 +43.5 +(1.6 +) +(3.8% +) +Debt +10.7 +21.5 +(10.8 +) +(50.0% +) +Cash provided by operating activities +123.3 +109.7 +13.6 +12.4% +Additions to property, plant and equipment +17.9 +17.1 +.8 +4.8% +Depreciation and amortization +22.8 +22.0 +.8 +3.6% +The Company continued to strengthen its balance sheet in 2007. Cash of $123.3 million was generated from operating activities in 2007. Accounts receivable increased 17.9% on a 5.0% revenue gain resulting from the timing of deliveries to large international customers and increased shipments. Accounts receivable days sales outstanding increased 1.0% in comparison to 2006. Inventory levels were down 10.0% at year end and inventory turns increased by 2.8% in comparison to the prior year primarily due to successful execution of inventory reduction programs. +The increase in accounts payable was attributed to the timing of inventory purchases from contract suppliers. The decrease in other accrued liabilities was primarily attributable to foreign currency forward exchange contracts, profit-sharing accruals, and a decrease in taxes payable. +The majority of capital expenditures were for information system enhancements, consumer-direct initiatives, distribution equipment and building improvements. The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2023. +The Company has a long-term revolving credit agreement that expires in July 2010 and allows for borrowings up to $150.0 million. The revolving credit facility is used to support working capital requirements. No amounts were outstanding under the revolving credit facility at December 29, 2007 or December 30, 2006. The Company was in compliance with all debt covenant requirements at December 29, 2007 and December 30, 2006. Proceeds from the existing credit facility along with cash flows from operations are expected to be sufficient to meet capital needs in the foreseeable future. Any excess cash flows from operating activities are expected to be used to purchase property, plant and equipment, pay down existing debt, fund internal and external growth initiatives, pay dividends or repurchase the Company's common stock. +The decrease in debt was the result of annual principal payments on the Company's senior notes. The Company had commercial letter-of-credit facilities outstanding of $2.1 million and $2.8 million at the end +29 +of 2007 and 2006, respectively. The total debt to total capital ratio for the Company was 2.2% in 2007 and 4.1% in 2006. +The Company's pension benefit results are based upon actuarial valuations. Inherent in these valuations are key assumptions, including discount rates and expected returns on plan assets. The Company is required to consider market conditions, including changes in interest rates, in selecting these assumptions. Pre-tax expense resulting from the Company's qualified defined benefit pension plans decreased $4.1 million for 2007 when compared to 2006 primarily due to the reduction in amortization of prior market value losses and a discount rate increase. In 2006, the Company adopted the provision of SFAS No. 158 requiring the recognition of the funded status of pension plans on its balance sheet. As a result, in 2006 the Company recorded a net reduction of $13.1 million within the accumulated other comprehensive income component of stockholders' equity, a reduction to net assets of $12.3 million and an increase to net liabilities of $1.6 million. This adjustment had no impact on the net earnings or cash flows of the Company. The Company estimates that pre-tax expense related to qualified defined benefit pension plans will decrease in 2008 as compared to 2007 by approximately $1.1 million primarily as a result of the reduction in the amortization of prior market value losses and a discount rate increase. +Applying the provisions of SFAS No. 87, SFAS No. 132 and SFAS No. 158, the Company's qualified defined benefit pension plans (the "Plans") were overfunded by $17.2 million in 2007 and $9.6 million in 2006. Under the Employee Retirement Income Security Act of 1974, the Plans had no minimum funding requirements for 2007 and 2006. Discretionary cash contributions were made to the Plans totaling $3.0 million in both 2007 and in 2006 to provide long-term stability to the Plans. The Company expects to contribute approximately $3.0 million to its qualified defined benefit pension plans and approximately $1.8 million to the Supplemental Executive Retirement Plan (SERP) in 2008. +In the fourth quarter and full year 2006 results, the Company recognized a one-time net income tax benefit of $1.5 million resulting from the closure of prior year income tax audits. In 2005, the Company elected to repatriate earnings of foreign subsidiaries as provided under the American Jobs Creation Act of 2004, which provided for a tax deduction of 85% of certain foreign earnings that were repatriated in 2005. During the fourth quarter of fiscal 2005, the Company repatriated foreign earnings of $41.5 million and, as a result, recorded a related tax expense of $1.4 million. No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the undistributed earnings of foreign subsidiaries of $176.2 million at December 29, 2007 ($125.3 million at December 30, 2006) as the Company expects such earnings will remain invested overseas indefinitely. +The Company's Board of Directors approved common stock repurchase programs on April 19, 2007 and December 13, 2005. These programs authorize the repurchase of 7.0 million and 3.0 million shares of common stock over a 36-month and 24-month period, respectively, commencing on the effective date of the program. The primary purpose of these stock repurchase programs is to increase shareholder value. The Company intends to continue repurchasing shares of its common stock in open market or privately negotiated transactions, from time-to-time, depending upon market conditions and other factors. +2007 +2006 +Cumulative +Authorization +effective date +Shares +repurchased +Market price +of shares +repurchased +Shares +repurchased +Market price +of shares +repurchased +Shares +repurchased +Market price +of shares +repurchased +April 19, 2007 +3,549,535 +$ +95,945,000 +- +$ +- +3,549,535 +$ +95,945,000 +December 13, 2005 +1,191,882 +$ +33,864,000 +1,808,118 +42,039,000 +3,000,000 +75,950,000 +October 5, 2004 +- +- +18,882 +407,000 +3,000,000 +64,862,000 +30 +The Company declared dividends of $18.8 million in 2007, or $.36 per share, which was a 20.0% increase on a per share basis over the $16.5 million, or $.30 per share, declared in 2006. On February 7, 2008, the Company declared a quarterly cash dividend of $.11 per share of common stock, an increase of 22.2% as compared to the same period of 2007. The quarterly dividend is payable on May 1, 2008, to shareholders of record on April 1, 2008. +On June 6, 2005, the Company announced an exclusive global footwear licensing agreement for Patagonia ® Footwear, with the initial product introduction debuting in Spring 2007. +During the second quarter of 2005, the Company purchased the remaining 5% ownership from the minority stockholder of Wolverine Europe Limited for a purchase price of $2.3 million, making it a wholly-owned subsidiary. The transaction eliminated the minority interest of $.6 million and resulted in goodwill of $1.8 million. +On January 3, 2005, the Company expanded its owned Cat ® and Wolverine ® Footwear operations in Canada. This expansion allowed the Company to directly wholesale all of its major brands in Canada. Assets consisting primarily of inventory, fixed assets and amortizable intangible assets totaling $2.1 million and assumed liabilities of $.8 million were acquired from a former Wolverine ® and Cat ® Footwear distributor for $2.3 million in cash and resulted in goodwill and intangible assets of approximately $1.0 million. Consolidated pro forma revenue and net earnings, assuming the transaction occurred at the beginning of 2005, were not materially different from reported amounts. Pursuant to SFAS No. 142, goodwill and indefinite-lived intangibles will not be amortized, but will be evaluated for impairment annually. Goodwill was assigned to the Company's branded footwear, apparel and licensing segment. The amortizable intangible assets have a weighted average useful life of approximately ten years. +On January 3, 2005, the Company expanded its owned Merrell ® operations into Sweden and Finland and its Sebago ® operations into the U.K. and Germany. Assets consisting primarily of inventory totaling approximately $.5 million were acquired from former distributors for cash. +These acquisitions are discussed further in Note 11 to the consolidated financial statements. +In early October 2006, the European Commission announced definitive anti-dumping duties at rates of 16.5% and 10.0% on imports from China and Vietnam, respectively. These definitive measures became effective October 7, 2006 and will remain in effect until October 6, 2008. The imposition of these anti-dumping measures could have a material impact on the Company's business, results of operations and financial condition. +NEW ACCOUNTING STANDARDS +In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements ("SFAS No. 157"). SFAS No. 157 establishes a framework for measuring the fair value of assets and liabilities. This framework is intended to provide increased consistency in how fair value determinations are made under various existing accounting standards that permit, or in some cases require, estimates of fair market value. SFAS No. 157 also expands financial statement disclosure requirements about a company's use of fair value measurements, including the effect of such measures on earnings. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 (fiscal year 2008 for the Company). In February 2008, the FASB issued FASB Staff Position (FSP) 157-2, Partial Deferral of the Effective Date of Statement 157 ("FSP 157-2"). FSP 157-2 delays the effective date of SFAS No. 157, for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008 (fiscal +31 +year 2009 for the Company). The adoption is not expected to have a material impact on the Company's consolidated financial statements. +In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 ("SFAS No. 159"). SFAS No. 159 allows companies to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007 (fiscal year 2008 for the Company). While the Company is currently evaluating the provisions of SFAS No. 159, the adoption is not expected to have a material impact on its consolidated financial statements. +In June 2007, the FASB ratified the consensus on Emerging Issues Task Force (EITF) Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards ("EITF 06-11"). EITF 06-11 requires companies to recognize the income tax benefit realized from dividends or dividend equivalents that are charged to retained earnings and paid to employees for non-vested equity-classified employee share-based payment awards as an increase to additional paid-in capital. EITF 06-11 is effective for fiscal years beginning after December 15, 2007 (fiscal year 2008 for the Company). The adoption is not expected to have a material impact on the Company's consolidated financial statements. +In December 2007 the FASB issued SFAS No. 141(R), Business Combinations ("SFAS No. 141(R)"). SFAS No. 141(R) establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statement to evaluate the nature and financial effects of the business combination. SFAS No. 141(R) is to be applied prospectively to business combinations for which the acquisition date is on or after an entity's fiscal year that begins after December 15, 2008 (fiscal year 2009 for the Company). The Company expects the adoption will have an impact on the consolidated financial statements when effective, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acquisitions consummated after the effective date. The Company will assess the impact of this standard on the consolidated financial statements if and when a future acquisition occurs. +In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51 ("SFAS No. 160"). SFAS No. 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent's equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement. SFAS No. 160 clarifies that changes in a parent's ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS No. 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008 (fiscal year 2009 for the Company). Earlier adoption is prohibited. The Company currently does not have any noncontrolling interests and will assess the impact of this standard on the consolidated financial statements if and when a future acquisition occurs. +32 +CRITICAL ACCOUNTING POLICIES +The preparation of the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates these estimates. Estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Historically, actual results have not been materially different from the Company's estimates. However, actual results may differ from these estimates under different assumptions or conditions. +The Company has identified the following critical accounting policies used in determining estimates and assumptions in the amounts reported. Management believes that an understanding of these policies is important to an overall understanding of the consolidated financial statements. +REVENUE RECOGNITION +Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped, legal title has passed to the customer and collectibility is reasonably assured. Revenue generated through programs with licensees and distributors involving products bearing the Company's trademarks is recognized as earned according to stated contractual terms upon either the purchase or shipment of branded products by licensees and distributors. +The Company records provisions against gross revenue for estimated stock returns and cash discounts in the period when the related revenue is recorded. These estimates are based on factors that include, but are not limited to, historical stock returns, historical discounts taken and analysis of credit memorandum activity. The actual amount of customer returns or allowances, which is uncertain, may differ from the Company's estimates. The Company would record either an increase or decrease to net sales in the period in which it determined an adjustment to be appropriate. +ACCOUNTS RECEIVABLE +The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from its customers' inability to make required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. Historically, losses have been within the Company's expectations. Adjustments to these estimates may be required if the financial condition of the Company's customers were to change. If the Company were to determine that increases or decreases to the allowance for uncollectible accounts were appropriate, the Company would record either an increase or decrease to general and administrative expenses in the period the Company made such a determination. At December 29, 2007 and December 30, 2006, management believes that it has provided sufficient reserves to address future collection uncertainties. +INVENTORY +The Company values its inventory at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for all domestic raw materials and work-in-process inventories, and certain domestic finished goods inventories. Cost is determined using methods approximating cost under the first-in, first-out (FIFO) method for all raw materials, work-in-process and finished good inventories in foreign countries. The FIFO method is also used for all finished goods inventories of the Company's retail business, due to the unique nature of that operation, and for certain domestic finished goods inventories that were acquired as part of asset purchase transactions. Once elected, the Company has applied these +33 +inventory cost valuation methods consistently from year to year. The Company reduces the value of its inventories to the lower of cost or market for excess or obsolete inventories based upon assumptions about future demand and market conditions. If the Company were to determine that the estimated market value of its inventory is less than the carrying value of such inventory, the Company would provide a reserve for such difference as a charge to cost of sales. If actual market conditions are different from those projected, adjustments to those inventory reserves may be required. The adjustments would increase or decrease the Company's cost of sales and net income in the period in which they were realized or recorded. Inventory quantities are verified at various times throughout the year by performing annual physical inventory observations and perpetual inventory cycle count procedures. If the Company determines that adjustments to the inventory quantities are appropriate, an increase or decrease to the Company's cost of sales and inventory would be recorded in the period in which such determination was made. At December 29, 2007 and December 30, 2006, management believes that it has provided sufficient reserves for excess or obsolete inventories. +GOODWILL AND OTHER NON-AMORTIZABLE INTANGIBLES +Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually. The first step of the goodwill impairment test requires that the fair value of the applicable reporting unit be compared with its recorded value. The Company establishes fair value by calculating the present value of the expected future cash flows of the reporting unit. The Company uses assumptions about expected future operating performance in determining estimates of those cash flows, which may differ from actual cash flows. If the recorded values of these assets are not recoverable, based on this discounted cash flow analysis, management performs the next step which compares the fair value of the reporting unit calculated in step one to the fair value of the tangible and intangible assets of the reporting unit, which results in an implied fair value of goodwill. Goodwill is reduced by any shortfall of implied goodwill to its carrying value. Impairment tests for other non-amortizable intangibles require the determination of the fair value of the intangible asset. The carrying value is reduced by any excess over fair value. The Company reviewed the carrying amounts of goodwill and other non-amortizable intangible assets and there was no impairment indicated for the years ended December 29, 2007 or December 30, 2006. +INCOME TAXES +The Company operates in multiple tax jurisdictions both inside and outside the United States. Accordingly, management must determine the appropriate allocation of income in accordance with local law for each of these jurisdictions. The Company believes its tax accruals are adequate to cover exposures related to changes in income allocation between tax jurisdictions. The carrying value of the Company's deferred tax assets assumes that the Company will be able to generate sufficient taxable income in future years to utilize these deferred tax assets. If these assumptions change, the Company may be required to record valuation allowances against its gross deferred tax assets in future years, which would result in additional income tax expense in the Company's consolidated statements of operations. Management evaluates the potential for realizing gross deferred tax assets and assesses the need for valuation allowances on a quarterly basis. The Company did not record a valuation allowance in 2007 or 2006. +On a periodic basis, the Company estimates what the effective tax rate will be for the full fiscal year and records a quarterly income tax provision in accordance with the anticipated annual rate. As the fiscal year progresses, that estimate is refined based upon actual events and earnings by tax jurisdictions during the year. This continual estimation process periodically results in a change to the expected effective tax rate for the fiscal year. When this occurs, the Company adjusts the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date provision equals the revised expected annual rate. +34 +STOCK-BASED COMPENSATION +The Company accounts for stock-based compensation in accordance with the fair value recognition provisions of SFAS No. 123(R), Share-Based Payment . The Company utilizes the Black-Scholes model, which requires the input of subjective assumptions. These assumptions include estimating (a) the length of time employees will retain their vested stock options before exercising them ("expected term"), (b) the volatility of the Company's common stock price over the expected term and (c) the number of options that will ultimately not complete their vesting requirements. Changes in the subjective assumptions can materially affect the estimate of fair value of stock-based compensation and, consequently, the related amounts recognized on the consolidated condensed statements of operations. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +The Company faces market risk to the extent that changes in foreign currency exchange rates affect the Company's foreign assets, liabilities and inventory purchase commitments and to the extent that its long-term debt requirements are affected by changes in interest rates. The Company manages these risks by attempting to denominate contractual and other foreign arrangements in U.S. dollars and by maintaining a significant percentage of its debt on a fixed-rate basis. The Company does not believe that there has been a material change in the nature of the Company's primary market risk exposures, including the categories of market risk to which the Company is exposed and the particular markets that present the primary risk of loss to the Company. As of the date of this Annual Report Form 10-K, the Company does not know of or expect there to be any material change in the general nature of its primary market risk exposure in the near term. +Under the provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities , as amended by SFAS Nos. 137 and 138, the Company is required to recognize all derivatives on the balance sheet at fair value. Derivatives that are not qualifying hedges must be adjusted to fair value through earnings. If a derivative is a qualifying hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings or recognized in accumulated other comprehensive income until the hedged item is recognized in earnings. +The Company conducts wholesale operations outside of the United States in Europe and Canada where the functional currencies are primarily the British pound, euro, and Canadian dollar. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with inventory purchases made by non-U.S. wholesale operations in foreign currencies in the normal course of business. At December 29, 2007 and December 30, 2006, the Company had outstanding forward currency exchange contracts to purchase $70.4 million and $56.4 million, respectively, of various currencies (principally U.S. dollars) with maturities ranging up to 252 days. +The Company also has production facilities in the Dominican Republic where financial statements reflect U.S. dollars as the functional currency; however, operating costs are paid in the local currency. Royalty revenue generated by the Company from third-party foreign licensees is calculated in the licensees' local currencies, but paid in U.S. dollars. Accordingly, the Company is subject to related foreign currency remeasurement gains and losses in 2008 and beyond. +Assets and liabilities outside the United States are primarily located in the United Kingdom, Canada and The Netherlands. The Company's investments in foreign subsidiaries with a functional currency other than the U.S. dollar are generally considered long-term. Accordingly, the Company does not hedge these net investments. For the year ended December 29, 2007, the strengthening of foreign currencies increased the value of these investments in net assets by $13.6 million. For the year ended December 30, 2006, the strengthening of foreign currencies increased the value of these investments in net assets by $9.5 million. +35 +These changes resulted in cumulative foreign currency translation adjustments at December 29, 2007 and December 30, 2006 of $35.4 million and $21.8 million, respectively, that are deferred and recorded as a component of accumulated other comprehensive income in stockholders' equity. +Because the Company markets, sells and licenses its products throughout the world, it could be affected by weak economic conditions in foreign markets that could reduce demand for its products. +The Company is exposed to changes in interest rates primarily as a result of its long-term debt requirements. The Company's interest rate risk management objectives are to limit the effect of interest rate changes on earnings and cash flows and to effectively manage overall borrowing costs. To achieve its objectives, the Company maintains substantially all fixed-rate debt to take advantage of lower relative interest rates currently available and finances seasonal working capital needs with variable-rate debt. The Company has not historically utilized interest rate swaps or similar hedging arrangements to fix interest rates; however, in 1998 the Company entered into an interest rate lock agreement to fix the interest rate prior to the issuance of 6.5% senior notes in the amount of $75 million. The contract was settled in 1998 and resulted in a prepayment of interest of $2.2 million that is being amortized over the term of the senior notes. The remaining unamortized balance at December 29, 2007 was $.2 million. The amortization of the prepayment creates an effective interest rate of 6.78% on the senior notes. +The Company does not enter into contracts for speculative or trading purposes, nor is it a party to any leveraged derivative instruments. +The following table lists required principal payments and related interest rates for the Company's short- and long-term debt by fiscal year of maturity. +2007 +2006 +2008 +2009 +2010 +2011 +2012 +There- +after +Total +Fair +Value +Total +Fair +Value +(Millions of Dollars, Except Percentages) +Denominated in U.S. Dollars: +Fixed rate +$10.7 +- +- +- +- +- +$10.7 +$11.0 +$21.4 +$21.7 +Average interest rate +6.5 +% +- +- +- +- +- +6.5 +% +- +6.5 +% +- +The Company has the following payments under contractual obligations due by period: +Total +Less than +1 year +1-3 years +3-5 years +More than +5 years +(Thousands of Dollars) +Long-term debt +$ +10,714 +$ +10,714 +$ +- +$ +- +$ +- +Estimated interest on long-term debt +696 +696 +- +- +- +Capital leases +20 +20 +- +- +- +Operating leases +159,258 +18,702 +33,568 +26,474 +80,514 +Purchase obligations (1) +161,804 +161,804 +- +- +- +Deferred compensation +1,442 +295 +440 +333 +374 +Pension (2) +3,000 +3,000 +- +- +- +SERP +18,262 +1,772 +3,259 +3,361 +9,870 +Dividends declared +10,084 +10,084 +- +- +- +Minimum royalties +6,676 +1,062 +2,872 +2,742 +- +Minimum advertising +12,479 +2,023 +4,268 +4,528 +1,660 +Total (3) +$ +384,435 +$ +210,172 +$ +44,407 +$ +37,438 +$ +92,418 +(1) +Purchase obligations primarily relate to inventory and capital expenditure commitments. +36 +(2) +Pension obligations reflect only planned pension funding as there are currently no required funding obligations under government regulation. Funding amounts are calculated on an annual basis and no required or planned funding beyond one year has been determined. +(3) +The Company adopted Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes, ("FIN 48") on December 31, 2006. The total amount of unrecognized tax benefits on the Consolidated Balance Sheet at December 29, 2007 is $2.9 million. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes. As a result, this amount is not included in the table above. +The Company had $154.8 million of additional borrowing capacity available under all of its existing credit facilities at December 29, 2007. The Company's additional borrowing capacity is summarized as follows: +Expiration of availability +Total commitments +available +Less than +1 year +1 year or +greater +(Millions of Dollars) +Revolving credit +$150.0 +$ - +$150.0 +Standby letters of credit +4.8 +4.8 +- +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk . +The response to this Item is set forth under the caption "Quantitative and Qualitative Disclosures About Market Risk" in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and is incorporated herein by reference. +Item 8. +Financial Statements and Supplementary Data . +The response to this Item is set forth in Appendix A of this Annual Report on Form 10-K and is incorporated herein by reference. +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . +None. +Item 9A. +Controls and Procedures . +Evaluation of Disclosure Controls and Procedures. +An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on and as of the time of such evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report. +Management's Report on Internal Control Over Financial Reporting. +Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Under the +37 +supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 29, 2007, based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 29, 2007. +The effectiveness of the Company's internal control over financial reporting as of December 29, 2007, has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report, which is included in Appendix A and is incorporated into this Item 9A by reference. +Changes in Internal Control Over Financial Reporting. +There was no change in the Company's internal control over financial reporting that occurred during the sixteen-week period ended December 29, 2007 that has materially affected, or that is reasonably likely to materially affect, the Company's internal control over financial reporting. +Item 9B. +Other Information . +None. +PART III +Item 10. +Directors and Executive Officers of the Registrant . +The Company's Audit Committee is comprised of four Board members, all of whom are independent under independence standards adopted by the Board and applicable SEC Regulations and New York Stock Exchange standards (including independence standards related specifically to Audit Committee membership). The Audit Committee members each have financial and business experience with companies of substantial size and complexity and have a significant understanding of generally accepted accounting principles, financial statements, internal controls and audit committee functions. The Company's Board of Directors has determined that David T. Kollat and Jeffrey M. Boromisa are audit committee financial experts, as defined by the SEC. Additional information regarding the Audit Committee is provided in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 17, 2008, under the caption "Wolverine's Board of Directors" under the subheading "Board Committees and Meetings - Audit Committee." +The Company has adopted an Accounting and Finance Code of Ethics that applies to the Company's principal executive officer, principal financial officer and principal accounting officer, and has adopted a Code of Conduct & Compliance that applies to the Company's directors and employees. The Accounting and Finance Code of Ethics and the Code of Conduct & Compliance are available on the Company's website, www.wolverineworldwide.com. Any waiver from the Accounting and Finance Code of Ethics or the Code of Conduct & Compliance with respect to the Company's executive officers and directors will be disclosed on the Company's website. Any amendment to the Accounting and Finance Code of Ethics will be disclosed on the Company's website. +The information regarding directors of the Company contained under the caption "Election of Directors" and under the caption "Wolverine's Board of Directors" under the subheading "Nominees for Terms Expiring in 2011," "Continuing Directors - Terms Expiring in 2010," and "Continuing Directors - +38 +Terms Expiring in 2009" in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 17, 2008, is incorporated herein by reference. +The information regarding directors and executive officers of the Company under the caption "Related Matters" under the subheading "Section 16(a) Beneficial Ownership Reporting Compliance" in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 17, 2008, is incorporated herein by reference. Additional information regarding Executive Officers is provided in the Supplemental Item following Item 4 of Part I above. +Item 11. +Executive Compensation . +The information contained under the captions "Executive Compensation," "Potential Payments Upon Termination or Change in Control," "Compensation Committee Interlocks and Insider Participation" and "Compensation Committee Report" in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 17, 2008, is incorporated herein by reference. +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters . +The information contained under the caption "Ownership of Wolverine Stock" contained in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 17, 2008, is incorporated herein by reference. +The following table provides information about Wolverine's equity compensation plans as of December 29, 2007: +39 +Equity Compensation Plan Information +Plan Category (1) +Number of +Securities to be +Issued Upon +Exercise of +Outstanding +Options, Warrants +and Rights +(a) +Weighted Average +Exercise Price of +Outstanding +Options, +Warrants and +Rights +(b) +Number of Securities +Remaining Available for +Future Issuance Under +Equity Compensation +Plans (Excluding +Securities Reflected in +Column (a)) +(c) +Equity compensation +plans approved by +security holders +4,588,245 +(2)(3) +$ +18.46 +4,386,758 +(4) +Equity compensation +plans not approved by +security holders +- +N/A +- +Total +4,588,245 +$ +18.46 +4,386,758 +Notes to Equity Compensation Plan Information +(1) +Each plan for which aggregated information is provided contains customary anti-dilution provisions that are applicable in the event of a stock split, stock dividend or certain other changes in the Company's capitalization. +(2) +Includes: (i) 4,137,061 stock options awarded to employees under the 1993 Stock Incentive Plan, the 1995 Stock Incentive Plan, the 1997 Stock Incentive Plan, the Stock Incentive Plan of 1999, the Stock Incentive Plan of 2001, the Stock Incentive Plan of 2003 and the Stock Incentive Plan of 2005; and (ii) and 451,184 stock options awarded to non-employee directors under the Stock Incentive Plan of 2005 and the Amended and Restated Directors' Stock Option Plan approved by stockholders in 2002 and the previous Amended and Restated Directors' Stock Option Plan initially adopted in 1988. Column (a) does not include stock units credited to outside directors' fee accounts or retirement accounts under the Outside Directors' Deferred Compensation Plan. Stock units do not have an exercise price. Each stock unit credited to a director's fee account and retirement account under the Outside Directors' Deferred Compensation Plan will be converted into one share of common stock upon distribution. Column (a) also does not include shares of restricted or unrestricted common stock previously issued under the Company's equity compensation plans. +(3) +Of this amount, 953,150 options were not exercisable as of December 29, 2007, due to vesting restrictions. +(4) +Comprised of: (i) 508,392 shares available for issuance under the Outside Directors' Deferred Compensation Plan upon the retirement of the current directors or upon a change in control; and (ii) 3,878,366 shares issuable under the various employee stock incentive plans. Of these total amounts available, the number of shares with respect to the following plans may be issued other than upon the exercise of an option, warrant or right as of December 29, 2007: +40 +• +Outside Directors' Deferred Compensation Plan: 508,392 +• +Stock Incentive Plan of 1999: 32,428 +• +Stock Incentive Plan of 2001: 382,966 +• +Stock Incentive Plan of 2003: 75,852 +• +Stock Incentive Plan of 2005: 1,693,560 +The Outside Directors' Deferred Compensation Plan is a supplemental, unfunded, nonqualified deferred compensation plan for non-employee directors. Beginning in 2006, the Company began paying an annual equity retainer to non-management directors in the form of a contribution under the Outside Directors' Deferred Compensation Plan. Participation in the plan in addition to the annual equity retainer is voluntary. The plan allows participating directors to receive, in lieu of some or all directors' fees, a number of stock units equal to the amount of the deferred directors' fees divided by the fair market value of the Company's common stock on the date of payment of the next cash dividend on the Company's common stock. These stock units are increased by a dividend equivalent based on dividends paid by the Company and the amount of stock units credited to the participating director's fee account and retirement account. Upon distribution, the participating directors receive a number of shares of the Company's common stock equal to the number of stock units to be distributed at that time. Distribution is triggered by termination of service as a director or by a change in control of the Company and can occur in a lump sum, in installments or on another deferred basis. Of the 508,392 shares issuable under the Outside Directors' Deferred Compensation Plan, 194,002 shares have been issued to a trust to satisfy the Company's obligations and are included in shares reported as issued and outstanding as of the record date. +The employee stock incentive plans listed above are equity-based incentive plans for officers, key employees, and, under the Stock Incentive Plan of 2005, directors. Those plans authorize awards of stock options, restricted common stock, common stock and, under certain plans, tax benefit rights, restricted stock units, deferred stock units, and/or stock appreciation rights. The Stock Incentive Plans of 2001 and 2003 specifically limit the number of shares that can be awarded as restricted or unrestricted common stock to 40% and 15%, respectively, of the shares authorized under the plan. The Stock Incentive Plan of 2005 provides that each share of restricted or unrestricted common stock, each restricted stock unit and each stock appreciation right is counted as two shares against the total number of shares authorized under the plan. The number of securities listed as remaining available in column (c) of the table assumes the grant of all stock options, which count as only one share against the total number of shares authorized under the Stock Incentive Plan of 2005. Actual shares available under the Stock Incentive Plan of 2005 will be less to the extent that awards of restricted or unrestricted common stock, restricted stock units or stock appreciation rights are issued from that plan. The numbers provided in this footnote and in column (c) will increase to the extent that options relating to the number of shares listed in column (a) of the table or other outstanding awards (e.g., shares of restricted or unrestricted stock, restricted stock units or stock appreciation rights) previously issued under a plan are canceled, surrendered, modified, exchanged for substitutes or expire or terminate prior to exercise or vesting because the number of shares underlying any such awards will again become available for issuance under the plan under which the award was granted. +Item 13. +Certain Relationships and Related Transactions, and Director Independence . +The information contained under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 17, 2008, is incorporated herein +41 +by reference. The information contained under the caption "Corporate Governance Principles" under the subheading "Independence" contained in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 17, 2008, is incorporated herein by reference. +Item 14. +Principal Accountant Fees and Services . +The information contained under the caption "Selection of Auditors" in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 17, 2008, is incorporated herein by reference. +PART IV +Item 15. +Exhibits and Financial Statement Schedules . +Item 15(a)(1). Financial Statements . Attached as Appendix A. +The following consolidated financial statements of Wolverine World Wide, Inc. and subsidiaries are filed as a part of this report: +• +Consolidated Balance Sheets as of December 29, 2007 and December 30, 2006. +• +Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Fiscal Years Ended December 29, 2007, December 30, 2006 and December 31, 2005. +• +Consolidated Statements of Operations for the Fiscal Years Ended December 29, 2007, December 30, 2006 and December 31, 2005. +• +Consolidated Statements of Cash Flows for the Fiscal Years Ended December 29, 2007, December 30, 2006 and December 31, 2005. +• +Notes to the Consolidated Financial Statements as of December 29, 2007. +• +Reports of Independent Registered Public Accounting Firm. +Item 15(a)(2). Financial Statement Schedules . Attached as Appendix B. +The following consolidated financial statement schedule of Wolverine World Wide, Inc. and subsidiaries is filed as a part of this report: +• +Schedule II--Valuation and Qualifying Accounts of Continuing Operations. +All other schedules (I, III, IV, and V) for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and, therefore, have been omitted. +Item 15(a)(3). Exhibits . +The following exhibits are filed as part of this report: +42 +Exhibit +Number +Document +3.1 +Restated Certificate of Incorporation. Previously filed as Exhibit 3.1 to the Company's Annual Report on Form 10-K for the period ended December 30, 2006. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the period ended September 8, 2007. Here incorporated by reference. +4.1 +Restated Certificate of Incorporation. See Exhibit 3.1 above. +4.2 +Amended and Restated By-laws. See Exhibit 3.2 above. +4.3 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. Previously filed as Exhibit 4.7 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. Here incorporated by reference. +4.4 +The Registrant has several classes of long-term debt instruments outstanding in addition to those described in Exhibits 4.3 and 4.5. The authorized amount of none of these classes of debt exceeds 10% of the Company's total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +4.5 +Credit Agreement dated as of July 22, 2005, among Wolverine World Wide, Inc. and certain of its subsidiaries, JPMorgan Chase Bank, N.A., as Administrative Agent, Harris, N.A., as Syndication Agent, Comerica Bank, Standard Federal Bank N.A. and National City Bank of the Midwest, as Documentation Agents, and certain other Banks that are parties to the Credit Agreement. Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated July 28, 2005. Here incorporated by reference. +10.1 +Amended and Restated 1993 Stock Incentive Plan.* Previously filed as Exhibit 10.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.2 +Amended and Restated 1995 Stock Incentive Plan.* Previously filed as Exhibit 10.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.3 +Amended and Restated 1997 Stock Incentive Plan.* Previously filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.4 +Amended and Restated Stock Incentive Plan of 1999.* Previously filed as Exhibit 10.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.5 +Amended and Restated Stock Incentive Plan of 2001.* Previously filed as Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +43 +10.6 +Amended and Restated Stock Incentive Plan of 2003.* Previously filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.7 +Amended and Restated Stock Incentive Plan of 2005.* Previously filed as Exhibit 10.7 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.8 +Amended and Restated Directors' Stock Option Plan.* Previously filed as Exhibit 10.8 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.9 +Amended and Restated Outside Directors' Deferred Compensation Plan.* +10.10 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Exhibit 10.2 to the Company's Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.11 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.12 +Amended and Restated Stock Option Loan Program.* +10.13 +Executive Severance Agreement.* Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. A participant schedule of current executive officers who are parties to the agreement is attached as Exhibit 10.13. +10.14 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.15 +Amended and Restated Benefit Trust Agreement dated April 25, 2007.* Previously filed as Exhibit 10.5 to the Company's Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.16 +Amended and Restated Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.16 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. An updated participant schedule of current executive officers participating in the plan is attached as Exhibit 10.16. +10.17 +Employees' Pension Plan (Restated as amended through November 30, 2007).* +10.18 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +44 +10.19 +Form of Non-Qualified Stock Option Agreement for Stephen L. Gulis, Blake W. Krueger and Timothy J. O'Donovan.* Previously filed as Exhibit 10.2 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.20 +Form of Non-Qualified Stock Option Agreement for employees other than those to whom Exhibit 10.19 applies.* Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.21 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.22 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.23 +Form of Non-Qualified Stock Option Agreement for Stephen L. Gulis, Blake W. Krueger and Timothy J. O'Donovan.* Previously filed as Exhibit 10.2 to the Company's Current Report of Form 8-K dated February 15, 2006. Here incorporated by reference. +10.24 +Form of Non-Qualified Stock Option Agreement for employees other than those to whom Exhibit 10.23 applies.* Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.25 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.26 +Form of Stock Option Agreement for non-employee directors.* Previously filed as Exhibit 10.23 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. Here incorporated by reference. +10.27 +Separation and Release Agreement between Wolverine World Wide, Inc. and Cheryl L. Johnson.* +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31.1 +Certification of President and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Executive Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +____________________________ +*Management contract or compensatory plan or arrangement. +45 +The Company will furnish a copy of any exhibit listed above to any stockholder without charge upon written request to Mr. Kenneth A. Grady, General Counsel and Secretary, 9341 Courtland Drive, Rockford, Michigan 49351. +46 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +WOLVERINE WORLD WIDE, INC. +Dated: February 26, 2008 +By: +/s/ Blake W. Krueger +Blake W. Krueger +Chief Executive Officer and President +(Principal Executive Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ Blake W. Krueger +Blake W. Krueger +Chief Executive Officer and President +(Principal Executive Officer) +February 26, 2008 +/s/ Stephen L. Gulis, Jr. +Stephen L. Gulis, Jr. +Executive Vice President, Chief +Financial Officer and Treasurer +(Principal Financial Officer) +February 26, 2008 +/s/ Nicholas P. Ottenwess +Nicholas P. Ottenwess +Vice President of Finance and +Corporate Controller +(Principal Accounting Officer) +February 26, 2008 +*/s/ Jeffrey M. Boromisa +Jeffrey M. Boromisa +Director +February 26, 2008 +*/s/ William K. Gerber +William K. Gerber +Director +February 26, 2008 +*/s/ Alberto L. Grimoldi +Alberto L. Grimoldi +Director +February 26, 2008 +*/s/ David T. Kollat +David T. Kollat +Director +February 26, 2008 +47 +*/s/ Brenda J. Lauderback +Brenda J. Lauderback +Director +February 26, 2008 +/s/ Blake W. Krueger +Blake W. Krueger +Director +February 26, 2008 +*/s/ Phillip D. Matthews +Phillip D. Matthews +Director +February 26, 2008 +*/s/ David P. Mehney +David P. Mehney +Director +February 26, 2008 +*/s/ Timothy J. O'Donovan +Timothy J. O'Donovan +Director and Chairman +February 26, 2008 +*/s/ Shirley D. Peterson +Shirley D. Peterson +Director +February 26, 2008 +*/s/ Michael A. Volkema +Michael A. Volkema +Director +February 26, 2008 +*By /s/ Blake W. Krueger +Blake W. Krueger +Attorney-in-Fact +Chief Executive Officer and +President +February 26, 2008 +48 +APPENDIX A +Financial Statements +CONSOLIDATED BALANCE SHEETS +As of Fiscal Year End +2007 +2006 +(Thousands of Dollars) +ASSETS +Current assets: +Cash and cash equivalents +$ +76,087 +$ +124,663 +Accounts receivable, less allowances (2007 - $13,643; 2006 - $13,320) +179,934 +152,608 +Inventories +Finished products +148,925 +168,603 +Raw materials and work-in-process +16,927 +15,656 +165,852 +184,259 +Deferred income taxes +11,909 +8,346 +Prepaid expenses and other current assets +11,859 +15,437 +Total current assets +445,641 +485,313 +Property, plant and equipment: +Land +882 +882 +Buildings and improvements +76,678 +71,687 +Machinery and equipment +149,944 +146,967 +Software +60,702 +58,187 +288,206 +277,723 +Less accumulated depreciation +202,789 +189,771 +85,417 +87,952 +Other assets: +Goodwill +39,573 +38,776 +Other non-amortizable intangibles +8,936 +8,506 +Cash surrender value of life insurance +32,886 +31,739 +Pension assets +17,752 +10,233 +Deferred income taxes +3,877 +3,736 +Other +4,296 +4,837 +107,320 +97,827 +Total assets +$ +638,378 +$ +671,092 +LIABILITIES AND STOCKHOLDERS' EQUITY +Current liabilities: +Accounts payable +$ +51,551 +$ +47,420 +Salaries, wages and other compensation +18,475 +19,254 +Income taxes +3,911 +6,435 +Taxes, other than income taxes +5,855 +4,414 +Other accrued expenses +32,109 +32,662 +Current maturities of long-term debt +10,731 +10,730 +Total current liabilities +122,632 +120,915 +Long-term debt, less current maturities +- +10,741 +Deferred compensation +10,204 +11,026 +Accrued pension liabilities +25,684 +22,744 +Other liabilities +1,079 +1,107 +Stockholders' equity: +Common stock, $1 par value: authorized 160,000,000 shares; shares +issued, including treasury shares: 2007 - 61,085,123; 2006 - 60,468,000 +61,085 +60,468 +Additional paid-in capital +47,786 +31,341 +Retained earnings +591,706 +519,815 +Accumulated other comprehensive income +22,268 +3,923 +Cost of shares in treasury: 2007 - 9,850,299 shares; 2006 - 5,005,487 shares +(244,066 +) +(110,988 +) +Total stockholders' equity +478,779 +504,559 +Total liabilities and stockholders' equity +$ +638,378 +$ +671,092 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +A-1 +CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY +AND COMPREHENSIVE INCOME +Fiscal Year +2007 +2006 +2005 +(Thousands of Dollars, Except Per Share Data) +COMMON STOCK +Balance at beginning of the year +$ +60,468 +$ +59,212 +$ +67,350 +Common stock issued under stock incentive plans +(2007 - 618,123 shares; 2006 - 1,255,286 shares; +2005 - 1,214,857 shares) +617 +1,256 +1,214 +Impact of stock split on treasury shares +- +- +(9,352 +) +Balance at end of the year +61,085 +60,468 +59,212 +ADDITIONAL PAID-IN CAPITAL +Balance at beginning of the year +31,341 +13,203 +99,518 +Stock-based compensation expense +8,316 +7,155 +- +Reclassification of unearned compensation upon +adoption of SFAS No. 123(R) +- +(5,873 +) +- +Amounts associated with common stock issued +under stock incentive plans: +Proceeds over par value +4,603 +12,254 +14,609 +Income tax benefits +3,572 +4,672 +3,720 +Impact of stock split on treasury shares +- +- +(104,726 +) +Issuance of treasury shares (2007 - 12,661 shares; +2006 - 14,511 shares; 2005 - 11,662 shares) +47 +55 +12 +Net change in employee notes receivable +(93 +) +(125 +) +70 +Balance at end of the year +47,786 +31,341 +13,203 +RETAINED EARNINGS +Balance at beginning of the year +519,815 +452,672 +437,406 +Impact of stock split on treasury shares +- +- +(44,725 +) +Net earnings +92,886 +83,647 +74,467 +Cash dividends declared (2007 - $.36 per share; +2006 - $.30 per share; 2005 - $.26 per share) +(18,844 +) +(16,504 +) +(14,476 +) +Cumulative effect of adopting FIN 48 (See Note 7) +(509 +) +- +- +Pension adjustments (See Note 6) +(1,642 +) +- +- +Balance at end of the year +591,706 +519,815 +452,672 +ACCUMULATED OTHER COMPREHENSIVE +INCOME +Balance at beginning of the year +3,923 +9,398 +19,446 +Foreign currency translation adjustments +13,643 +9,548 +(11,544 +) +Change in fair value of foreign exchange contracts, +net of taxes (2007 - $929; 2006 - $901; 2005 - +$1,280) +(1,007 +) +(1,657 +) +2,085 +Pension adjustments, net of taxes +(2007 - ($3,396); 2006 - $6,885; 2005 - $303) +5,709 +(13,366 +) +(589 +) +Balance at end of the year +22,268 +3,923 +9,398 +UNEARNED COMPENSATION +Balance at beginning of the year +- +(5,873 +) +(4,955 +) +Awards under restricted stock incentive plans +- +- +(4,190 +) +Compensation expense +- +- +3,272 +Reclassification of unearned compensation upon +adoption of SFAS No. 123(R) +- +5,873 +- +Balance at end of the year +- +- +(5,873 +) +COST OF SHARES IN TREASURY +Balance at beginning of the year +(110,988 +) +(66,291 +) +(160,474 +) +Common stock purchased for treasury (2007 - 4,587,473 +shares; 2006 - 1,937,450 shares; 2005 - 2,994,210 shares) +(133,379 +) +(45,009 +) +(64,856 +) +Issuance of treasury shares (2007 - 12,661 shares; +2006 - 14,511 shares; 2005 - 11,662 shares) +301 +312 +236 +Impact of stock split on treasury shares +- +- +158,803 +Balance at end of the year +(244,066 +) +(110,988 +) +(66,291 +) +Total stockholders' equity at end of the year +$ +478,779 +$ +504,559 +$ +462,321 +COMPREHENSIVE INCOME +Net earnings +$ +92,886 +$ +83,647 +$ +74,467 +Foreign currency translation adjustments +13,643 +9,548 +(11,544 +) +Change in fair value of foreign exchange contracts, net +of taxes +(1,007 +) +(1,657 +) +2,085 +Pension liability adjustment, net of taxes +5,709 +(306 +) +(589 +) +Total comprehensive income +$ +111,231 +$ +91,232 +$ +64,419 +( ) Denotes deduction. +See accompanying notes to consolidated financial statements. +A-2 +CONSOLIDATED STATEMENTS OF OPERATIONS +Fiscal Year +2007 +2006 +2005 +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +1,198,972 +$ +1,141,887 +$ +1,060,999 +Cost and expenses: +Cost of products sold +727,041 +700,349 +655,800 +Selling and administrative expenses +333,151 +318,243 +291,891 +Interest expense +2,470 +2,973 +3,647 +Interest income +(3,134 +) +(3,175 +) +(1,736 +) +Other expense +873 +1,205 +150 +1,060,401 +1,019,595 +949,752 +Earnings before income taxes +138,571 +122,292 +111,247 +Income taxes +45,685 +38,645 +36,780 +Net earnings +$ +92,886 +$ +83,647 +$ +74,467 +Net earnings per share: +Basic +$ +1.77 +$ +1.52 +$ +1.33 +Diluted +1.70 +1.47 +1.27 +See accompanying notes to consolidated financial statements. +A-3 +CONSOLIDATED STATEMENTS OF CASH FLOWS +Fiscal Year +2007 +2006 +2005 +(Thousands of Dollars) +OPERATING ACTIVITIES +Net earnings +$ +92,886 +$ +83,647 +$ +74,467 +Adjustments necessary to reconcile net earnings +to net cash provided by operating activities: +Depreciation +20,223 +21,024 +19,470 +Amortization +2,568 +968 +593 +Deferred income taxes +(5,660 +) +(8,543 +) +(4,908 +) +Stock-based compensation expense +8,316 +7,155 +3,272 +Excess tax benefits from stock-based compensation +(2,620 +) +(3,599 +) +- +Pension +2,884 +7,254 +6,221 +Other +4,339 +3,498 +2,378 +Changes in operating assets and liabilities: +Accounts receivable +(21,530 +) +6,409 +(7,739 +) +Inventories +22,450 +(18,764 +) +19,375 +Other operating assets +3,141 +(3,382 +) +11,221 +Accounts payable +3,140 +5,434 +(4,862 +) +Other operating liabilities +(6,849 +) +8,588 +(2,153 +) +Net cash provided by operating activities +123,288 +109,689 +117,335 +INVESTING ACTIVITIES +Business acquisitions, net of cash acquired +- +- +(4,602 +) +Additions to property, plant and equipment +(17,879 +) +(17,067 +) +(19,160 +) +Other +(4,441 +) +(2,039 +) +3,599 +Net cash used in investing activities +(22,320 +) +(19,106 +) +(20,163 +) +FINANCING ACTIVITIES +Proceeds from long-term borrowings +168,287 +61,685 +69,972 +Payments of long-term debt +(179,026 +) +(72,624 +) +(81,465 +) +Cash dividends paid +(18,391 +) +(16,079 +) +(14,814 +) +Purchase of common stock for treasury +(133,379 +) +(45,009 +) +(64,856 +) +Proceeds from shares issued under stock incentive plans +5,662 +13,752 +11,951 +Excess tax benefits from stock-based compensation +2,620 +3,599 +- +Net cash used in financing activities +(154,227 +) +(54,676 +) +(79,212 +) +Effect of foreign exchange rate changes +4,683 +3,498 +(4,874 +) +Increase (decrease) in cash and cash equivalents +(48,576 +) +39,405 +13,086 +Cash and cash equivalents at beginning of the year +124,663 +85,258 +72,172 +Cash and cash equivalents at end of the year +$ +76,087 +$ +124,663 +$ +85,258 +OTHER CASH FLOW INFORMATION +Interest paid +$ +1,916 +$ +2,545 +$ +3,171 +Net income taxes paid +48,336 +35,784 +27,207 +( ) Denotes reduction in cash and cash equivalents. +See accompanying notes to consolidated financial statements. +A-4 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. Summary of Significant Accounting Policies +NATURE OF OPERATIONS +Wolverine World Wide, Inc. (NYSE: WWW) is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, performance outdoor footwear, apparel, work shoes and boots, and uniform shoes and boots. The Company's global portfolio of owned and licensed brands includes: Bates ®, Cat ® Footwear, Harley-Davidson ® Footwear, Hush Puppies ®, HyTest ®, Merrell ®, Patagonia ® Footwear, Sebago ®, Stanley ® Footgear and Wolverine ®. Apparel and licensing programs are utilized to extend the Company's owned brands into product categories beyond footwear. The Company also operates a retail division to showcase its brands and branded footwear and apparel from other manufacturers, a tannery that produces Wolverine Performance Leathers ™ and a pigskin procurement operation. +PRINCIPLES OF CONSOLIDATION +The consolidated financial statements include the accounts of Wolverine World Wide, Inc. and its wholly owned subsidiaries (collectively, the "Company"). All intercompany accounts and transactions have been eliminated in consolidation. +FISCAL YEAR +The Company's fiscal year is the 52- or 53-week period that ends on the Saturday nearest to December 31. Fiscal years presented in this report include the 52-week periods ended December 29, 2007, December 30, 2006 and December 31, 2005. +USE OF ESTIMATES +The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. +REVENUE RECOGNITION +Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped, legal title has passed to the customer and collectibility is reasonably assured. Revenue generated through programs with licensees and distributors involving products bearing the Company's trademarks is recognized as earned according to stated contractual terms upon either the purchase or shipment of branded products by licensees and distributors. +The Company records provisions against gross revenue for estimated stock returns and cash discounts in the period when the related revenue is recorded. These estimates are based on factors that include, but are not limited to, historical stock returns, historical discounts taken and analysis of credit memorandum activity. +COST OF PRODUCTS SOLD +Cost of products sold for the Company's operations include the actual product costs, including inbound freight charges, purchasing, sourcing, inspection and receiving costs. Warehousing costs are included in selling and administrative expenses. +SHIPPING AND HANDLING COSTS +Shipping and handling costs that are charged to and reimbursed by the customer are recognized as revenue, while the related expenses incurred by the Company are recorded as cost of products sold in the consolidated statements of operations. +A-5 +CASH EQUIVALENTS +All short-term investments with a maturity of three months or less when purchased are considered cash equivalents. +ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS +The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from its customers' inability to make required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. Adjustments to these estimates may be required if the financial condition of the Company's customers were to change. The Company does not require collateral or other security on trade accounts receivable. +INVENTORIES +Inventories are valued at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for all domestic raw materials and work-in-process inventories, and certain U.S. finished goods inventories. Cost is determined using methods approximating cost under the first-in, first-out (FIFO) method for all raw materials, work-in-process and finished goods inventories in foreign countries. The FIFO method is also used for all finished goods inventories of the Company's retail business, due to the unique nature of that operation, and for certain U.S. finished goods inventories that were acquired as part of asset purchase transactions. Once elected, the Company has applied these inventory cost valuation methods consistently from year to year. +PROPERTY, PLANT AND EQUIPMENT +Property, plant and equipment are stated on the basis of cost and include expenditures for new facilities, major renewals, betterments and software. Normal repairs and maintenance are expensed as incurred. +Depreciation of property, plant and equipment is computed using the straight-line method. The depreciable lives range from five to forty years for buildings and improvements and from three to ten years for machinery, equipment and software. Leasehold improvements are depreciated at the lesser of the estimated useful life or lease term, including reasonably assured lease renewals as determined at lease inception. +GOODWILL AND OTHER INTANGIBLES +Goodwill represents the excess of the purchase price over the fair value of net tangible and identifiable intangible assets of acquired businesses. Other intangibles consist primarily of trademarks, brand names, patents and customer relationships. Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets . The Company reviews the carrying amounts of goodwill and other non-amortizable intangible assets annually by reporting unit to determine if such assets may be impaired. If the carrying amounts of these assets are not recoverable based upon a discounted cash flow analysis, such assets are reduced by the estimated shortfall of fair value to recorded value. Other amortizable intangible assets (principally patents) are amortized using the straight-line method over their estimated useful lives (periods ranging from two to ten years). Other amortizable intangible assets are included in other assets on the consolidated balance sheets and have net carrying amounts of $3,487,000 and $3,389,000 for 2007 and 2006, respectively, and accumulated amortization of $4,986,000 and $2,457,000 for 2007 and 2006, respectively. Estimated aggregate amortization expense for such intangibles for each of the five fiscal years subsequent to 2007 is as follows: 2008 - $1,197,000; 2009 - $1,046,000; 2010 - $781,000; 2011 - $343,000; 2012 - $60,000. +The Company has performed the required annual impairment tests and has determined that there was no impairment indicated for recorded goodwill and other non-amortizable intangibles. +A-6 +The changes in the carrying amount of goodwill and other non-amortizable intangibles for the years ended December 29, 2007 and December 30, 2006 are as follows: +Goodwill +Trademarks +Total +(Thousands of Dollars) +Balance at December 31, 2005 +$ +35,624 +$ +8,347 +$ +43,971 +Intangibles acquired +- +277 +277 +Trademark disposals +- +(118 +) +(118 +) +Foreign currency translation effects +3,152 +- +3,152 +Balance at December 30, 2006 +$ +38,776 +$ +8,506 +$ +47,282 +Intangibles acquired +- +430 +430 +Foreign currency translation effects +797 +- +797 +Balance at December 29, 2007 +$ +39,573 +$ +8,936 +$ +48,509 +IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS +The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or an asset group may not be recoverable. Each impairment test is based on a comparison of the carrying amount of the asset or asset group to the future undiscounted net cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment amount to be recognized is the amount by which the carrying value of the assets exceeds their fair value. +STOCK-BASED COMPENSATION +Prior to January 1, 2006, the Company followed Accounting Principles Board (APB) Opinion No. 25 , Accounting for Stock Issued to Employees , and related Interpretations, in accounting for its stock incentive plans. The Company did not recognize stock-based compensation expense related to employee stock options in its statements of operations for periods prior to the adoption of SFAS No. 123(R), Share-Based Payment , as options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R) using the modified prospective transition method. Under that transition method, compensation cost recognized in the years ended December 29, 2007 and December 30, 2006 includes: (a) compensation cost for all stock-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimate in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation , and (b) compensation cost for all stock-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Results of prior periods have not been restated. +The Company recognized compensation costs of $8,316,000 and $7,155,000 and related income tax benefits of $2,092,000 and $1,967,000 for its stock-based compensation plans in the statements of operations for the years ended December 29, 2007 and December 30, 2006, respectively. Compensation costs capitalized as part of inventory and property, plant and equipment were not material. +A-7 +Pro forma information regarding net earnings and earnings per share has been determined as if the Company had applied the fair value recognition provisions of SFAS No. 123 to its stock awards for all periods presented. For purposes of pro forma disclosures, the estimated fair values of stock options are amortized to expense over the related vesting periods and awards subject to acceleration of vesting upon retirement are recognized over the explicit service period up to the date of actual retirement. The Company's pro forma information under SFAS No. 123 is as follows: +2005 +(Thousands of Dollars, Except Per Share Data) +Net earnings, as reported +$ +74,467 +Add: +Total stock-based employee compensation expense +included in reported net income, net of related tax effects +3,272 +Deduct: +Total stock-based employee compensation expense +determined under fair value method for all awards, +net of related tax effects +7,266 +Pro forma net earnings +$ +70,473 +Net earnings per share: +Basic-as reported +$ +1.33 +Basic-pro forma +1.26 +Diluted-as reported +1.27 +Diluted-pro forma +1.20 +The Company estimated the fair value of employee stock options on the date of grant using the Black-Scholes model. The estimated weighted-average fair value for each option granted was $6.87, $5.29 and $5.10 per share in 2007, 2006 and 2005, respectively, with the following weighted-average assumptions: +2007 +2006 +2005 +Expected market price volatility (1) +23.3% +24.5% +23.9% +Risk-free interest rate (2) +4.8% +4.6% +3.7% +Dividend yield (3) +1.4% +1.4% +1.1% +Expected term (4) +4 years +4 years +4 years +(1) +Based on historical volatility of the Company's common stock. The expected volatility is based on the daily percentage change in the price of the stock over four years. +(2) +Represents the U.S. Treasury yield curve in effect for the expected term of the option at the time of grant. +(3) +Represents the Company's cash dividend yield for the expected term. +(4) +Represents the period of time that options granted are expected to be outstanding. The Company determined that all employee groups exhibit similar exercise and post-vesting termination behavior to determine the expected term. +Stock-based compensation expense recognized in the consolidated condensed statements of operations for the years ended December 29, 2007 and December 30, 2006 has been reduced for estimated forfeitures, as it is based on awards ultimately expected to vest. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience. In the Company's pro forma information required under SFAS No. 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred. The cumulative effect of the change in accounting for forfeitures was not material. +ADVERTISING COSTS +Advertising costs are expensed as incurred and customer specific advertising dollars are expensed when earned by customers. Total advertising expense was $45,982,000 in 2007, $42,037,000 in 2006 and $40,059,000 in 2005, and includes customer specific advertising dollars of $12,160,000 in 2007, +A-8 +$9,327,000 in 2006 and $6,445,000 in 2005. The Company provides sales incentives to certain retail customers in the form of a cooperative advertising program and accounts for this in accordance with EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products) . Under this program, customers are reimbursed for Company-approved advertising expenditures where the value to the Company is objectively verifiable. +INCOME TAXES +The provision for income taxes is based on the earnings reported in the consolidated financial statements. A deferred income tax asset or liability is determined by applying currently enacted tax laws and rates to the cumulative temporary differences between the carrying values of assets and liabilities for financial statement and income tax purposes. +EARNINGS PER SHARE +Basic earnings per share is computed based on weighted-average shares of common stock outstanding during each year after adjustment for nonvested common stock issued under restricted stock incentive plans. Diluted earnings per share assumes the exercise of dilutive stock options and the vesting of all common stock under restricted stock programs. +The following table sets forth the reconciliation of weighted average shares used in the computation of basic and diluted earnings per share: +2007 +2006 +2005 +Weighted average shares outstanding during the year +53,140,581 +55,655,822 +57,241,893 +Adjustment for nonvested restricted common stock +(641,088 +) +(802,624 +) +(1,098,177 +) +Denominator for basic earnings per share +52,499,493 +54,853,198 +56,143,716 +Effect of dilutive stock options +1,586,804 +1,622,103 +1,742,344 +Adjustment for nonvested common stock - treasury method +401,369 +455,806 +789,065 +Denominator for diluted earnings per share +54,487,666 +56,931,107 +58,675,125 +Options to purchase 546,247 shares of common stock in 2007, 507,775 shares in 2006 and 516,335 shares in 2005 have not been included in the denominator for the computation of diluted earnings per share because the related exercise prices were greater than the average market price for the period and, therefore, they were antidilutive. +STOCK SPLIT +On December 15, 2004, the Company announced a three-for-two stock split in the form of a stock dividend on shares of common stock outstanding at January 3, 2005 that was distributed to stockholders on February 1, 2005. All share and per share amounts in the consolidated financial statements and related notes have been adjusted for all periods to reflect the stock split. Treasury shares were not split in the transaction; however, in conjunction with the stock split, 9,352,361 shares of treasury stock were issued to fund a portion of the transaction. +FOREIGN CURRENCY +For the Company's international subsidiaries, the local currency is the functional currency. Assets and liabilities of these subsidiaries are translated into U.S. dollars at the year-end exchange rate. Operating statement amounts are translated at average exchange rates for the period. The cumulative translation adjustments resulting from changes in exchange rates are included in the consolidated balance sheets as a component of accumulated other comprehensive income in stockholders' equity. Transaction gains and losses are included in the consolidated statements of operations and were not material. +FINANCIAL INSTRUMENTS AND RISK MANAGEMENT +The Company's financial instruments consist of cash and cash equivalents, accounts and notes receivable, accounts and notes payable and long-term debt. Except for fixed rate long-term debt with a carrying value of $10,714,000 and a fair value of $10,976,000 at December 29, 2007 and a carrying value of $21,429,000 and a fair value of $21,723,000 at December 30, 2006, the Company's estimate of the fair +A-9 +values of these financial instruments approximates their carrying amounts for the respective years. Fair value was determined using discounted cash flow analyses and current interest rates for similar instruments. The Company does not hold or issue financial instruments for trading purposes. +The Company follows SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities , as amended by SFAS Nos. 137 and 138, which requires that all derivative instruments be recorded on the consolidated balance sheets at fair value and establishes criteria for designation and effectiveness of hedging relationships. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with inventory purchases made by non-U.S. wholesale operations in foreign currencies in the normal course of business. At December 29, 2007 and December 30, 2006, foreign exchange contracts with a notional value of $70,357,000 and $56,399,000, respectively, were outstanding to purchase various currencies (principally U.S. dollars) with maturities ranging up to 252 days. These contracts have been designated as cash flow hedges. As of December 29, 2007 and December 30, 2006, liabilities of $1,918,000 and $1,352,000, respectively, have been recognized for the fair value of the foreign currency forward exchange contracts. +The fair value of the foreign currency forward exchange contracts represents the estimated receipts or payments necessary to terminate the contracts. Hedge effectiveness is evaluated by the hypothetical derivative method. Any hedge ineffectiveness is reported within the cost of products sold caption of the consolidated statements of operations. Hedge ineffectiveness was not material in 2007 or 2006. If, in the future, the foreign exchange contracts are determined to be ineffective hedges or terminated before their contractual termination dates, the Company would be required to reclassify into earnings all or a portion of the unrealized amounts related to the cash flow hedges that are currently included in accumulated other comprehensive income within stockholders' equity. +COMPREHENSIVE INCOME +Comprehensive income represents net earnings and any revenue, expenses, gains and losses that, under accounting principles generally accepted in the United States, are excluded from net earnings and recognized directly as a component of stockholders' equity. +Ending accumulated other comprehensive income is as follows: +2007 +2006 +(Thousands of Dollars) +Foreign currency translation adjustments +$ +35,433 +$ +21,790 +Foreign currency cash flow hedge adjustments, net of taxes +(2007 - $1,543; 2006 - $614) +(2,055 +) +(1,048 +) +Pension adjustments, net of taxes +(2007 - $5,268; 2006 - $8,664) +(11,110 +) +(16,819 +) +Accumulated other comprehensive income +$ +22,268 +$ +3,923 +RECLASSIFICATIONS +Certain amounts previously reported in 2006 and 2005 have been reclassified to conform with the presentation used in 2007. +2. Inventories +Inventories of $61,070,000 at December 29, 2007 and $71,420,000 at December 30, 2006 have been valued using the LIFO method. If the FIFO method had been used, inventories would have been $8,983,000 and $8,191,000 higher than reported at December 29, 2007 and December 30, 2006, respectively. +A-10 +3. Debt +Long-term debt consists of the following obligations: +2007 +2006 +(Thousands of Dollars) +6.5% senior notes payable +$ +10,714 +$ +21,429 +Other +17 +42 +10,731 +21,471 +Less current maturities +10,731 +10,730 +$ +- +$ +10,741 +The 6.5% unsecured senior notes payable require annual principal payments of $10,714,000 due through the maturity date of December 8, 2008. In connection with the issuance of these senior notes, the Company entered into an interest rate lock agreement with a bank that was settled in 1998 and resulted in a prepayment of interest of $2,200,000. This prepayment is being amortized over the remaining term of the notes using the effective interest method. The remaining unamortized balance at December 29, 2007 was $231,000. +The Company has an unsecured revolving credit agreement that allows for borrowings up to $150,000,000, subject to increase or decrease as specified in the credit agreement. This agreement, which expires in July 2010, requires that interest be paid at a variable rate based on one of the following options elected by the Company: prime, LIBOR or money market rate plus applicable spread. No amounts were outstanding under revolving credit facilities at December 29, 2007 or December 30, 2006. +The Company had commercial letters of credit outstanding of $2,060,000 and $2,813,000 at December 29, 2007 and December 30, 2006, respectively. +The long-term loan agreements contain restrictive covenants that, among other things, require the Company to maintain certain financial ratios and minimum levels of consolidated net worth. At December 29, 2007, the Company was in compliance with all restrictive covenants. The agreements also impose restrictions on securing additional debt, sale and merger transactions and the disposition of significant assets. +Interest costs of $237,000 in 2007, $170,000 in 2006 and $208,000 in 2005 were capitalized in connection with various capital improvement and computer hardware and software installation projects. +4. Leases +The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2023. Certain leases contain renewal provisions and generally require the Company to pay utilities, insurance, taxes and other operating expenses. At December 29, 2007, minimum rental payments due under all noncancelable leases were as follows: 2008 - $18,702,000; 2009 - $18,260,000; 2010 - $15,308,000; 2011 - $13,648,000; 2012 - $12,826,000; thereafter - $80,514,000. +Rental expense under all operating leases consisted primarily of minimum rentals and totaled $14,681,000 in 2007, $13,934,000 in 2006 and $12,403,000 in 2005. +5. Capital Stock +The Company has 2,000,000 authorized shares of $1 par value preferred stock, of which none is issued or outstanding. The Company had designated 500,000 shares of preferred stock as Series B junior participating preferred stock for possible future issuance under a preferred stock rights plan. +As of December 29, 2007, the Company had stock options outstanding or available for grant under stock incentive plans adopted in 1993, 1995, 1997, 1999, 2001, 2003 and 2005. Shares of restricted stock may also be granted under each of these plans, with the exception of the 1993, 1995 and 1997 plans. As of +A-11 +December 29, 2007, the Company had approximately 3,387,120 stock incentive units available for issuance under the Stock Incentive Plan of 2005. Under the provisions of the Stock Incentive Plan of 2005, each option granted counts as one stock incentive unit and each share of restricted stock granted counts as two stock incentive units. In addition, as of December 29, 2007, the Company had approximately 491,246 stock incentive units available for grant under the balance of its other plans. Options granted under each plan have an exercise price equal to the fair market value of the underlying stock on the grant date, expire no later than ten years from the grant date and generally vest over three years. Common stock issued under these plans is subject to certain restrictions, including a prohibition against any sale, transfer or other disposition by the officer or employee during the vesting period (except for certain transfers for estate planning purposes for certain officers) and a requirement to forfeit all or a certain portion of the award upon certain terminations of employment or upon failure to achieve performance criteria in certain instances. These restrictions typically lapse over a three- to five-year period from the date of the award. The Company has elected to recognize expense for these stock-based incentive plans ratably over the vesting term on a straight-line basis. Certain option and restricted share awards provide for accelerated vesting under various scenarios, including retirement and upon a change in control of the Company. With regard to acceleration of vesting upon retirement, employees of eligible retirement age are vested in accordance with plan provisions and applicable stock option and restricted stock agreements. The Company issues shares to plan participants upon exercise or vesting of stock-based incentive awards from either authorized, but unissued, shares or treasury shares. +A summary of the transactions under the stock option plans is as follows: +Shares +Under +Option +Weighted- +Average +Exercise +Price +Average +Remaining +Contractual +Term +(Years) +Aggregate +Intrinsic +Value +Outstanding at January 1, 2005 +5,582,349 +$13.14 +Granted +643,695 +22.89 +Exercised +(1,166,838 +) +11.62 +Cancelled +(18,494 +) +16.30 +Outstanding at December 31, 2005 +5,040,712 +$14.72 +5.6 +$39,201,000 +Granted +735,210 +22.71 +Exercised +(1,168,639 +) +12.51 +Cancelled +(32,338 +) +20.46 +Outstanding at December 30, 2006 +4,574,945 +$16.53 +5.6 +$54,873,000 +Granted +623,577 +30.16 +Exercised +(551,020 +) +14.67 +Cancelled +(59,257 +) +27.73 +Outstanding at December 29, 2007 +4,588,245 +$18.46 +5.4 +$31,096,000 +Estimated forfeitures +(13,852 +) +Vested or expected to vest at +December 29, 2007 +4,574,393 +$18.43 +5.3 +$31,086,000 +Nonvested at December 29, 2007 +and expected to vest +(939,298 +) +Exercisable at December 29, 2007 +3,635,095 +$16.22 +4.5 +$30,303,000 +The total pre-tax intrinsic value of options exercised during the year ended December 29, 2007 was $7,498,000. As of December 29, 2007, there was $2,498,000 of unrecognized compensation cost related to stock option awards that is expected to be recognized over a weighted-average period of 1.2 years. +A-12 +The aggregate intrinsic value in the preceding table represents the total pre-tax intrinsic value, based on the Company's closing stock price of $24.50 as of December 29, 2007, which would have been received by the option holders had all option holders exercised in-the-money options as of that date. The total number of in-the-money options exercisable as of December 29, 2007 was 3,591,347. As of December 30, 2006, 3,897,145 outstanding options were exercisable, and the weighted-average exercise price was $15.46. +A summary of the nonvested restricted shares issued under stock award plans is as follows: +Shares +Weighted- +Average +Grant Date +Fair Value +Nonvested at January 1, 2005 +905,562 +$ 11.85 +Granted +188,150 +23.03 +Vested +(159,821 +) +10.80 +Forfeited +- +- +Nonvested at December 31, 2005 +933,891 +$ 14.28 +Granted +178,950 +22.59 +Vested +(324,735 +) +12.06 +Forfeited +(12,296 +) +17.09 +Nonvested at December 30, 2006 +775,810 +$ 17.09 +Granted +146,950 +30.17 +Vested +(335,695 +) +14.81 +Forfeited +(13,684 +) +27.64 +Nonvested at December 29, 2007 +573,381 +$ 21.52 +As of December 29, 2007, there was $3,732,000 of unrecognized compensation cost related to nonvested share-based compensation arrangements granted under restricted stock award plans. That cost is expected to be recognized over a weighted-average period of 1.6 years. The total fair value of shares vested during the year ended December 29, 2007 was $9,793,000. +6. Retirement Plans +The Company has noncontributory, defined benefit pension plans covering a majority of its domestic employees. The Company's principal defined benefit pension plan provides benefits based on the employees' years of service and final average earnings (as defined in the plan), while the other plan provides benefits at a fixed rate per year of service. The Company intends to annually contribute amounts deemed necessary to maintain the plans on a sound actuarial basis. +The Company has a Supplemental Executive Retirement Plan ("SERP") for certain current and former employees that entitles them to receive payments from the Company following retirement based on the employees' years of service and final average earnings (as defined in the SERP). Under the SERP, the employees can elect early retirement with a corresponding reduction in benefits. The Company also has individual deferred compensation agreements with certain former employees that entitle them to receive payments from the Company for a period of fifteen to eighteen years following retirement. The Company maintains life insurance policies with a cash surrender value of $32,157,000 at December 29, 2007 and $31,025,000 at December 30, 2006 that are intended to fund deferred compensation benefits under the SERP and deferred compensation agreements. +The Company has a defined contribution money accumulation plan ("MAP") covering substantially all domestic employees that provides for Company contributions based on earnings. Prior to January 1, 2007, this plan was combined with the principal defined benefit pension plan for funding purposes under Code Section 414(k) of the Internal Revenue Code ("IRC"). On January 1, 2007, the assets and projected benefit obligation attributable to the Code Section 414(k) arrangement were split off from the defined benefit pension plan and merged with the MAP. The Company recognized expense for the MAP of $2,078,000 in 2007, $2,100,000 in 2006 and $2,031,000 in 2005. The Company has certain defined +A-13 +contribution plans at foreign subsidiaries. Contributions to these plans were $1,327,000 in 2007, $978,000 in 2006 and $962,000 in 2005. The Company also has a defined benefit plan at a foreign location that provides for retirement benefits based on years of service. The obligation recorded under this plan was $2,466,000 at December 29, 2007 and $2,500,000 at December 30, 2006 with the majority recognized in the deferred compensation liability on the accompanying balance sheet. +On December 30, 2006, the Company adopted the recognition and disclosure provisions of SFAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans . SFAS No. 158 requires the Company to recognize the funded status of its pension plans in the December 30, 2006 consolidated balance sheets, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The adjustment to accumulated other comprehensive income at adoption represents the net unrecognized actuarial losses and unrecognized prior service costs, which were previously netted against the plan's funded status in the Company's consolidated balance sheets pursuant to the provisions of SFAS No. 87, Employers' Accounting for Pensions . These amounts will be subsequently recognized as a component of net periodic pension cost on the same basis as the amounts recognized in accumulated other comprehensive income at adoption of SFAS No. 158. +The incremental effects of adopting the provisions of SFAS No. 158 on the Company's consolidated balance sheets at December 30, 2006 are presented in the following table. There was no effect on the Company's consolidated statements of operations for the year ended December 30, 2006, or for any prior period presented, and it will not affect the Company's operating results in future periods. +Before +Implementation +of SFAS No. 158 +Change +Due to +SFAS No. 158 +After +Implementation +of SFAS No. 158 +(Thousands of Dollars) +Assets: +Prepaid pension cost +$ +28,443 +$ +(18,210 +) +$ +10,233 +Deferred income taxes +1,936 +6,728 +8,664 +Intangible asset - pension +854 +(854 +) +- +Total assets +$ +31,233 +$ +(12,336 +) +$ +18,897 +Liabilities and Stockholders' Equity: +Accrued pension liabilities +$ +21,166 +$ +1,578 +$ +22,744 +Accumulated other comprehensive income +(3,759 +) +(13,060 +) +(16,819 +) +Total liabilities and stockholders' equity +$ +17,407 +$ +(11,482 +) +$ +5,925 +A-14 +Effective in 2007, the Company adopted the measurement date provisions of SFAS No. 158 requiring the measurement date of the defined benefit pension plans to correspond with the Company's fiscal year end. As a result, the Company recognized a reduction of $1,642,000 in retained earnings and a reduction in accumulated other comprehensive income of $6,338,000. The previous measurement date was September 30. The following summarizes the status of and changes in the Company's pension assets and related obligations for its pension plans (which include the Company's defined benefit pension plans and the SERP) as of: +12/29/2007 +09/30/2006 +(Thousands of Dollars) +Change in projected benefit obligations: +Projected benefit obligations at beginning of the year +$ +176,262 +$ +167,631 +Service cost pertaining to benefits earned during the year +6,061 +4,940 +Interest cost on projected benefit obligations +13,701 +10,342 +Actuarial losses +141 +1,124 +Plan amendment +717 +- +IRC Code Section 414(k) split-off +(10,785 +) +- +Benefits paid to plan participants +(11,006 +) +(7,775 +) +Projected benefit obligations at end of the year +$ +175,091 +$ +176,262 +Change in fair value of pension assets: +Fair value of pension assets at beginning of the year +$ +163,498 +$ +158,407 +Actual return on plan assets +20,682 +8,991 +Company contributions +4,770 +3,875 +IRC Code Section 414(k) split-off +(10,785 +) +- +Benefits paid to plan participants +(11,006 +) +(7,775 +) +Fair value of pension assets at end of the year +$ +167,159 +$ +163,498 +Funded status +$ +(7,932 +) +$ +(12,764 +) +Amounts recognized in the consolidated balance sheets: +Non current assets +17,752 +10,233 +Non current liabilities +(25,684 +) +(22,997 +) +Net amount recognized +$ +(7,932 +) +$ +(12,764 +) +Amounts recognized in accumulated other comprehensive income, net of tax: +Unrecognized net actuarial loss +$ +9,757 +$ +15,529 +Unrecognized prior service cost +1,353 +1,290 +Net amount recognized +$ +11,110 +$ +16,819 +Funded status of pension plans and SERP (supplemental): +Funded status of qualified defined benefit plans and SERP +$ +(7,932 +) +$ +(12,764 +) +Nonqualified trust assets (cash surrender value of life insurance) recorded +in other assets and intended to satisfy the projected benefit obligation +of unfunded supplemental employee retirement plans +30,715 +29,020 +Net funded status of pension plans and SERP (supplemental) +$ +22,783 +$ +16,256 +A-15 +Information for pension plans with an accumulated benefit obligation in excess of plan assets: +December 29, +2007 +September 30, +2006 +(Thousands of Dollars) +Projected benefit obligations +$ +28,729 +$ +32,847 +Accumulated benefit obligations +26,910 +31,268 +Fair value of plan assets +2,886 +9,463 +The accumulated benefit obligations for all defined benefit pension plans and the SERP were $164,094,000 at December 29, 2007 and $165,935,000 at September 30, 2006. +The following is a summary of net pension and SERP cost recognized by the Company: +2007 +2006 +2005 +(Thousands of Dollars) +Service cost pertaining to benefits earned during the year +$ +(4,849 +) +$ +(4,940 +) +$ +(4,272 +) +Interest cost on projected benefit obligations +(11,011 +) +(10,342 +) +(9,444 +) +Expected return on pension assets +14,024 +12,844 +12,013 +Net amortization loss +(5,569 +) +(8,743 +) +(7,800 +) +Net pension cost +$ +(7,405 +) +$ +(11,181 +) +$ +(9,503 +) +The prior service cost and actuarial loss included in accumulated other comprehensive income and expected to be recognized in net periodic pension cost during 2008 is $458,000 ($302,000, net of tax) and $3,509,000 ($2,316,000, net of tax), respectively. Expense for qualified defined benefit pension plans was $4,707,000 in 2007, $8,759,000 in 2006 and $7,916,000 in 2005. +2007 +2006 +Weighted average assumptions used to determine benefit obligations at measurement date: +Discount rate +6.70% +6.25% +Rate of compensation increase +3.50% +3.50% +Weighted average assumptions used to determine net periodic benefit cost for the years ended: +Discount rate +6.25% +6.00% +Expected long-term rate of return on plan assets +8.75% +8.75% +Rate of compensation increase +3.50% +3.50% +Unrecognized net experience losses exceeding certain corridors are amortized over a five-year period, unless the minimum amortization method based on average remaining service periods produces a higher amortization. The Company utilizes a bond matching calculation to determine the discount rate. +A-16 +The long-term rate of return is based on overall market expectations for a balanced portfolio with an asset mix similar to the Company's, utilizing historic returns for broad market and fixed income indices. +2007 +2006 +Weighted average asset allocations at measurement date by asset category are as follows: +Equity securities +75.4% +72.6% +Fixed income investments +20.0% +20.0% +Cash and money market investments +4.6% +7.4% +100.0% +100.0% +The Company's investment policy for plan assets uses a blended approach of U.S. and foreign equities combined with U.S. fixed income investments. Policy guidelines indicate that total equities should not exceed 80% and fixed income securities should not exceed 50%. Within the equity and fixed income classifications, the investments are diversified. +The Company expects to contribute $3,000,000 to its qualified defined benefit pension plans and $1,772,000 to the SERP in 2008. +Expected benefit payments for the five years subsequent to 2007 and the sum of the five years following those are as follows: 2008 - $9,622,000; 2009 - $9,895,000; 2010 - $10,218,000; 2011 - $10,730,000; 2012 - $11,062,000; and 2013 through 2017 - $64,832,000. +7. Income Taxes +Earnings before income taxes consist of the following: +2007 +2006 +2005 +(Thousands of Dollars) +United States +$ +87,648 +$ +84,379 +$ +73,541 +Foreign +50,923 +37,913 +37,706 +$ +138,571 +$ +122,292 +$ +111,247 +The provisions for income taxes consist of the following: +2007 +2006 +2005 +(Thousands of Dollars) +Currently payable: +Federal +$ +37,404 +$ +35,442 +$ +30,458 +State +977 +784 +636 +Foreign +12,964 +10,962 +10,594 +Deferred credit +(5,660 +) +(8,543 +) +(4,908 +) +$ +45,685 +$ +38,645 +$ +36,780 +A reconciliation of the Company's total income tax expense and the amount computed by applying the statutory federal income tax rate of 35% to earnings before income taxes is as follows: +2007 +2006 +2005 +(Thousands of Dollars) +Income taxes at statutory rate +$ +48,500 +$ +42,850 +$ +38,937 +State income taxes, net of federal income tax reduction +302 +349 +314 +Nontaxable earnings of foreign affiliates +(2,026 +) +(2,123 +) +(1,625 +) +Research and development credits +(877 +) +(481 +) +(740 +) +Repatriation of earnings of foreign subsidiaries +- +- +1,400 +Foreign earnings taxed at rates differing from +the U.S. statutory rate +(1,439 +) +(93 +) +(853 +) +Tax reserve adjustments +670 +(1,535 +) +- +Other +555 +(322 +) +(653 +) +$ +45,685 +$ +38,645 +$ +36,780 +A-17 +Significant components of the Company's deferred income tax assets and liabilities as of the end of 2007 and 2006 are as follows: +2007 +2006 +(Thousands of Dollars) +Deferred income tax assets: +Accounts receivable and inventory valuation allowances +$ +6,486 +$ +4,570 +Deferred compensation accruals +1,916 +2,140 +Future benefit of foreign net operating losses +254 +254 +Accrued pension costs +5,268 +8,664 +Other amounts not deductible until paid +10,370 +8,422 +Total deferred income tax assets +24,294 +24,050 +Deferred income tax liabilities: +Tax over book depreciation +(4,164 +) +(6,388 +) +Prepaid pension costs +(2,670 +) +(3,983 +) +Other +(1,674 +) +(1,597 +) +Total deferred income tax liabilities +(8,508 +) +(11,968 +) +Net deferred income tax assets +$ +15,786 +$ +12,082 +The Company adopted the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109 , on the first day of fiscal year 2007, December 31, 2006. Prior to adoption of FIN 48, the Company had unrecognized tax benefits of $1,599,000, net of tax. As a result of the implementation of FIN 48, the Company recognized an increase in the liability for unrecognized tax benefits of $369,000, which was accounted for as a reduction to the December 31, 2006 balance of retained earnings. +The following table summarizes the activity related to the Company's unrecognized tax benefits: +2007 +(Thousands of Dollars) +Balance at December 31, 2006 +$ +2,415 +Increases related to current year tax positions +1,001 +Release due to settlements of audits +(489 +) +Balance at December 29, 2007 +$ +2,927 +The Company had unrecognized tax benefits of $2,382,000 as of December 29, 2007, that if recognized currently would reduce the annual effective tax rate. Unrecognized tax benefits are not expected to change significantly over the next 12 months. The Company recognizes interest and penalties related to unrecognized tax benefits through interest expense and income tax expense, respectively. The Company has accrued approximately $140,000 for interest as part of the cumulative effect of implementing the provisions of FIN 48, which was accounted for as reduction to the December 31, 2006 balance of retained earnings. Net interest accrued as of December 29, 2007 was $282,000. +The Company is subject to periodic audits by domestic and foreign tax authorities. Currently, the Company is undergoing routine periodic audits in both domestic and foreign tax jurisdictions. It is reasonably possible that the amounts of unrecognized tax benefits could change in the next 12 months as a result of the audits; however, any payment of tax is not expected to be significant to the consolidated financial statements. +For the majority of tax jurisdictions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2004. +No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the remaining undistributed earnings of foreign subsidiaries of $176,219,000 at +A-18 +December 29, 2007 as the Company expects such earnings will remain invested overseas indefinitely. (At December 30, 2006, undistributed foreign earnings were $125,293,000). +8. Litigation and Contingencies +The Company is involved in various environmental claims and other legal actions arising in the normal course of business. The environmental claims include sites where the U.S. Environmental Protection Agency has notified the Company that it is a potentially responsible party with respect to environmental remediation. These remediation claims are subject to ongoing environmental impact studies, assessment of remediation alternatives, allocation of costs between responsible parties and concurrence by regulatory authorities and have not yet advanced to a stage where the Company's liability is fixed. However, after taking into consideration legal counsel's evaluation of all actions and claims against the Company, management is currently of the opinion that their outcome will not have a material adverse effect on the Company's consolidated financial position or future results of operations. +The Company is involved in routine litigation incidental to its business and is a party to legal actions and claims, including, but not limited to, those related to employment and intellectual property. Some of the legal proceedings include claims for compensatory as well as punitive damages. While the final outcome of these matters cannot be predicted with certainty, considering, among other things, the meritorious legal defenses available and liabilities that have been recorded along with applicable insurance, it is currently the opinion of the Company's management that these items will not have a material adverse effect on the Company's financial condition or future results of operations. +Pursuant to certain of the Company's lease agreements, the Company has provided financial guarantees to third parties in the form of indemnification provisions. These provisions indemnify and reimburse the third parties for costs, including but not limited to adverse judgments in lawsuits, taxes and operating costs. The terms of the guarantees are equal to the terms of the related lease agreements. The Company is not able to calculate the maximum potential amount of future payments it could be required to make under these guarantees, as the potential payment is dependent upon the occurrence of future unknown events. +The Company has future minimum royalty obligations due under the terms of certain licenses held by the Company. These minimum future obligations are as follows: +2008 +2009 +2010 +2011 +2012 +(Thousands of Dollars) +Minimum royalties +$1,062 +$1,328 +$1,544 +$1,772 +$970 +Minimum royalties are based on both fixed obligations and assumptions regarding the consumer price index. Royalty obligations in excess of minimum requirements are based upon future sales levels. In accordance with these agreements, the Company incurred royalty expense of $3,456,000, $3,159,000 and $3,145,000 for 2007, 2006 and 2005, respectively. +The terms of certain license agreements also require advertising expenditures based on the level of sales. In accordance with these agreements, the Company's advertising obligations, based on actual sales, totaled $2,590,000, $2,331,000 and $1,906,000 for 2007, 2006 and 2005, respectively. +9. Business Segments +The Company has one reportable segment that is engaged in manufacturing, sourcing, marketing, licensing and distributing branded footwear, apparel and accessories to the retail sector, including casual shoes, dress shoes, performance outdoor footwear, boots, uniform shoes, work shoes, slippers, moccasins and apparel and accessories. Revenue of this segment is derived from the sale of branded footwear and apparel to external customers as well as royalty income from the licensing of the Company's trademarks and brand names to licensees and distributors. The business units comprising the branded footwear, apparel and licensing segment manufacture or source, market and distribute products in a similar manner. +A-19 +Branded footwear, apparel and licensed products are distributed through wholesale channels and under licensing and distributor arrangements. +The other business units in the following tables consist of the Company's retail, tannery and pigskin procurement operations. The Company operated 90 retail stores in North America and 20 consumer-direct internet sites at December 29, 2007 that sell Company-manufactured and sourced products, as well as footwear manufactured by unaffiliated companies. The other business units distribute products through retail and wholesale channels. +The Company measures segment profits as earnings before income taxes. The accounting policies used to determine profitability and total assets of the branded products and other business segments are the same as disclosed in Note 1. +Business segment information is as follows: +2007 +Branded +Footwear, +Apparel +and Licensing +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +1,099,205 +$ +99,767 +$ +- +$ +1,198,972 +Intersegment sales +45,603 +2,616 +- +48,219 +Interest (income) expense - net +9,578 +1,128 +(11,370 +) +(664 +) +Depreciation expense +9,660 +3,621 +6,942 +20,223 +Earnings (loss) before income taxes +145,686 +2,338 +(9,453 +) +138,571 +Total assets +491,926 +52,018 +94,434 +638,378 +Additions to property, plant and equipment +7,313 +3,380 +7,186 +17,879 +2006 +Branded +Footwear, +Apparel +and Licensing +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +1,036,929 +$ +104,958 +$ +- +$ +1,141,887 +Intersegment sales +38,712 +2,798 +- +41,510 +Interest (income) expense - net +9,862 +1,050 +(11,114 +) +(202 +) +Depreciation expense +9,800 +3,859 +7,365 +21,024 +Earnings (loss) before income taxes +133,463 +6,976 +(18,147 +) +122,292 +Total assets +439,248 +50,040 +181,804 +671,092 +Additions to property, plant and equipment +6,943 +3,205 +6,919 +17,067 +A-20 +2005 +Branded +Footwear, +Apparel +and Licensing +Other +Businesses +Corporate +Consolidated +(Thousands of Dollars) +Revenue +$ +964,522 +$ +96,477 +$ +- +$ +1,060,999 +Intersegment sales +36,232 +3,437 +- +39,669 +Interest (income) expense - net +9,706 +1,009 +(8,804 +) +1,911 +Depreciation expense +7,845 +3,735 +7,890 +19,470 +Earnings (loss) before income taxes +120,668 +5,847 +(15,268 +) +111,247 +Total assets +406,024 +41,600 +178,956 +626,580 +Additions to property, plant and equipment +7,975 +4,721 +6,464 +19,160 +Geographic information, based on shipping destination, related to revenue from external customers included in the consolidated statements of operations is as follows: +2007 +2006 +2005 +(Thousands of Dollars) +United States +$ +730,654 +$ +721,459 +$ +705,413 +Foreign countries: +Europe +250,428 +220,370 +200,286 +Canada +86,339 +80,289 +66,157 +Other +131,551 +119,769 +89,143 +Total foreign countries revenue +468,318 +420,428 +355,586 +$ +1,198,972 +$ +1,141,887 +$ +1,060,999 +The Company's long-lived assets (primarily property, plant and equipment and intangible assets) are as follows: +2007 +2006 +2005 +(Thousands of Dollars) +United States +$ +135,756 +$ +137,807 +$ +131,820 +Foreign countries +35,352 +34,003 +40,277 +The Company does not believe that it is dependent upon any single customer, since no customer accounts for more than 10% of consolidated revenue. +The Company sources approximately 89% (based on pairs) of its footwear products from unrelated suppliers primarily located in Asia. The remainder is produced in Company-owned manufacturing facilities in the United States and the Dominican Republic. All apparel and accessories are sourced from unrelated suppliers. While changes in suppliers could cause delays in manufacturing and a possible loss of sales, management believes that other suppliers could provide similar products on comparable terms. +Revenue derived from the branded footwear, apparel and licensing segment accounted for approximately 92% of revenue in 2007 and 91% in 2006 and 2005. No other product groups account for more than 10% of consolidated revenue. +Approximately 14% of the Company's employees are subject to bargaining unit contracts extending through various dates ranging from 2008 through 2009. +A-21 +10. Quarterly Results of Operations (Unaudited) +The Company reports its quarterly results of operations on the basis of 12-week periods for each of the first three quarters and a 16- or 17-week period for the fourth quarter. The fourth quarters of 2007 and 2006 include 16 weeks. +The Company's unaudited quarterly results of operations are as follows: +2007 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +281,052 +$ +250,329 +$ +310,168 +$ +357,423 +Gross margin +114,001 +95,528 +124,952 +137,450 +Net earnings +22,289 +15,518 +29,483 +25,596 +Net earnings per share: +Basic +$ +.41 +$ +.29 +$ +.56 +$ +.51 +Diluted +.39 +.28 +.54 +.49 +2006 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +262,839 +$ +238,457 +$ +298,856 +$ +341,735 +Gross margin +105,875 +90,405 +117,542 +127,716 +Net earnings +19,629 +14,234 +26,140 +23,644 +Net earnings per share: +Basic +$ +.36 +$ +.26 +$ +.48 +$ +.42 +Diluted +.34 +.25 +.46 +.42 +11. Business Acquisitions +During the second quarter of 2005, the Company purchased the remaining 5% ownership from the minority stockholder of Wolverine Europe Limited, making it a wholly-owned subsidiary. The purchase price was $2,322,000. The transaction eliminated the minority interest of $566,000 and resulted in goodwill of $1,756,000. +On January 3, 2005, the Company converted its Cat ® and Wolverine ® businesses in Canada from a non-affiliated distributor-based operation to a Company-owned wholesale operation. This expansion allowed the Company to directly wholesale all major brands in Canada. Assets consisting primarily of inventory, fixed assets and amortizable intangible assets totaling $2,117,000 and assumed liabilities of $883,000 were acquired from a former Wolverine ® and Cat ® Footwear distributor for cash of $2,280,000 and resulted in goodwill and intangible assets of $1,046,000. Consolidated pro forma revenue and net earnings, assuming the transaction occurred at the beginning of 2005, were not materially different from reported amounts. Pursuant to SFAS No. 142, goodwill and indefinite-lived intangibles will not be amortized, but will be evaluated for impairment annually. Goodwill was assigned to the Company's branded footwear, apparel and licensing segment. The amortizable intangible assets have a weighted average useful life of approximately ten years. +On January 3, 2005, the Company converted its Merrell ® operations in Sweden and Finland and its Sebago ® operations in the United Kingdom and Germany from a non-affiliated distributor-based operation to a Company-owned wholesale operation. Assets consisting primarily of inventory totaling $544,000 were acquired from former distributors for cash. +A-22 +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +Wolverine World Wide, Inc. +We have audited the accompanying consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of December 29, 2007 and December 30, 2006, and the related consolidated statements of stockholders' equity and comprehensive income, operations, and cash flows for each of the three fiscal years in the period ended December 29, 2007. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Wolverine World Wide, Inc. and subsidiaries at December 29, 2007 and December 30, 2006, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended December 29, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. +As discussed in Note 1 to the consolidated financial statements, in 2006 the Company changed its method of accounting for share-based payments in connection with the required adoption of Statement of Financial Accounting Standards No. 123(R). As discussed in Note 6 to the consolidated financial statements, in 2006 and in 2007 the Company changed its method of accounting for defined benefit plans in connection with the required adoption of Statement of Financial Accounting Standards No. 158. As discussed in Note 7 to the consolidated financial statements, in 2007 the Company changed its method of accounting for uncertain tax positions in connection with the required adoption of Financial Accounting Standards Board Interpretation No. 48. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Wolverine World Wide, Inc.'s internal control over financial reporting as of December 29, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 8, 2008 expressed an unqualified opinion thereon. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +February 8, 2008 +A-23 +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +Wolverine World Wide, Inc. +We have audited Wolverine World Wide, Inc. and subsidiaries' internal control over financial reporting as of December 29, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Wolverine World Wide, Inc.'s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company's internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, Wolverine World Wide, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 29, 2007, based on the COSO criteria . +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2007 consolidated financial statements of Wolverine World Wide, Inc. and subsidiaries and our report dated February 8, 2008 expressed an unqualified opinion thereon. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +February 8, 2008 +A-24 +APPENDIX B +Schedule II - Valuation and Qualifying Accounts of Continuing Operations +Wolverine World Wide, Inc. and Subsidiaries +Column A +Column B +Column C +Column D +Column E +Additions +(1) +(2) +Description +Balance at +Beginning of +Period +Charged to +Costs and +Expenses +Charged to +Other +Accounts +(Describe) +Deductions +(Describe) +Balance at +End of +Period +Fiscal year ended December 29, 2007 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +6,324,000 +$ +2,169,000 +$ +1,627,000 +(A) +$ +6,866,000 +Allowance for sales returns +5,322,000 +30,363,000 +30,416,000 +(B) +5,269,000 +Allowance for cash discounts +1,674,000 +14,955,000 +15,121,000 +(C) +1,508,000 +Inventory valuation allowances +10,458,000 +6,831,000 +2,387,000 +(D) +14,902,000 +$ +23,778,000 +$ +54,318,000 +$ +49,551,000 +$ +28,545,000 +Fiscal year ended December 30, 2006 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +4,656,000 +$ +3,106,000 +$ +1,438,000 +(A) +$ +6,324,000 +Allowance for sales returns +2,540,000 +29,675,000 +26,893,000 +(B) +5,322,000 +Allowance for cash discounts +1,533,000 +14,920,000 +14,779,000 +(C) +1,674,000 +Inventory valuation allowances +6,456,000 +9,954,000 +5,952,000 +(D) +10,458,000 +$ +15,185,000 +$ +57,655,000 +$ +49,062,000 +$ +23,778,000 +Fiscal year ended December 31, 2005 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +4,834,000 +$ +1,706,000 +$ +1,884,000 +(A) +$ +4,656,000 +Allowance for sales returns +1,786,000 +28,405,000 +27,651,000 +(B) +2,540,000 +Allowance for cash discounts +1,580,000 +13,023,000 +13,070,000 +(C) +1,533,000 +Inventory valuation allowances +5,844,000 +10,941,000 +10,329,000 +(D) +6,456,000 +$ +14,044,000 +$ +54,075,000 +$ +52,934,000 +$ +15,185,000 +(A) +Accounts charged off, net of recoveries. +(B) +Actual customer returns. +(C) +Discounts given to customers. +(D) +Adjustment upon disposal of related inventories. +Commission File No. 001-6024 +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +EXHIBITS +TO +FORM 10-K +For the Fiscal Year Ended +December 29, 2007 +Wolverine World Wide, Inc. +9341 Courtland Drive +Rockford, Michigan 49351 +EXHIBIT INDEX +Exhibit +Number +Document +3.1 +Restated Certificate of Incorporation. Previously filed as Exhibit 3.1 to the Company's Annual Report on Form 10-K for the period ended December 30, 2006. Here incorporated by reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the period ended September 8, 2007. Here incorporated by reference. +4.1 +Restated Certificate of Incorporation. See Exhibit 3.1 above. +4.2 +Amended and Restated By-laws. See Exhibit 3.2 above. +4.3 +Note Purchase Agreement dated as of December 8, 1998, relating to 6.50% Senior Notes due on December 8, 2008. Previously filed as Exhibit 4.7 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. Here incorporated by reference. +4.4 +The Registrant has several classes of long-term debt instruments outstanding in addition to those described in Exhibits 4.3 and 4.5. The authorized amount of none of these classes of debt exceeds 10% of the Company's total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +4.5 +Credit Agreement dated as of July 22, 2005, among Wolverine World Wide, Inc. and certain of its subsidiaries, JPMorgan Chase Bank, N.A., as Administrative Agent, Harris, N.A., as Syndication Agent, Comerica Bank, Standard Federal Bank N.A. and National City Bank of the Midwest, as Documentation Agents, and certain other Banks that are parties to the Credit Agreement. Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated July 28, 2005. Here incorporated by reference. +10.1 +Amended and Restated 1993 Stock Incentive Plan.* Previously filed as Exhibit 10.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.2 +Amended and Restated 1995 Stock Incentive Plan.* Previously filed as Exhibit 10.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.3 +Amended and Restated 1997 Stock Incentive Plan.* Previously filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.4 +Amended and Restated Stock Incentive Plan of 1999.* Previously filed as Exhibit 10.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.5 +Amended and Restated Stock Incentive Plan of 2001.* Previously filed as Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.6 +Amended and Restated Stock Incentive Plan of 2003.* Previously filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.7 +Amended and Restated Stock Incentive Plan of 2005.* Previously filed as Exhibit 10.7 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.8 +Amended and Restated Directors' Stock Option Plan.* Previously filed as Exhibit 10.8 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. +10.9 +Amended and Restated Outside Directors' Deferred Compensation Plan.* +10.10 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Exhibit 10.2 to the Company's Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.11 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.12 +Amended and Restated Stock Option Loan Program.* +10.13 +Executive Severance Agreement.* Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. A participant schedule of current executive officers who are parties to the agreement is attached as Exhibit 10.13. +10.14 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and executive officer. Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.15 +Amended and Restated Benefit Trust Agreement dated April 25, 2007.* Previously filed as Exhibit 10.5 to the Company's Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.16 +Amended and Restated Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.16 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Here incorporated by reference. An updated participant schedule of current executive officers participating in the plan is attached as Exhibit 10.16. +10.17 +Employees' Pension Plan (Restated as amended through November 30, 2007).* +10.18 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +ii +10.19 +Form of Non-Qualified Stock Option Agreement for Stephen L. Gulis, Blake W. Krueger and Timothy J. O'Donovan.* Previously filed as Exhibit 10.2 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.20 +Form of Non-Qualified Stock Option Agreement for employees other than those to whom Exhibit 10.19 applies.* Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.21 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K dated February 9, 2005. Here incorporated by reference. +10.22 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.23 +Form of Non-Qualified Stock Option Agreement for Stephen L. Gulis, Blake W. Krueger and Timothy J. O'Donovan.* Previously filed as Exhibit 10.2 to the Company's Current Report of Form 8-K dated February 15, 2006. Here incorporated by reference. +10.24 +Form of Non-Qualified Stock Option Agreement for employees other than those to whom Exhibit 10.23 applies.* Previously filed as Exhibit 10.3 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.25 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company's Current Report on Form 8-K dated February 15, 2006. Here incorporated by reference. +10.26 +Form of Stock Option Agreement for non-employee directors.* Previously filed as Exhibit 10.23 to the Company's Annual Report on Form 10-K for the fiscal year ended January 1, 2005. Here incorporated by reference. +10.27 +Separation and Release Agreement between Wolverine World Wide, Inc. and Cheryl L. Johnson.* +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31.1 +Certification of President and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Executive Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +____________________________ +*Management contract or compensatory plan or arrangement. \ No newline at end of file diff --git a/raw/filings/0000110471/2007/0000905729-08-000096/filing_metadata.csv b/raw/filings/0000110471/2007/0000905729-08-000096/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..4a4ef72c995fe2b9c1133648aa015d9887cac507 --- /dev/null +++ b/raw/filings/0000110471/2007/0000905729-08-000096/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000110471,WWW,WOLVERINE WORLD WIDE INC /DE/,10-K,2008-02-26,2007-12-29,2008-02-26T22:05:52.000Z,0000905729-08-000096,www10k_022608.htm,WOLVERINE WORLD WIDE FORM 10-K - 02-26-08,1280243,0,0,https://www.sec.gov/Archives/edgar/data/110471/000090572908000096/www10k_022608.htm,https://www.sec.gov/Archives/edgar/data/110471/000090572908000096/,2007,2007,1 diff --git a/raw/filings/0000110471/2007/0000905729-08-000096/item1.txt b/raw/filings/0000110471/2007/0000905729-08-000096/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..9ffdcc1e97df913ca046359387b71299f8149d66 --- /dev/null +++ b/raw/filings/0000110471/2007/0000905729-08-000096/item1.txt @@ -0,0 +1,89 @@ +Item 1. +Business . +General. +Wolverine World Wide, Inc. (the "Company") is a leading designer, manufacturer and marketer of a broad line of quality casual shoes, rugged outdoor and work footwear. The Company, a Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Approximately 47.5 million pairs of Company branded footwear were sold during fiscal 2007, making the Company a global leader among footwear companies in the marketing of branded casual, work and outdoor footwear. The Company's products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort and performance. The products are marketed throughout the world under widely recognized brand names, including Bates ®, Cat ® Footwear, Harley-Davidson ® Footwear, Hush Puppies ®, HyTest ®, Merrell ®, Patagonia ® Footwear, Sebago ® and Wolverine ®. The Company believes that its primary competitive strengths are its well-recognized brand names, broad range of comfortable footwear, patented and proprietary designs and comfort technologies, numerous distribution channels and diversified manufacturing and sourcing base. Cat ® is a registered trademark of Caterpillar Inc., Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. and Patagonia ® is a registered trademark of Patagonia, Inc. +The Company's footwear is sold under a variety of brand names designed to appeal to most consumers of casual, work and outdoor footwear at numerous price points. The Company's footwear products are organized under four operating units: (i) the Wolverine Footwear Group, focusing primarily on the Bates ®, HyTest ® and Wolverine ® product lines of work, outdoor, uniform and lifestyle boots and shoes, and Wolverine ® brand apparel, (ii) the Outdoor Group, currently focusing on Patagonia ® and Merrell ® product lines of performance and lifestyle footwear, and Merrell ® brand apparel, (iii) the Heritage Brands Group, focusing on the Cat ® product lines of work and lifestyle footwear, the Harley-Davidson ® lines of lifestyle and performance footwear, and the Sebago ® lines of lifestyle and performance footwear, and (iv) The Hush Puppies Company, focusing on the Hush Puppies ® brand of comfortable casual and dress footwear. The Company also licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, gloves, handbags and plush toys. +The Company's Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support for the various Company brands. The Company's footwear is distributed domestically through 90 Company-owned retail stores and to numerous accounts including department stores, footwear chains, catalogs, specialty retailers, mass merchants and Internet retailers. Many of the retailers to which Wolverine distributes operate multiple storefront locations. The Company's products are marketed worldwide in nearly 200 countries and territories through Company-owned wholesale operations, licensees and distributors. +3 +The Company, through its Wolverine Leathers Division, operates a tannery which tans pigskin leather for the shoe and leather goods industries. A significant portion of the pigskin leather tanned by the Company is used in the footwear marketed by the Company, and is also sold to Company licensees and other domestic and foreign manufacturers of footwear. In addition, Wolverine Procurement, Inc., a Company-owned subsidiary, performs skinning operations and purchases raw pigskins which it then cures and sells to outside customers for processing into pigskin leather products. +For financial information regarding the Company, see the consolidated financial statements of the Company and the notes thereto, which are attached as Appendix A to this Form 10-K. The Company has one reportable segment, Branded Footwear and Licensing. The Branded Footwear and Licensing segment is engaged in manufacturing, sourcing, licensing, marketing and distributing branded footwear and apparel, including casual shoes and apparel, dress shoes, boots, uniform shoes, work shoes and rugged outdoor footwear and apparel. The Company's Other Business units consist of its retail stores, tannery and pigskin procurement operations. Financial information regarding the Company's business segments and financial information about geographic areas is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Form 10-K. +Branded Footwear, Apparel and Licensing. +The Company sources and markets a broad range of footwear styles including shoes, boots and sandals under many recognizable brand names including Bates ®, Cat ®, Harley-Davidson ®, Hush Puppies ®, HyTest ®, Merrell ®, Patagonia ®, Sebago ® and Wolverine ®. The Company combines quality materials and skilled workmanship from around the world to produce footwear according to its specifications at both Company-owned and independent manufacturing facilities. The Company also markets Merrell ® and Wolverine ® brand apparel and licenses its brands for use on non-footwear products including apparel, eyewear, watches, socks, handbags and plush toys. Current significant licensing programs include Hush Puppies ® apparel, eyewear, watches, socks, handbags and plush toys, and Wolverine ® brand gloves, eyewear, socks and headwear. +The Company's four branded apparel, footwear and licensing operating units are described below. +1. The Outdoor Group . The Outdoor Group consists of Merrell ® and Patagonia ® Footwear and Merrell ® Apparel. Outdoor Group products include performance outdoor and hiking footwear, casual and after-sport footwear and performance and casual Merrell ® Apparel. +Merrell ® Footwear. The Merrell ® footwear line consists primarily of technical hiking, rugged outdoor and outdoor-inspired casual footwear designed for backpacking, day hiking and everyday use. The Merrell ® footwear line also includes the "After-Sport" category, incorporating Merrell ® footwear's technical hiking and outdoor expertise with Wolverine Performance Leathers ™ and other technical materials to create footwear with unique styling, performance and comfort features. Merrell ® footwear products are sold primarily through outdoor specialty retailers, department stores and catalogs. Merrell ® footwear is marketed in approximately 160 countries and territories worldwide. +Merrell ® Apparel. The Merrell ® Apparel line consists primarily of technical outdoor and outdoor-inspired casual apparel. In addition to Merrell ® Apparel, the Outdoor Group markets Merrell ® packs, bags and luggage. +4 +Patagonia® Footwear. In 2005, the Company entered into a license agreement providing the Company with exclusive worldwide rights to manufacture, market, distribute and sell footwear under the Patagonia ® , Water Girl ® and other trademarks. The Outdoor Group launched its Patagonia ® Footwear line in Spring 2007. +2. Wolverine Footwear Group . The Wolverine Footwear Group encompasses footwear primarily under the Wolverine ®, Bates ®, and HyTest ® brands and markets footwear designed with performance and comfort features to serve a variety of work, outdoor and lifestyle functions. The Wolverine Footwear Group also markets Wolverine ® brand apparel. +Wolverine ® Work and Industrial Footwear . The Wolverine ® brand has built its reputation by offering high quality work boots and shoes that incorporate innovative technologies to deliver comfort and durability. The Wolverine ® brand, which has been in existence for 125 years, markets work and outdoor footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® technology and MultiShox ® technology, has allowed the Wolverine ® brand to introduce a broad line of work footwear with a focus on comfort. The Wolverine Fusion ®, DuraShocks SR ™ and Wolverine Compressor ® technologies represent the Company's tradition of comfortable work and industrial footwear, a tradition that is continued and enhanced with the development of the MultiShox ® Individual Comfort System and the new Contour Welt ™ product line. The Wolverine ® work product line features work boots and shoes, including steel toe boots and shoes, targeting male and female industrial and farm workers. The Wolverine ® rugged casual and outdoor sport product lines incorporate DuraShocks ® technology and other comfort features into products designed for casual and outdoor sport use. The rugged casual line targets active lifestyles and includes trail shoes, rugged casuals and outdoor sandals. The outdoor sport line is designed to meet the demands of hunters, fishermen and other active outdoor sportsmen and women. Warmth, waterproofing and comfort are achieved through the use of Gore-Tex ® (a registered trademark of W.L. Gore & Associates, Inc.) and Thinsulate ® (a registered trademark of Minnesota Mining and Manufacturing Company) brand fabrics, the Company's performance leathers and patented DuraShocks ® technologies. +Wolverine ® Apparel and Licensing . The Wolverine Footwear Group markets a line of work and rugged casual Wolverine ® brand apparel. In addition, the Wolverine ® brand is licensed for use on eyewear, headwear, gloves and socks. +Bates ® Uniform Footwear . The Bates Uniform Footwear Division is an industry leader in supplying footwear to military and civilian uniform users. The Bates Uniform Footwear Division utilizes DuraShocks ®, DuraShocks SR ™, CoolTech ® and other proprietary comfort technologies in the design of its military-style boots and oxfords including the Bates ®, Enforcer Series ® and Special Ops ™ footwear lines. The Bates Uniform Footwear Division contracts with the U.S. Department of Defense and the militaries of several foreign countries to supply military footwear. Civilian uniform uses include police, security, postal, restaurant and other industrial occupations. Bates Uniform Footwear Division's products are also distributed through specialty retailers and catalogs. +HyTest ® Safety Footwear . The HyTest ® product line consists primarily of high-quality work boots and shoes designed to protect industrial workers from foot injuries. HyTest ® footwear incorporates various specialty safety features into its product lines, +5 +including steel toe, composite toe, metatarsal guards, electrical hazard, static dissipating and conductive footwear to protect against hazards of the workplace. In addition, HyTest ® brand footwear incorporates features such as FootRests ® comfort technology to provide comfort together with safety for working men and women. HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company's occupational and work footwear brands to workers at industrial facilities and also through direct sales arrangements with large industrial customers. +3. The Heritage Brands Group . The Heritage Brands Group consists of Caterpillar ® Footwear, Harley-Davidson ® Footwear and Sebago ® Footwear. Sebago ® Footwear was recently added to the Heritage Brands Group. +Caterpillar ® Footwear. Pursuant to a license arrangement with Caterpillar Inc., the Company has exclusive worldwide rights to manufacture, market and distribute footwear under the Caterpillar ®, Cat & Design ®, Walking Machines ® and other trademarks. The Company believes the association with Cat ® equipment enhances the reputation of its footwear for quality, ruggedness and durability. Cat ® brand footwear products include work boots and shoes, sport boots, rugged casuals and lifestyle footwear, including lines of work and casual footwear featuring iTechnology ™ and Hidden Tracks ® comfort features. In addition, the Company also manufactures and markets Cat ® Marine Power ® footwear, designed for industrial and recreational marine uses. Cat ® footwear products target work and industrial users and active lifestyle users. Cat ® footwear is marketed in approximately 135 countries and territories worldwide. Cat ®, Caterpillar ®, Cat & Design ®, Walking Machines ® and Marine Power ® are registered trademarks of Caterpillar Inc. +Harley-Davidson ® Footwear . Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has the exclusive right to manufacture, market, distribute and sell Harley-Davidson ® brand footwear throughout the world. Harley-Davidson ® brand footwear products include motorcycle, casual, fashion, work and western footwear for men, women and children. Harley-Davidson ® footwear is sold globally through a network of independent Harley-Davidson ® dealerships as well as through department stores and specialty retailers. Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. +Sebago® Footwear. The Sebago ® product line consists primarily of performance nautical and American-inspired casual footwear for men and women such as boat shoes and handsewn loafers that have been manufactured and distributed since 1946. Highly recognized Sebago ® line extensions include Sebago Docksides ®, Sebago Drysides ™, Sebago Campsides ™ and Athletic Marine. The Sebago ® product line is marketed in approximately 110 countries and territories worldwide. The Sebago ® manufacturing and design tradition of quality componentry, durability, comfort and "Americana" heritage is further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. +4. The Hush Puppies Company . Since 1958, the Hush Puppies ® brand has been a leader in the casual footwear market. The brand offers shoes and boots for men, women and children, and is marketed in approximately 130 countries and territories. The modern styling is complemented by a variety of comfort features and proprietary technologies that have earned the +6 +brand its reputation for comfort. In addition, the Hush Puppies ® brand is licensed for use on apparel, eyewear, handbags, socks, watches and plush toys. +Other Businesses. +In addition to manufacturing, sourcing, marketing and distributing the Company's footwear and apparel products as reported in the Branded Footwear and Licensing segment, the Company also (i) operates a Company-owned pigskin tannery through its Wolverine Leathers Division, (ii) purchases and cures raw pigskins for sale to various customers through its wholly-owned subsidiary Wolverine Procurement, Inc., and (iii) operates 90 domestic retail footwear stores. +1. The Wolverine Leathers Division . The Wolverine Leathers Division produces and markets pigskin leathers primarily for use in the footwear industry. Wolverine Leathers & Design ® brand products are primarily manufactured in the Company's pigskin tannery located in Rockford, Michigan. The Company believes pigskin leathers offer superior performance and advantages over cowhide leathers. The Company's waterproof and stain resistant leathers are featured in some of the Company's domestic footwear lines and many products offered by the Company's international licensees and distributors. Wolverine performance leathers are also featured in certain outside brands of athletic and outdoor footwear. +2. Wolverine Procurement, Inc . Wolverine Procurement, Inc. performs skinning operations and purchases raw pigskins from third parties, which it cures and sells to the Wolverine Leathers Division and to outside customers for processing into pigskin leather products. +3. Wolverine Retail . The Company operates 90 domestic retail shoe stores as of February 2008. These stores are under the Hush Puppies ®, Hush Puppies and Family SM , Track'N Trail ®, Rockford Footwear Depot ® and Merrell ® names. Both the Rockford Footwear Depot ® and Track'N Trail ® retail formats carry a large selection of Company branded footwear featuring such brands as Wolverine ®, Merrell ®, Hush Puppies ®, Cat ®, Patagonia ® , Sebago ® and Harley-Davidson ®. The Company also operates direct-to-customer retail websites, including www.upfootgear.com , www.trackandtrail.com , www.catfootwear.com , www.hushpuppies.com, www.sebago.com and www.merrell.com . +Marketing. +The Company's overall marketing strategy is to develop brand-specific plans and related promotional materials for the United States and international markets to foster a differentiated and consistent image for each of the Company's core brands. Each brand group has its own marketing personnel who develop the marketing strategy for products within that group. Marketing campaigns and strategies vary by brand and may target accounts and/or end users as they strive to increase overall brand awareness for the Company's branded products. The Company's advertisements typically emphasize fashion, comfort, quality, durability, functionality and other performance and lifestyle aspects of the Company's products. Components of the brand-specific plans vary and may include print, radio and television advertising, event sponsorships, in-store point of purchase displays, promotional materials, and sales and technical assistance. +The Company's brand groups provide its international licensees and distributors with creative direction and materials to convey consistent messages and brand images. Examples of marketing assistance that may be provided by the Company to its licensees and distributors are (i) direction on the +7 +categories of footwear to be promoted, (ii) photography and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point of purchase presentation specifications, blueprints and packaging, (v) sales materials, and (vi) consulting on retail store layout and design. The Company believes its brand names provide a competitive advantage and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution. +The Company uses a wide variety of domestic distribution channels to distribute its branded footwear products. To meet the diverse needs of its broad customer base, the Company uses the following distribution strategies. +• +Traditional wholesale distribution is used to service department stores, large footwear chains, specialty retailers, catalogs, independent retailers and uniform outlets. A dedicated sales force and customer service team, advertising and point of purchase support, and in-stock inventories are used to service these accounts. +• +Volume direct programs provide footwear at competitive prices with limited marketing support. These programs service major retail, mail order, mass merchant and government customers. +• +A network of independent Shoemobile ® distribution outlets is used to distribute the Company's work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and enters bids for contracts to supply specific footwear products. Such contracts typically contain future purchase options that are not required to be exercised. +In addition to its wholesale activities, the Company also operates a domestic retail operation as described above. The Company continues to develop various programs, both independently and with its retail customers, for the distribution of its products. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's revenue in fiscal 2007. +The Company experiences moderate fluctuations in sales volume during the year as reflected in quarterly revenue (and taking into consideration the 16 weeks or 17 weeks included in the fourth accounting period versus the 12 weeks included in the first three accounting periods). The Company also experiences some fluctuation in its levels of working capital, typically including an increase in working capital requirements near the end of the third quarter. The Company provides working capital for such fluctuations through internal financing and through a revolving credit agreement that the Company has in place. The Company expects current seasonal sales patterns to continue in future years. +International Operations and Global Licensing. +The Company records revenue from foreign sources through a combination of (i) sales of branded footwear products generated from the Company's owned operations in Canada, the United Kingdom, Austria, Finland, France, Germany, Italy, The Netherlands, Spain, Sweden and Switzerland and from sales to international distributors for certain markets and businesses, and (ii) from royalty income through a network of independent licensees and distributors. The Company's owned operations include Hush +8 +Puppies (UK) Ltd., Wolverine Europe B.V. (formerly known as Merrell Europe B.V.), Merrell (Europe) Limited, Wolverine Europe Limited and Wolverine World Wide Corporation, Inc. (formerly known as Hush Puppies Canada Footwear, Ltd.). The Company's owned operations are located in markets where the Company believes it can gain a strategic advantage. +The Company derives royalty income from sales of products (primarily Company footwear) bearing the Hush Puppies ®, Wolverine ®, Bates ®, Merrell ®, Sebago ® and other trademarks by independent distributors and licensees. The Company also derives royalty income from sales of footwear bearing the Cat ® and Harley-Davidson ® trademarks through foreign distributors. License and distribution arrangements enable the Company to develop sales in international markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. +The Company continues to develop a global network of licensees and distributors to market its footwear brands. The Company assists in designing products that are appropriate to each foreign market but are consistent with the global brand position. Independent licensees and distributors purchase goods from either the Company or authorized third-party manufacturers pursuant to distribution agreements or manufacture branded products consistent with Company standards pursuant to license agreements. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and market support provided by the Company. +Manufacturing and Sourcing. +The Company controls the sourcing and/or manufacture of approximately 73% of the pairs of footwear marketed under the Company's brand names globally. The balance is controlled directly by the Company's licensees. Of the pairs purchased by the Company, approximately 89% are purchased or sourced from third parties, with the remainder produced at Company-operated facilities. Footwear produced by the Company is manufactured at Company-operated facilities in several domestic and certain affiliated foreign facilities located in Michigan, Arkansas, and the Dominican Republic. For some of the Company-produced footwear, a "twin plant" concept is utilized whereby a majority of the labor intensive cutting and fitting construction of the "upper" portion of shoes and boots is performed at the Company's facilities in the Dominican Republic and Arkansas, and the technology intensive construction, or "bottoming," is performed primarily at the Company's Michigan facilities. +The Company's factories each have the flexibility to produce a variety of footwear, which departs from the industry's historical practice of dedicating a given facility to production of specific footwear products. This flexibility allows the Company to quickly respond to changes in market preference and demand. The Company currently produces military footwear and work, casual and dress casual footwear in its owned facilities. +The Company sources a majority of its footwear from a variety of foreign manufacturing facilities in the Asia-Pacific region, South America and India. The Company maintains technical offices in the Asia-Pacific region to facilitate the sourcing and importation of quality footwear. The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. In addition, the Company has adopted "Engagement Criteria for Partners & Sources" to require that its domestic and foreign manufacturers, licensees and distributors use ethical business standards, comply with all applicable health and safety laws and regulations, are committed to environmentally safe practices, treat employees fairly with respect to wages, benefits and working conditions, and do not use child or prison labor. +9 +The Company's owned manufacturing operations allow the Company to (i) reduce its production lead time, enabling it to quickly respond to market demand and reduce inventory risk, (ii) lower freight and shipping costs, and (iii) closely monitor product quality. The Company's foreign manufacturing strategy allows the Company to (a) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (b) source the highest quality raw materials from around the world, and (c) avoid additional capital expenditures necessary for owned factories and equipment. The Company believes that its overall global manufacturing strategy gives the Company the flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company owns and operates a pigskin tannery through its Wolverine Leathers Division. The Company and its licensees receive a majority of their pigskin leather requirements from the tannery. +The Company's principal required raw material is quality leather, which it purchases from a select group of domestic and offshore suppliers, including the Company's tannery. The global availability of common upper materials and specialty leathers eliminates any reliance by the Company upon a sole supplier. The Company currently purchases the vast majority of the raw pigskins used in a significant portion of its tannery operations from one domestic source. This source has been a reliable and consistent supplier for over 30 years. Alternative sources of pigskin are available; however the price, processing and/or product characteristics are less advantageous to the Company. The Company purchases all of its other raw materials and component parts from a variety of sources, none of which is believed by the Company to be a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas, tariffs and duties, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers. A sustained disruption of such sources of supply could have an adverse impact on the Company's operations and financial condition. +Trademarks, Licenses and Patents. +The Company holds a significant portfolio of registered and common law trademarks that identify its branded footwear and apparel products. The owned trademarks that are most widely used by the Company include Hush Puppies ®, Wolverine ®, Bates ®, Wolverine Fusion ®, DuraShocks ®, MultiShox ®, Wolverine Compressor ®, Hidden Tracks ®, iTechnology TM , Bounce ®, Comfort Curve ®, HyTest ®, Merrell ®, Continuum ®, Sebago ®, Q-Form ® and Track 'N Trail ®. Pigskin leather produced by the Company's Wolverine Leathers Division is sold under the trademarks Wolverine Leathers & Design ®, Wolverine Warrior Leather ®, Weather Tight ® and All Season Weather Leathers ™. The Company has obtained license rights to manufacture, market and distribute footwear throughout the world under the Cat ®, Harley-Davidson ® and Patagonia ® trademarks, and the right to manufacture, market and distribute footwear in the United States and other countries under the Stanley ® trademark, all pursuant to license arrangements with the respective trademark owners. The Company's license agreement for Stanley ® footgear will terminate effective June 30, 2008. The Cat ® footwear license has a current term extending through December 2011. The Harley-Davidson ® footwear license is long term and extends for more than five years. The Patagonia ® Footwear license extends for more than five years and also includes conditional renewal options. All of these license agreements are subject to early termination provisions. +10 +The Company believes that its products are identified by consumers by its trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims of ownership of its trademarks that could materially affect its current business. It is the policy of the Company to pursue registration of its primary marks whenever practicable and to vigorously defend its trademarks against infringement or other threats. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company vigorously protects its proprietary rights under applicable laws. +Order Backlog. +At February 16, 2008, the Company had an order backlog of approximately $389 million compared with an order backlog of approximately $354 million at February 17, 2007, determined on a basis consistent with the current year. Substantially all of the backlog relates to demand for products expected to be shipped in 2008. Orders in backlog are subject to cancellation by customers and to changes in planned customer demand or at-once orders. The backlog at a particular time is affected by a number of factors, including seasonality, retail conditions, expected customer demand, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments. +Competition. +The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous domestic and foreign marketers, manufacturers and importers of footwear, some of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are located in the United States and Europe. The Company has at least thirty major competitors in connection with the sale of its casual, work and outdoor footwear. Product performance and quality, including technological improvements, product identity, competitive pricing and ability to control costs, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The footwear industry in general is subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotion of brand awareness, manufacturing and sourcing efficiencies, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the footwear industry. Market shares in the non-athletic footwear industry are highly fragmented and no one company has a dominant market position. +Research and Development. +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to the development of new production techniques and to improving the function, performance, reliability and quality of its branded footwear and other products. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, for example, has led to specific biomechanical design concepts, such as Bounce ®, DuraShocks ® and Hidden Tracks ® comfort technologies, that have been incorporated in the Company's footwear. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. +11 +Environmental Matters. +Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company uses and generates certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites and other regulatory issues. +Employees. +As of December 29, 2007, the Company had approximately 4,651 domestic and foreign production, office and sales employees. Approximately 667 employees were covered by four union contracts expiring at various dates through April 30, 2009. The Company presently considers its employee relations to be good. +Available Information. +Information about the Company, including the Company's Code of Conduct & Compliance, Corporate Governance Guidelines, Director Independence Standards, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, and Governance Committee Charter, is available at its website, www.wolverineworldwide.com. Printed copies of the documents listed above are available, without charge, by writing to the Company at 9341 Courtland Drive, N.E., Rockford, Michigan 49351, Attention: General Counsel. +The Company also makes available on or through its website, free of charge, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports (along with certain other Company filings with the Securities and Exchange Commission ("SEC")) as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These materials are also accessible on the SEC's website at www.sec.gov. \ No newline at end of file diff --git a/raw/filings/0000110471/2007/0000905729-08-000096/item13.txt b/raw/filings/0000110471/2007/0000905729-08-000096/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..477bf533f90d951ad0278c35d092af12e56c8edc --- /dev/null +++ b/raw/filings/0000110471/2007/0000905729-08-000096/item13.txt @@ -0,0 +1,5 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence . +The information contained under the caption "Related Matters" under the subheading "Certain Relationships and Related Transactions" contained in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 17, 2008, is incorporated herein +41 +by reference. The information contained under the caption "Corporate Governance Principles" under the subheading "Independence" contained in the definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 17, 2008, is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000110471/2007/0000905729-08-000096/item9a.txt b/raw/filings/0000110471/2007/0000905729-08-000096/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..da079209b0325f97ff18cdb8f5acedd56c789b39 --- /dev/null +++ b/raw/filings/0000110471/2007/0000905729-08-000096/item9a.txt @@ -0,0 +1,11 @@ +Item 9A. +Controls and Procedures . +Evaluation of Disclosure Controls and Procedures. +An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on and as of the time of such evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report. +Management's Report on Internal Control Over Financial Reporting. +Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Under the +37 +supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 29, 2007, based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 29, 2007. +The effectiveness of the Company's internal control over financial reporting as of December 29, 2007, has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report, which is included in Appendix A and is incorporated into this Item 9A by reference. +Changes in Internal Control Over Financial Reporting. +There was no change in the Company's internal control over financial reporting that occurred during the sixteen-week period ended December 29, 2007 that has materially affected, or that is reasonably likely to materially affect, the Company's internal control over financial reporting. \ No newline at end of file diff --git a/raw/filings/0000110471/2007/0000905729-08-000096/rp_note.txt b/raw/filings/0000110471/2007/0000905729-08-000096/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000110471/2007/0000905729-08-000096/rpt_disclosure.txt b/raw/filings/0000110471/2007/0000905729-08-000096/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..8611eefca6475e751d1909e7f320f64b06f1cfd1 --- /dev/null +++ b/raw/filings/0000110471/2007/0000905729-08-000096/rpt_disclosure.txt @@ -0,0 +1,348 @@ +“Certain Relationships and Related Transactions.” +7 +Table of Contents +Stock +Ownership Requirements for Directors and Executive +Officers +For many years, the Board has believed that directors and +management should have a significant financial stake in +Wolverine to align their interests with those of the +stockholders. For that reason, several years ago the Board +adopted formal requirements that directors and executive +management own specified amounts of Wolverine stock (including +ownership credit for stock units allocated to non-employee +directors under the Deferred Compensation Plan) within five +years of their respective election to the Board or appointment +as a member of executive management. The ownership requirements +are as follows: (i) for directors, five times the current +Board retainer, (ii) for the Chief Executive Officer, five +times base salary, (iii) for other executive officers, +between two and three times base salaries, and (iv) for +other executive management, between one and two times base +salaries. +Code of +Conduct & Compliance +For years, Wolverine and its employees and directors have +followed an extensive Code of Conduct & Compliance +(“Code”). This comprehensive Code establishes basic +guidelines to help employees and directors comply with +applicable legal requirements and sets forth Wolverine’s +expectations regarding business ethics, integrity, honesty, +fairness and keeping commitments. The Code contains +Wolverine’s principles and procedures regarding conflicts +of interest, corporate opportunities, confidentiality, fair +dealing, protection and proper use of Wolverine’s assets, +compliance with laws, rules and regulations, engagement criteria +for Wolverine’s trading partners, “whistle +blower” protection provisions, expectations regarding the +integrity of books and records, and guidelines and procedures +for many other subjects. Employees are surveyed annually to +identify any areas of noncompliance with the Code, and the +results of this survey are reported to the Board. +Accounting +and Finance Code of Ethics +The Board has adopted an Accounting and Finance Code of Ethics +(“Finance Ethics Code”). This is an ethics code +focused on the financial reporting process and is intended to +protect the interests of all of Wolverine’s constituents, +including stockholders, employees, customers and the communities +in which Wolverine conducts business. Many of the basic tenets +of the Finance Ethics Code have been incorporated for many years +in the Code. The Finance Ethics Code is applicable to +Wolverine’s Chief Executive Officer, Chief Financial +Officer and Corporate Controller and sets forth specific rules +of conduct and expectations regarding the financial reporting +process, protection of Wolverine’s assets, compliance with +rules and regulations and honest and ethical conduct in +connection with the financial reporting process and related +disclosures. The Finance Ethics Code and the Code are available +on the Corporate Governance section of the Investors section of +Wolverine’s website at www.wolverineworldwide.com , +where Wolverine will post any waiver of these codes for +directors or executive officers. +Board +Committee Charters +The Board has organized and formed three committees, the Audit +Committee, the Compensation Committee and the Governance +Committee. The Board has approved a committee charter for each +committee that contains basic principles regarding the +committee’s organization, purpose, authority and +responsibilities. The performance of each committee is reviewed +annually by committee members and the Board. +Leadership +Since 1993, the Board has operated with an independent Lead +Director, who is selected by the independent directors. The +duties of the independent Lead Director include: +(a) working closely with the Chairman regarding the agenda +and scheduling for Board and committee meetings; +(b) overseeing information sent to the Board; +(c) presiding over executive sessions; (d) serving as +a liaison between the Chairman and the independent Directors; +(e) presiding over Board meetings in the absence of the +Chairman; and (f) being available for consultation and +communications with stockholders as appropriate. +Attendance +The Board prides itself on its ability to recruit and retain +directors who have a diversity of experience, who have the +highest personal and professional integrity, who have +demonstrated exceptional ability and judgment and who are +effective (in conjunction with the other members of the Board) +in collectively serving the long-term interests of the +stockholders. Board and committee attendance is central to the +proper functioning of the Board of Directors and is a priority. +Directors are expected to make every effort to attend every +Board meeting. Directors are also expected to attend the Annual +Meeting of Stockholders in person. All 11 then-current directors +attended the 2007 annual meeting. +8 +Table of Contents +Communication +with the Board +Stockholders and interested parties may communicate with members +of Wolverine’s Board of Directors through various links +provided on the Corporate Governance section of the Investors +section of Wolverine’s website at +www.wolverineworldwide.com or by sending correspondence +to the Board, a specific Board committee or a Board member +c/o General +Counsel, Wolverine World Wide, Inc., 9341 Courtland Drive, N.E., +Rockford, Michigan 49351. Any communications submitted by any of +the above means (or the means described below) are received by +Wolverine’s General Counsel and forwarded to the +appropriate person or persons. Complaints or concerns regarding +Wolverine’s financial statements and accounting, auditing, +internal control and reporting practices can be reported to the +audit committee (including anonymous and confidential +submissions) by sending an +e-mail to +financialconcerns@wwwinc.com or by writing to the audit +committee +c/o the +General Counsel at the above address. +Board and +Company Culture +Wolverine’s comprehensive governance guidelines and +principles are coupled with a robust, open and effective Board +environment that promotes respect, trust and candor, fosters a +culture of open dissent and permits each director to express +opinions and contribute to the Board process. Directors are +expected to have unrestricted access to management and any +company information they desire. The participation of Board +members and the open exchange of opinions is further encouraged +at the Board committee level through the periodic rotation of +Board members among its standing committees. This open and +candid operating environment is shared by management and the +Board and is essential to fully realize the benefits of +Wolverine’s formal governance guidelines, principles, +charters and policies. +9 +Table of Contents +Ownership +of Wolverine Stock +Five +Percent Stockholders +The following table sets forth information concerning the number +of shares of Wolverine stock held by each entity known to +Wolverine to be the beneficial owner of more than five percent +of Wolverine’s outstanding shares of common stock: +Five Percent Stockholders +Amount and Nature of Beneficial +Ownership of Common Stock +Shared Voting +Total +Name and Address +Sole Voting +Sole Dispositive +or Dispositive +Beneficial +Percent +of Beneficial Owner +Power +Power +Power +Ownership +of Class +Barclays Global Investors, NA(1) +2,326,764 +3,034,322 +0 +3,034,322 +5.8 +45 Fremont Street +San Francisco, CA 94105 +Franklin Resources, Inc.(2) +3,092,239 +3,092,239 +0 +3,092,239 +5.9 +One Franklin Parkway +San Mateo, CA 94403 +(1) +Based on information set forth in Schedule 13G filed +February 5, 2008. The Schedule 13G indicates that +Barclays Global Investors, NA and other related entities (some +of which are investment advisors or banks) beneficially own, in +the aggregate, 3,034,322 shares of Wolverine common stock. +(2) +Based on information set forth in Schedule 13G filed +February 8, 2008. The Schedule 13G indicates that +Franklin Resources, Inc. and one or more open- or close-end +investment companies and other managed accounts that are +investment management clients of investment managers that are +direct and indirect subsidiaries of Franklin Resources, Inc. +beneficially own, in the aggregate, 3,092,239. +10 +Table of Contents +Stock +Ownership By Management +The following table sets forth the number of shares of common +stock beneficially owned as of March 3, 2008, by each of +Wolverine’s directors and nominees for director, each of +the named executive officers and all of Wolverine’s +directors, nominees for director and executive officers as a +group. An asterisk in the column for “Percent of +Class” means the individual beneficially owns less than one +percent of the common stock: +Stock Ownership By Management +Amount and Nature of Beneficial +Ownership of Common Stock(1) +Sole Voting +Shared Voting +Total +Name of +and Dispositive +or Dispositive +Stock +Beneficial +Percent +Beneficial Owner +Power +Power(2) +Options(3) +Ownership(3) +of Class +Jeffrey M. Boromisa +— +— +10,736 +10,736 +* +Kenneth A. Grady +6,800 +— +3,034 +9,834 +* +William K. Gerber +500 +— +6,891 +7,391 +* +Alberto L. Grimoldi +10,168 +— +42,784 +52,952 +* +Stephen L. Gulis, Jr. +158,632 +1,890 +254,529 +415,051 +* +David T. Kollat +83,934 +— +56,665 +140,599 +* +Blake W. Krueger +234,899 +— +283,037 +517,936 +1.01 +Brenda J. Lauderback +5,100 +— +11,040 +16,140 +* +Phillip D. Matthews(4) +34,238 +— +56,665 +90,903 +* +David P. Mehney +50,520 +49,250 +56,665 +156,435 +* +Timothy J. O’Donovan +309,510 +125,821 +502,351 +937,682 +1.83 +Nicholas P. Ottenwess +33,291 +190 +85,961 +119,442 +* +Shirley D. Peterson +3,000 +— +19,603 +22,603 +* +Michael A. Volkema +5,000 +— +14,903 +19,903 +* +James D. Zwiers +37,641 +— +32,842 +70,483 +* +All directors and executive officers as a group +980,233 +177,151 +1,437,706 +2,595,090 +5.07 +(1) +The numbers of shares stated are based on information provided +by each person listed and include shares personally owned of +record and shares that, under applicable regulations, are +considered to be otherwise beneficially owned. +(2) +These numbers include shares over which the listed person is +legally entitled to share voting or dispositive power by reason +of joint ownership, trust or other contract or property right, +and shares held by spouses, children or other relatives over +whom the listed person may have influence by reason of +relationship. +(3) +The numbers in the Stock Options column represent shares that +may be acquired within 60 days after March 3, 2008, by +the exercise of stock options granted under Wolverine’s +various stock option plans. These numbers are also included in +the Total Beneficial Ownership column. +(4) +Mr. Matthews pledged 34,238 shares of Wolverine common +stock in connection with a post-paid variable forward sale +contact entered into on February 15, 2007 with an +unaffiliated third party buyer. +11 +Table of Contents +Executive +Compensation +COMPENSATION \ No newline at end of file diff --git a/raw/filings/0000110471/2010/0000950123-11-021208/filing.txt b/raw/filings/0000110471/2010/0000950123-11-021208/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..a035d9fecd70d12b0f9b50f4d1287b04b339be0e --- /dev/null +++ b/raw/filings/0000110471/2010/0000950123-11-021208/filing.txt @@ -0,0 +1,8096 @@ +10-K +1 +k50131e10vk.htm +FORM 10-K +e10vk +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. +20549 +FORM 10-K +þ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE +SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended January 1, +2011 +o +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: +001-6024 +WOLVERINE WORLD WIDE, +INC. +(Exact name of registrant as +specified in its charter) +Delaware +38-1185150 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer Identification +No.) +9341 Courtland Drive N.E., +Rockford, Michigan +49351 +(Address of principal executive +offices) +(Zip Code) +Registrant’s telephone number, including area code: +(616) 866-5500 +Securities registered pursuant to Section 12(b) of the +Securities Exchange Act: +Title of each class +Name of each exchange on which +registered +Common Stock, $1 Par Value +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: +None +Indicate by check mark whether the registrant is a well-known +seasoned issuer, as defined in Rule 405 of the Securities +Act. +Yes þ No o +Indicate by check mark whether the registrant is not required to +file reports pursuant to Section 13 or Section 15(d) of the +Act. +Yes o No þ +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 þ No o +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 þ No +o +Indicate by check mark if disclosure of delinquent filers +pursuant to Item 405 of Regulation S-K is not contained +herein, and will not be contained, to the best of +registrant’s knowledge, in definitive proxy or information +statements incorporated by reference in Part III of this +Form 10-K or +any amendment to this +Form 10-K. o +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. (Check one): +Large +accelerated +filer þ +Accelerated +filer o +Non-accelerated +filer o +Smaller reporting +company o +(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 +Act). Yes o No þ +The aggregate market value of the registrant’s voting stock +held by non-affiliates of the registrant based on the closing +price on the New York Stock Exchange on June 18, 2010, +the last business day of the registrant’s most recently +completed second fiscal quarter: $1,398,615,588. +Number of shares outstanding of the registrant’s Common +Stock, $1 par value as of February 25, 2011: +49,613,399. +DOCUMENTS +INCORPORATED BY REFERENCE +Portions of the definitive proxy statement for the +registrant’s annual stockholders’ meeting to be held +April 21, 2011 are incorporated by reference into +Part III of this report. +Table of +Contents +PART I +4 +Item 1. +Business +4 +Item 1A. +Risk Factors +11 +Item 1B. +Unresolved Staff Comments +18 +Item 2. +Properties +18 +Item 3. +Legal Proceedings +18 +Supplemental Item. +Executive Officers of the Registrant +19 +Item 4. +(Removed and Reserved) +20 +PART II +20 +Item 5. +Market for Registrant’s Common Equity, +Related Stockholder Matters and Issuer Purchases of Equity +Securities +20 +Item 6. +Selected Financial Data +23 +Item 7. +Management’s Discussion and Analysis of +Financial Condition and Results of Operations +24 +Item 7A. +Quantitative and Qualitative Disclosures About +Market Risk +37 +Item 8. +Financial Statements and Supplementary +Data +37 +Item 9. +Changes in and Disagreements with Accountants +on Accounting and Financial Disclosure +37 +Item 9A. +Controls and Procedures +37 +Item 9B. +Other Information +37 +PART III +38 +Item 10. +Directors, Executive Officers and Corporate +Governance +38 +Item 11. +Executive Compensation +38 +Item 12. +Security Ownership of Certain Beneficial +Owners and Management and Related Stockholder Matters +38 +Item 13. +Certain Relationships and Related +Transactions, and Director Independence +40 +Item 14. +Principal Accountant Fees and Services +40 +PART IV +41 +Item 15. +Exhibits and Financial Statement +Schedules +41 +SIGNATURES +45 +EX-10.13 +EX-10.16 +EX-10.30 +EX-10.33 +EX-21 +EX-23 +EX-24 +EX-31.1 +EX-31.2 +EX-32.1 +EX-101 INSTANCE DOCUMENT +EX-101 SCHEMA DOCUMENT +EX-101 CALCULATION LINKBASE DOCUMENT +EX-101 LABELS LINKBASE DOCUMENT +EX-101 PRESENTATION LINKBASE DOCUMENT +EX-101 DEFINITION LINKBASE DOCUMENT +2 +Table of Contents +FORWARD-LOOKING +STATEMENTS +This document contains “forward-looking +statements” – that is, statements relating to +future, not past, events. In this context, forward-looking +statements often address management’s beliefs, assumptions, +current expectations, estimates and projections about future +business and financial performance, global conditions, and the +Company itself. Such statements often contain words such as +“anticipates,” “believes,” +“estimates,” “expects,” +“forecasts,” “intends,” “is +likely,” “plans,” “predicts,” +“projects,” “should,” “will,” +variations of such words, and similar expressions. +Forward-looking statements, by their nature, address matters +that are, to varying degrees uncertain. For the Company, +uncertainties that could cause the Company’s performance to +differ materially from what is expressed in forward-looking +statements include: +• +changes in national, regional or global economic and market +conditions; +• +the impact of financial and credit markets on the Company, its +suppliers and customers; +• +changes in interest rates, tax laws, duties, tariffs, quotas or +applicable assessments in countries of import and export; +• +the impact of regulation, regulatory and legal proceedings, and +legal compliance risks; +• +currency fluctuations; +• +increases in costs of future pension funding requirements; +• +the risks of doing business in developing countries, and +politically or economically volatile areas; +• +the ability to secure and protect owned intellectual property or +use currently licensed intellectual property; +• +changes in consumer preferences, spending patterns, buying +patterns, or demand for the Company’s products; +• +changes in relationships with, including the loss of, +significant customers; +• +the exercise of future purchase options by the +U.S. Department of Defense on previously awarded contracts; +• +the cost, availability and management of raw materials, +inventories, services, labor, and contract manufacturers; +• +service interruptions at shipping and receiving ports; +• +the ability to adapt and compete in global footwear, apparel and +consumer-direct markets; +• +strategic actions, including acquisitions and dispositions, and +our success in integrating acquired businesses; +and many other matters of national, regional and global scale, +including those of a political, environmental, economic, +business and competitive nature. These uncertainties could cause +a material difference between an actual outcome and a +forward-looking statement. These uncertainties are described in +more detail in Part I, Item 1A, “Risk +Factors” of this +Form 10-K +Report. The Company does not undertake an obligation to update, +amend or clarify forward-looking statements, whether as a result +of new information, future events or otherwise. +3 +Table of Contents +PART I +Item 1. +Business +General +Wolverine World Wide, Inc. (the “Company”) is a +leading marketer of branded casual, active lifestyle, work, +outdoor sport and uniform footwear and apparel and accessories. +The Company, a Delaware corporation, is the successor of a +Michigan corporation of the same name, originally organized in +1906, which in turn was the successor of a footwear business +established in Grand Rapids, Michigan in 1883. +Approximately 50 million pairs/units of the Company’s +branded footwear and apparel were sold in the fiscal year ended +January 1, 2011 (“fiscal 2010”) in approximately +190 countries and territories around the world. The +Company’s products generally feature contemporary styling +with proprietary technologies designed to provide maximum +comfort and performance. The products are marketed throughout +the world under widely recognized brand names, including +Bates ® , +Cat ® +Footwear, +Chaco ® , +Cushe ® , +Harley-Davidson ® +Footwear, Hush +Puppies ® , +HyTest ® , +Merrell ® , +Patagonia ® +Footwear, +Sebago ® , +Soft +Style ® +and +Wolverine ® . +The Company believes that its primary competitive advantages are +its well-recognized brand names, its patented proprietary +designs and comfort technologies, its wide range of distribution +channels and its diversified manufacturing and sourcing base. +Cat ® +is a registered trademark of Caterpillar Inc., +Harley-Davidson ® +is a registered trademark of H-D Michigan, Inc. and +Patagonia ® +is a registered trademark of Patagonia, Inc. +The Company’s products are sold at various price points +under a variety of brand names designed to appeal to a wide +range of consumers of casual, work and outdoor footwear. The +Company’s wholesale footwear and apparel business is +organized into four operating segments: (i) the Outdoor +Group, consisting of +Merrell ® , +Patagonia ® +and +Chaco ® +footwear, and +Merrell ® +brand apparel, (ii) the Wolverine Footwear Group, +consisting of the +Bates ® , +HyTest ® +and +Wolverine ® +boots and shoes, and +Wolverine ® +brand apparel, (iii) the Heritage Brands Group, consisting +of +Cat ® +footwear, +Harley-Davidson ® +footwear and +Sebago ® +footwear and apparel, and (iv) The Hush Puppies Group, +consisting of Hush +Puppies ® +footwear, Soft +Style ® +footwear and +Cushe ® +footwear. The Company also licenses some of its brands for use +on non-footwear products. +The Company’s Global Operations Group is responsible for +manufacturing, sourcing, distribution and customer support for +the Company’s business. The Company sells products in the +United States, Canada and approximately 10 countries in Europe +to a wide range of retail customers, including department +stores, national chains, catalogs, specialty retailers, mass +merchants and Internet retailers, and to governments and +municipalities. Many of the retailers carrying Wolverine +products operate multiple storefront locations. The +Company’s products are marketed worldwide in a total of +approximately 190 countries and territories through +Company-owned wholesale and retail operations, licensees and +distributors. +For financial information regarding the Company, see the +consolidated financial statements and the accompanying notes, +which are attached as Appendix A to this +Form 10-K. +The Company has one reportable segment, branded footwear, +apparel, and licensing. The branded footwear, apparel, and +licensing segment engages in manufacturing, sourcing, licensing, +marketing and distributing branded footwear and apparel, +including casual shoes and apparel, boots, uniform shoes, work +shoes and rugged outdoor footwear and apparel. The +Company’s other operating segments consist of its +consumer-direct operations and leather and pigskin procurement +operations, which are described below. Financial information +regarding the Company’s reportable segment and other +operating segments and financial information by geographic area +is found in Note 9 to the consolidated financial statements +of the Company that are attached as Appendix A to this +Annual Report on +Form 10-K. +Branded +Footwear, Apparel and Licensing +The Company sources and markets a broad range of footwear +styles, including shoes, boots and sandals under many +recognizable brand names, including +Bates ® , +Cat ® , +Chaco ® , +Cushe ® , +Harley-Davidson ® , +Hush +Puppies ® , +HyTest ® , +Merrell ® , +Patagonia ® , +Sebago ® , +Soft +Style ® +and +Wolverine ® . +The Company combines quality materials and skilled +4 +Table of Contents +workmanship to produce footwear according to its specifications +at both Company-owned and third-party manufacturing facilities. +The Company also markets +Merrell ® , +Sebago ® , +and +Wolverine ® +brand apparel and accessories and licenses some of its brands +for use on non-footwear products, including Hush +Puppies ® +apparel, eyewear, watches, socks, handbags and plush toys and +Wolverine ® +brand eyewear and gloves. +The Company’s branded footwear, apparel, and licensing +operating segments for fiscal 2010 are described below. +1. +The Outdoor Group The Outdoor Group +consists of +Merrell ® +Footwear, +Merrell ® +Apparel and Accessories, +Patagonia ® +Footwear and +Chaco ® +Footwear. Outdoor Group products include performance outdoor and +hiking footwear, casual and after-sport footwear and performance +and casual +Merrell ® +apparel. +Merrell ® +Footwear: The +Merrell ® +footwear line consists primarily of technical hiking, rugged +outdoor and outdoor-inspired casual footwear designed for +backpacking, day hiking and everyday use. The +Merrell ® +footwear line also includes the “After-Sport” +category, incorporating +Merrell ® +footwear’s technical hiking and outdoor expertise with +Wolverine Performance +Leathers tm +and other technical materials to create footwear with unique +styling, performance and comfort features. +Merrell ® +footwear products are sold primarily through sporting goods +chains, outdoor specialty retailers, department stores, on-line +retailers and catalogs. +Merrell ® +footwear is marketed in approximately 150 countries and +territories worldwide. +Merrell ® +Apparel and Accessories: The +Merrell ® +apparel line consists primarily of technical outdoor and +outdoor-inspired casual apparel and performance socks. In +addition to +Merrell ® +apparel, the Outdoor Group markets +Merrell ® +accessories, including packs, bags and luggage. +Patagonia ® +Footwear: Pursuant to an agreement with Lost +Arrow Corporation, the Company has the exclusive footwear +marketing and distribution rights under +Patagonia ® +and other trademarks. The +Patagonia ® +footwear line focuses primarily on casual and outdoor +performance footwear. +Patagonia ® +is a registered trademark of Patagonia, Inc. +Chaco ® +Footwear: The +Chaco ® +brand, which the Company acquired in January 2009, was created +to meet the needs of the whitewater enthusiast and continues to +focus primarily on performance sandals for the outdoor +enthusiast. In order to help evolve the brand into a four-season +offering, the Company introduced closed-toe products in fall +2010. +Chaco ® +footwear is sold primarily through specialty outdoor retailers +and department stores. +2. +Wolverine Footwear Group The Wolverine +Footwear Group markets footwear, apparel and accessories +products under the +Wolverine ® +brand and footwear under the +Bates ® +and +HyTest ® +brands. Wolverine Footwear Group products incorporate +performance and comfort features to serve a variety of work, +outdoor and lifestyle functions. +Wolverine ® +Footwear: The +Wolverine ® +brand offers high quality work boots and shoes that incorporate +innovative technologies to deliver comfort and durability. The +Wolverine ® +brand, which has been in existence for 128 years, markets +work and outdoor footwear in three categories: (i) work and +industrial; (ii) outdoor sport; and (iii) rugged +casual. The development of +DuraShocks ® , +MultiShox ® , +Wolverine +Fusion ® +and Wolverine +Compressor ® +technologies as well as the development of the Contour +Welt ® +line have allowed the +Wolverine ® +brand to introduce a broad line of work footwear with a focus on +comfort. The +Wolverine ® +work product line features work boots and shoes with protective +features such as toe caps, metatarsal guards and electrical +hazard protection; the target consumers for the +Wolverine ® +work product line are industrial and farm workers. The +Wolverine ® +rugged casual and outdoor sport product lines incorporate +DuraShocks ® , +Wolverine +iCS tm +and other technologies and comfort features into products +designed for casual and outdoor sport use. The target consumers +for the +5 +Table of Contents +rugged casual line products have active lifestyles. The outdoor +sport line is designed to meet the needs of hunters, fishermen +and other active outdoor sports enthusiasts. +Wolverine ® +Apparel and Licensing: The Wolverine Footwear +Group markets a line of work and rugged casual +Wolverine ® +brand apparel. In addition, the Company licenses its +Wolverine ® +brand for use on eyewear and gloves. +Bates ® +Uniform Footwear: The Bates Uniform Footwear +Division is a leader in supplying footwear to military and +civilian uniform users. The Bates Uniform Footwear Division +utilizes +DuraShocks ® , +DuraShocks +SR tm , +CoolTech , Wolverine +iCS tm +and other proprietary comfort technologies in the design of its +military-style boots and oxfords. The Bates Uniform Footwear +Division contracts with the U.S. Department of Defense and +the military branches of several foreign countries to supply +military footwear. Civilian uniform users include individuals in +police, security, postal, restaurant and other industrial +occupations. The Bates Uniform Footwear Division’s products +are also distributed through specialty retailers and catalogs. +HyTest ® +Safety Footwear: The +HyTest ® +product line consists primarily of high-quality work boots and +shoes that incorporate various specialty safety features +designed to protect against hazards of the workplace, including +steel toe, composite toe, metatarsal guards, and electrical +hazard, static dissipating and conductive footwear. +HyTest ® +footwear is distributed primarily through a network of +independently owned +Shoemobile ® +mobile truck retail outlets providing direct sales of the +Company’s occupational and work footwear brands to workers +at industrial facilities and also through direct sales +arrangements with large industrial customers. +3. +The Heritage Brands Group The Heritage +Brands Group consists of +Cat ® +Footwear, +Harley-Davidson ® +Footwear and the +Sebago ® +product line. +Cat ® +Footwear: Pursuant to a license arrangement +with Caterpillar Inc., the Company has exclusive footwear +marketing and distribution rights under +Caterpillar ® , +Cat ® , +Cat & Design, Walking +Machines ® +and other trademarks. The Company believes the association with +Cat ® +equipment encourages customers to characterize the footwear as +high-quality, rugged and durable. +Cat ® +brand footwear products include work boots and shoes, sport +boots, rugged casual and lifestyle footwear, including lines of +work and casual footwear featuring +iTechnology tm +and Hidden +Tracks ® +comfort features. +Cat ® +footwear targets work and industrial users and active lifestyle +users. +Cat ® +footwear is marketed in approximately 145 countries and +territories worldwide. +Cat ® , +Caterpillar ® , +Cat & Design and Walking +Machines ® +are registered trademarks of Caterpillar Inc. +Harley-Davidson ® +Footwear: Pursuant to a license arrangement +with the Harley-Davidson Motor Company, the Company has the +exclusive footwear marketing and distribution rights for +Harley-Davidson ® +branded footwear. +Harley-Davidson ® +branded footwear products include motorcycle, casual, fashion, +work and western footwear for men, women and children. +Harley-Davidson ® +footwear is sold globally through a network of independent +Harley-Davidson ® +dealerships, department stores and specialty retailers. +Harley-Davidson ® +is a registered trademark of H-D Michigan, Inc. +Sebago ® : The +Sebago ® +product line has been marketed since 1946 and consists primarily +of performance nautical and American-inspired casual footwear +for men and women, such as boat shoes and hand sewn loafers. +Highly recognized +Sebago ® +line extensions include Sebago +Docksides tm , +Drysides tm +and Athletic Marine. The +Sebago ® +product line is marketed in approximately 125 countries and +territories worldwide. The +Sebago ® +manufacturing and design tradition of quality components, +durability, comfort and “Americana” heritage is +further supported by targeted distribution to better-grade +independent, marine and department store retailers throughout +the world. The Company also markets a classic and marine +Sebago ® +apparel line. +6 +Table of Contents +4. +The Hush Puppies Group +Hush +Puppies ® : Since +1958, the Hush +Puppies ® +brand has been a leader in casual footwear. The brand offers +shoes, sandals and boots for men, women and children, and is +marketed in approximately 140 countries and territories. The +modern styling is complemented by a variety of comfort features +and proprietary technologies that have earned the brand its +reputation for comfort, style and value. In addition, the +Hush +Puppies ® +brand is licensed for use on certain items, including apparel, +eyewear, handbags, socks, watches and plush toys. +Soft +Style ® : The +Soft +Style ® +product line consists primarily of women’s dress and casual +footwear. +Cushe ® : The +Cushe ® +business was acquired in January 2009 and focuses on relaxed, +design-led footwear for active men and women. The +Cushe ® +Footwear business targets younger adult consumers and +better-grade retailers with products ranging from sport casual +footwear to sandals. +Cushe ® +is marketed under three primary collections: Universal Traveler, +Urban Safari and Coastal Supremacy. +Other +Businesses +In addition to its branded footwear, apparel and licensing +operations, the Company also (i) operates 81 retail stores +in North America and 7 retail stores in the United Kingdom that +feature footwear and apparel, (ii) operates a performance +leathers business through its Wolverine Leathers Division; and +(iii) purchased and cured raw pigskins for sale to various +customers through its wholly-owned subsidiary, Wolverine +Procurement, Inc. +1. +Wolverine Retail The Company’s +consumer-direct business operates 81 North American and +7 United Kingdom-based retail stores as of February 2011. +These stores are operated under the Hush +Puppies ® , +Hush Puppies and +Family SM , +Track’N +Trail ® , +Rockford Footwear +Depot ® +and +Merrell ® +names. The Rockford Footwear +Depot ® , +Track’N +Trail ® , +Hush +Puppies ® +and Hush Puppies and +Family SM +retail formats carry a large selection of Company-branded +products, featuring such brands as +Wolverine ® , +Merrell ® , +Hush +Puppies ® , +Cat ® , +Chaco ® , +Cushe ® , +Patagonia ® , +Sebago ® +and +Harley-Davidson ® . +The Company also operates +Merrell ® +concept stores and Hush +Puppies ® +concept stores, providing a platform to showcase these brands +exclusively. In addition, the Company operates 38 +consumer-direct retail websites, including, www.merrell.com, +www.wolverine.com, www.hushpuppies.com , www.chacousa.com, +www.cushe.com, www.catfootwear.com , www.sebago.com, and +www.batesfootwear.com . +2. +The Wolverine Leathers Division The +Wolverine Leathers Division markets pigskin leather primarily +for use in the footwear industry. The Company believes pigskin +leather offers superior performance and other advantages over +cowhide leather. The Company’s waterproof and stain +resistant leathers are featured in some of the Company’s +footwear lines and many products offered by the Company’s +international licensees and distributors. +3. +Wolverine Procurement, Inc . Wolverine +Procurement, Inc. performs skinning operations and purchases raw +pigskins from third parties, which it cures and sells to outside +customers for processing into pigskin leather products. +Substantially all of the assets of Wolverine Procurement, Inc. +were sold to a third-party buyer on December 29, 2010. +Marketing +The Company’s marketing strategy is to develop +brand-specific plans and related promotional materials for +U.S. and international markets to foster a consistent +message for each of the Company’s core brands. Each brand +group has dedicated marketing personnel who develop the +marketing strategy for brands within that group. Marketing +campaigns and strategies vary by brand and are designed to +target accounts +and/or end +users as the brand groups +7 +Table of Contents +strive to increase awareness of, and affinity for, the +Company’s brands. The Company’s advertisements +typically emphasize fashion, comfort, quality, durability, +functionality and other performance and lifestyle aspects of the +Company’s products. Components of the brand-specific plans +vary and may include print, radio and television advertising, +social networking sites, event sponsorships, in-store +point-of-purchase +displays, promotional materials, and sales and technical +assistance. +The Company’s brand groups provide its licensees and +distributors with creative direction, brand images and other +materials to convey consistent brand messaging, including +(i) direction on the categories of footwear to be promoted, +(ii) photography and layouts, (iii) broadcast +advertising, including commercials and film footage, +(iv) point-of-purchase +presentation specifications, blueprints and packaging, +(v) sales materials and (vi) consulting services +regarding retail store layout and design. The Company believes +its brand names provide it with a competitive advantage and the +Company makes significant expenditures on marketing and +promotion to support the position of its products and enhance +brand awareness. +Domestic +Sales and Distribution +The Company uses a wide variety of domestic distribution +channels and strategies to distribute its branded products: +• +The Company uses a dedicated sales force and customer service +team, advertising and +point-of-purchase +support and maintains in-stock inventories to service +consumer-direct business, department stores, national chains, +specialty retailers, catalogs, independent retailers and uniform +outlets. +• +Volume direct programs ship products directly to the retail +customer without going through a Company distribution center and +provide products at competitive prices with limited marketing +support. The Company uses these programs to service major +retail, catalogs, mass merchant and government customers. +• +A network of independent +Shoemobile ® +distribution outlets distributes the Company’s work and +occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military +and submits bids for contracts to supply specific footwear +products. Such contracts typically contain future purchase +options that are not required to be exercised. +In addition to its wholesale activities, the Company also +operates a consumer-direct business as described above. The +Company continues to develop new programs, both independently +and in conjunction with its consumer-direct customers, for the +distribution of its products. +A broad distribution base insulates the Company from dependence +on any one customer. No customer of the Company accounted for +more than 10% of the Company’s revenue in fiscal 2010. +The Company experiences moderate fluctuations in sales volume +during the year as reflected in quarterly revenue (and taking +into consideration the 16 weeks or 17 weeks included +in the Company’s fourth accounting quarter versus the +12 weeks included in the first three accounting quarters). +The Company expects current seasonal sales patterns to continue +in future years. The Company also experiences some fluctuation +in its levels of working capital, typically including an +increase in working capital requirements near the end of the +first and third quarters. The Company meets its working capital +requirements through effective cash generation and, as needed, a +revolving credit agreement. +International +Operations and Global Licensing +The Company’s foreign-sourced revenue is generated from a +combination of (i) sales of branded footwear and apparel +through the Company’s owned operations in Canada, the +United Kingdom and approximately eight branch offices in Europe; +(ii) sales to third-party distributors for certain markets +and businesses; and (iii) royalty income from a network of +third-party licensees and distributors. The Company’s owned +operations are located in markets where the Company believes it +can gain a strategic advantage by directly controlling the sale +of its products into +8 +Table of Contents +retail accounts. License and distribution arrangements enable +the Company to develop sales in other markets without the +capital commitment required to maintain related foreign +operations, employees, inventories or localized marketing +programs. +The Company continues to develop its network of licensees and +distributors to market its branded products. The Company assists +its licensees in designing products that are appropriate to each +foreign market, but consistent with the global brand position. +Pursuant to distribution or license agreements, third-party +licensees and distributors either purchase goods from the +Company or authorized third-party manufacturers or manufacture +branded products consistent with Company standards. Distributors +and licensees are responsible for independently marketing and +distributing Company branded products in their respective +territories, with product and marketing support from the Company. +Manufacturing +and Sourcing +The Company directly controls the majority of the units of +footwear and apparel manufactured or sourced under the +Company’s brand names. The balance is controlled directly +by the Company’s licensees. A substantial majority of the +units sourced +and/or +manufactured by the Company are purchased or sourced from third +parties, with the remainder produced at Company-owned +facilities. The Company sources a majority of its footwear from +numerous third-party manufacturers in the Asia-Pacific region, +South America and India. The Company maintains offices in the +Asia-Pacific region to facilitate and develop strategies for the +sourcing and importation of quality footwear and apparel. The +Company has established guidelines for each of its third-party +manufacturers in order to monitor product quality, labor +practices and financial viability. The Company has adopted +“Engagement Criteria for Partners & +Sources,” a policy that requires that the Company’s +domestic and foreign manufacturers, licensees and distributors +use ethical business standards; comply with all applicable +health and safety laws and regulations; commit to use +environmentally safe practices; treat employees fairly with +respect to wages, benefits and working conditions; and not use +child or prison labor. Footwear produced by the Company is +manufactured at Company-operated facilities located in Michigan +and the Dominican Republic. +The Company’s owned manufacturing operations allow the +Company to (i) reduce its production lead time, enabling it +to more quickly respond to market demand and reduce inventory +risk, (ii) lower freight, shipping and duty costs for sales +to certain markets, and (iii) more closely monitor product +quality. The Company’s third-party sourcing strategy allows +the Company to (i) benefit from lower manufacturing costs +and +state-of-the-art +manufacturing facilities, (ii) source high quality raw +materials from around the world, and (iii) avoid capital +expenditures necessary for additional owned factories. The +Company believes that its overall global manufacturing strategy +provides the flexibility to properly balance the need for timely +shipments, high quality products and competitive pricing. +The Company’s principal required raw material is quality +leather, which it purchases from a select group of domestic and +foreign suppliers. The global availability of common upper +materials and specialty leathers eliminates any reliance by the +Company on a sole supplier. +The Company currently purchases all of the raw pigskins used for +its Wolverine Leathers Division from one domestic source, which +has been a reliable and consistent supplier for over +30 years. Alternative sources of raw pigskin are available, +but with less advantageous pricing, quality and compatibility +with the Company’s processing method. The Company purchases +all of its other raw materials and component parts from a +variety of sources and does not believe that any of these +sources are a dominant supplier. +The Company is subject to the normal risks of doing business +abroad due to its international operations, including the risk +of expropriation, acts of war or terrorism, political +disturbances and similar events, the imposition of trade +barriers, quotas, tariffs and duties, loss of most favored +nation trading status and currency and exchange rate +fluctuations. With respect to international sourcing activities, +management believes that over a period of time, it could arrange +adequate alternative sources of supply for the products +currently obtained from its foreign suppliers, but that a +sustained disruption of such sources of supply could have an +adverse impact on the Company’s results of operations and +financial position. +9 +Table of Contents +Trademarks, +Licenses and Patents +The Company holds a significant portfolio of registered and +common law trademarks that identify its branded products. The +Company’s owned trademarks include Hush +Puppies ® , +Wolverine ® , +Bates ® , +Cushe ® , +Chaco ® , +Soft +Style ® , +Wolverine +Fusion ® , +DuraShocks ® , +MultiShox ® , +Wolverine +Compressor ® , +Hidden +Tracks ® , +iTechnology tm , +Bounce ® , +Comfort +Curve ® , +HyTest ® , +Merrell ® , +M Circle Design (registered design trademark), +Continuum ® , +Sebago ® , +Q +Form ® +and Track ’N +Trail ® . +The Company’s Wolverine Leathers Division markets its +pigskin leathers under the trademarks Wolverine Warrior +Leather ® , +Weather +Tight ® +and All Season Weather +Leathers tm . +The Company has exclusive footwear marketing and distribution +rights under the +Cat ® , +Harley-Davidson ® and +Patagonia ® +trademarks pursuant to license arrangements with the respective +trademark owners. The +Cat ® , +Harley-Davidson ® , +and +Patagonia ® +licenses extend for five or more years and are subject to early +termination for breach. +The Company believes that consumers identify its products by the +Company’s trademarks and that its trademarks are valuable +assets. The Company is not aware of any infringing uses or any +prior claims of ownership of its trademarks that could +materially affect its current business. The Company has a policy +of registering its primary trademarks and vigorously defending +its trademarks against infringement or other threats whenever +practicable. The Company also holds many design and utility +patents, copyrights and various other proprietary rights. The +Company vigorously protects its proprietary rights under +applicable laws. +Order +Backlog +At February 19, 2011, the Company had an order backlog of +approximately $628 million compared to an order backlog of +approximately $424 million at February 20, 2010, +determined on a consistent basis. All of the backlog relates to +orders for products expected to be shipped in 2011. Orders in +the backlog are subject to cancellation by customers and to +changes in planned customer demand or at-once orders. The +backlog at any particular time is affected by a number of +factors, including seasonality, retail conditions, expected +customer demand, product availability and the schedule for the +manufacture and shipment of products. Accordingly, a comparison +of backlog from period to period is not necessarily meaningful +and may not be predictive of eventual actual shipments. +Competition +The Company markets its footwear and apparel lines in a highly +competitive and fragmented environment. The Company competes +with numerous domestic and international marketers and +importers, some of which are larger and have greater resources +than the Company. The Company has at least forty major +competitors for its brands of footwear and apparel. Product +performance and quality, including technological improvements, +product identity, competitive pricing and ability to control +costs, and the ability to adapt to style changes are all +important elements of competition in the footwear and apparel +markets served by the Company. The footwear and apparel +industries in general are subject to changes in consumer +preferences. The Company strives to maintain its competitive +position through promotions designed to increase brand +awareness, manufacturing and sourcing efficiencies, and the +style, comfort and value of its products. Future sales by the +Company will be affected by its continued ability to sell its +products at competitive prices and to meet shifts in consumer +preferences. +Because of the lack of reliable published statistics, the +Company is unable to state with certainty its competitive +position in the footwear and apparel industries. Market shares +in the non-athletic footwear and apparel industry are highly +fragmented and no one company has a dominant market position. +Research +and Development +In addition to normal and recurring product development, design +and styling activities, the Company engages in research and +development activities related to the development of new +production techniques and to the improvement of the function, +performance, reliability and quality of its branded footwear and +other products. For example, the Company’s continuing +relationship with the Biomechanics Evaluation Laboratory at +Michigan +10 +Table of Contents +State University has helped validate and refine specific +biomechanical design concepts, such as +Bounce ® , +DuraShocks ® +and Hidden +Tracks ® +comfort technologies, which have been incorporated in the +Company’s footwear. While the Company expects to continue +to be a leading developer of footwear innovations, research and +development costs do not represent a material portion of +operating expenses. +Environmental +Matters +Compliance with domestic and foreign federal, state and local +requirements regulating the discharge of materials into the +environment, or otherwise relating to the protection of the +environment have not had, nor are they expected to have, any +material effect on the capital expenditures, earnings or +competitive position of the Company. The Company uses and +generates certain substances and wastes that are regulated or +may be deemed hazardous under certain federal, state and local +regulations with respect to the environment. The Company works +with domestic and foreign federal, state and local agencies from +time to time to resolve cleanup issues at various waste sites +and other regulatory issues. +Employees +As of January 1, 2011, the Company had approximately 4,139 +domestic and foreign production, office and sales employees. +Approximately 51 employees were covered by a single union +contract that expires on March 31, 2011. The Company +presently considers its employee relations to be good. +Available +Information +Information about the Company, including the Company’s Code +of Conduct & Compliance, Corporate Governance +Guidelines, Director Independence Standards, Accounting and +Finance Code of Ethics, Audit Committee Charter, Compensation +Committee Charter, and Governance Committee Charter, is +available at its website at +www.wolverineworldwide.com/investor-relations/corporate-governance . +Printed copies of the documents listed above are available, +without charge, by writing to the Company at 9341 Courtland +Drive, N.E., Rockford, Michigan 49351, Attention: General +Counsel. +The Company also makes available on or through its website, free +of charge, the Company’s Annual Report on +Form 10-K, +quarterly reports on +Form 10-Q +and current reports on +Form 8-K, +and amendments to those reports (along with certain other +Company filings with the Securities and Exchange Commission +(“SEC”)) as soon as reasonably practicable after +electronically filing such material with, or furnishing it to, +the SEC. These materials are also accessible on the SEC’s +website at www.sec.gov . +Item 1A. +Risk +Factors +Changes in general economic conditions and other factors +affecting consumer spending could adversely affect the +Company’s sales, operating results or financial position +The Company’s global operations depend on factors affecting +consumer disposable income and spending patterns. These factors +include general economic conditions, employment, business +conditions, interest rates and taxation. Customers may defer or +cancel purchases of the Company’s products due to +uncertainty about global economic conditions. Consumer +confidence may decline due to recessionary economic cycles, high +interest rates on consumer or business borrowings, restricted +credit availability, inflation, high levels of unemployment or +consumer debt, high tax rates or other economic factors. +Declining consumer confidence could adversely affect demand for +the Company’s products. Changes in the amount or severity +of bad weather and the growth or decline of global footwear, +apparel or consumer-direct markets could affect negatively +consumer spending patterns. A decline in demand for the +Company’s products could reduce the Company’s revenues +or profit margins. +11 +Table of Contents +General economic conditions and regulatory factors such as those +listed above, as well as increased costs of fuel, labor, +commodities, insurance and health care, may increase the +Company’s cost of sales and operating expenses. Such +increases could adversely affect the Company’s financial +position and results of operations. +The Company operates in competitive industries and +markets. +The Company competes with a large number of marketers of +footwear or apparel, and consumer-direct companies. Some of +these competitors are larger and have greater resources than the +Company. Important elements of such competition include product +performance and quality, including technological improvements, +product identity, competitive pricing and the ability to adapt +to style changes. Consumer preferences for and the popularity of +particular designs and categories of footwear and apparel +generally change. The Company strives to maintain and improve +its competitive position through increasing brand awareness, +gaining sourcing efficiencies, and enhancing the style, comfort +and perceived value of its products. The Company’s +continued ability to sell its products at competitive prices and +to meet shifts in consumer preferences will affect its future +sales. If the Company is unable to respond effectively to +competitive pressures and changes in consumer spending, its +results of operations and financial position may be adversely +affected. +Many of the Company’s competitors have more developed +consumer and customer bases, lower prices, or greater financial, +technical or marketing resources than the Company, particularly +in the apparel and consumer-direct businesses. The +Company’s competitors may implement more effective +marketing campaigns; adopt more aggressive pricing policies; +make more attractive offers to potential employees, distribution +partners and manufacturers; or respond more quickly to changes +in consumer preferences, than the Company. The Company’s +results of operations and financial position could be adversely +affected if the Company’s businesses are not successful. +The Company’s operating results depend on effectively +managing inventory levels. +The Company’s ability to manage its inventories effectively +is an important factor in its operations. Inventory shortages +can impede the Company’s ability to meet orders, adversely +affect the timing of shipments to customers, and, consequently, +diminish brand loyalty. Conversely, excess inventories can +result in lower gross margins if the Company lowers prices in +order to liquidate excess inventories. Excess inventories can +also drive increased interest costs. The Company’s +business, results of operations and financial position could be +adversely affected if the Company is unable to effectively +manage its inventory. +Increases or changes in duties, quotas, tariffs and other +trade restrictions could adversely impact the Company’s +sales and profitability. +All of the Company’s products manufactured overseas and +imported into the U.S., the European Union and other countries +are subject to customs duties collected by customs authorities. +Customs information submitted by the Company is routinely +subject to review by customs authorities. Additional +U.S. or foreign customs duties, quotas, tariffs, +anti-dumping duties, safeguard measures, cargo restrictions to +prevent terrorism or other trade restrictions may be imposed on +the importation of the Company’s products in the future. +The imposition of such costs or restrictions in foreign +countries where the Company operates, as well as in countries +where the Company’s +third-party +distributors and licensees operate, could result in increases in +the cost of the Company’s products generally and could +adversely affect the sales and profitability of the Company. +In December 2009, the European Union approved a +15-month +extension of anti-dumping duties on specific types of leather +upper footwear originating in China and Vietnam and imported +into member states of the European Union. Because the Company +sources a substantial portion of its products from suppliers +located in China and Vietnam, these anti-dumping duties +negatively affected the Company’s sales and gross margin in +the European Union. The European Union announced in January 2011 +that the anti-dumping duties described above will be removed on +March 31, 2011. +12 +Table of Contents +Foreign currency exchange rate fluctuations could adversely +impact the Company’s business. +Foreign currency fluctuations affect the Company’s reported +revenue and profitability. In addition, because the Company may +employ hedging strategies over time, changes in currency +exchange rates may impact the Company’s financial results +positively or negatively in one period and not another, which +may make it difficult to compare the Company’s operating +results from different periods. Currency exchange rate +fluctuations may also adversely impact third parties who +manufacture the Company’s products by making their +purchases of raw materials or other production costs more +expensive and more difficult to finance, thereby raising prices +for the Company, its distributors and licensees. For a more +detailed discussion of risk relating to foreign currency +fluctuation, see Item 7A, Quantitative and Qualitative +Disclosures About Market Risk. +Significant raw material shortages, supplier capacity +constraints, supplier production disruptions, supplier quality +issues or price increases could increase the Company’s +operating costs and adversely impact the competitive position of +the Company’s products. +The Company currently sources most of its products from +third-party manufacturers in foreign countries, predominantly +China. As is common in the industry, the Company does not have +long-term contracts with its third-party suppliers. There can be +no assurance that the Company will not experience difficulties +with such suppliers, including reduction in the availability of +production capacity, failure to meet production deadlines or +increases in manufacturing costs. The Company’s future +results will depend partly on its ability to maintain positive +working relationships with third-party suppliers. +Foreign manufacturing is subject to a number of risks, including +work stoppages, transportation delays and interruptions, +political instability, foreign currency fluctuations, changing +economic conditions, expropriation, nationalization, the +imposition of tariffs, import and export controls and other +non-tariff barriers and changes in governmental policies. +Various factors could significantly interfere with the +Company’s ability to source its products, including adverse +developments in trade or political relations with China or other +countries where the Company sources its products, or a shift in +China’s manufacturing capacity away from footwear and +apparel to other industries. Any of these events could have an +adverse effect on the Company’s business, results of +operations and financial position and in particular on the +Company’s ability to meet customer demands and produce its +products in a cost-effective manner. +The Company’s ability to competitively price its products +depends on the cost of components, services, labor, equipment +and raw materials, including leather and materials used in the +production of footwear outsoles. The cost of services and +materials is subject to change based on availability and market +conditions that are difficult to predict. Various conditions, +such as diseases affecting the availability of leather, affect +the cost of the footwear marketed by the Company. In addition, +fuel prices and numerous other factors, such as the possibility +of service interruptions at shipping and receiving ports, affect +the Company’s shipping costs. Increases in cost for +services and materials used in production could have a negative +impact on the Company’s results of operations and financial +position. +The Company purchases raw pigskins for its leathers operations +from a single domestic source pursuant to +short-term +contracts. Although this source has been a reliable and +consistent supplier for over 30 years, there are no +assurances that it will continue as a supplier. Failure of this +source to continue to supply the Company with raw pigskin or to +supply the Company with raw pigskin on less favorable terms +could increase the Company’s cost of raw materials for its +leather business and, as a result, have a negative impact on the +Company’s results of operations and financial position. +A significant reduction in customer purchases of the +Company’s products or failure of customers to pay for the +Company’s products in a timely manner could adversely +affect the Company’s business. +The Company’s financial success is directly related to its +customers continuing to purchase its products. The Company does +not typically have long-term contracts with its customers. Sales +to the Company’s customers are generally on an +order-by-order +basis and are subject to rights of cancellation and rescheduling +by the customers. +13 +Table of Contents +Failure to fill customers’ orders in a timely manner could +harm the Company’s relationships with its customers. +Furthermore, if any of the Company’s major customers +experience a significant downturn in its business, or fail to +remain committed to the Company’s products or brands, they +may reduce or discontinue purchases from the Company, which +could have an adverse effect on the Company’s results of +operations and financial position. +The Company sells its products to customers and extends credit +based on an evaluation of each customer’s financial +condition. The financial difficulties of a customer could cause +the Company to stop doing business with that customer or reduce +its business with that customer. The Company’s inability to +collect from its customers or a cessation or reduction of sales +to certain customers because of credit concerns could have an +adverse effect on the Company’s business, results of +operations and financial position. +The general trend toward consolidation in retail and specialty +retail could lead to fewer customers, customers seeking more +favorable terms of purchase from the Company and could lead to a +decrease in the number of stores that carry the Company’s +products. In addition, changes in the channels of distribution, +such as the continued growth of Internet commerce and the trend +toward the sale of private label products by major retailers, +could have an adverse effect on the Company’s results of +operations and financial position. +The Company has been awarded a number of U.S. Department of +Defense contracts that include future purchase options for +Bates ® +footwear. Failure by the Department of Defense to exercise these +purchase options or the failure of the Company to secure future +U.S. Department of Defense contracts could have an adverse +effect on the Company’s results of operations and financial +position. +Changes in the credit markets could adversely affect the +Company’s financial success. +Changes in credit markets could adversely impact the +Company’s future results of operations and financial +position. If the Company’s third-party distributors, +suppliers and retailers are not able to obtain financing on +favorable terms, or at all, they may delay or cancel orders for +the Company’s products, or fail to meet their obligations +to the Company in a timely manner, either of which could +adversely impact the Company’s sales, cash flow and +operating results. In addition, any lack of available credit +and/or the +increased cost of credit may significantly impair the +Company’s ability to obtain additional credit to finance +future expansion plans, or refinance existing credit, on +favorable terms, or at all. +Unfavorable findings resulting from a government audit could +subject the Company to a variety of penalties and sanctions, and +could negatively impact the Company’s future revenues. +The federal government has the right to audit the Company’s +performance under its government contracts. If a government +audit uncovers improper or illegal activities, the Company could +be subject to civil and criminal penalties and administrative +sanctions, including termination of contracts, forfeiture of +profits, suspension of payments, fines, and suspension or +debarment from doing business with U.S. federal government +agencies. The Company could also suffer serious harm to its +reputation if the government alleges that the Company acted in +an improper or illegal manner, whether or not any such +allegations have merit. If, as the result of an audit or for any +other reason, the Company is suspended or barred from +contracting with the federal government generally, or any +specific agency, if the Company’s reputation or +relationship with government agencies is impaired, or if the +government otherwise ceases doing business with the Company or +significantly decreases the amount of business it does with the +Company, the Company’s revenue and profitability could +decrease. The Company is also subject to customs and other +audits in various jurisdictions where it operates. Negative +audit findings could have an adverse effect on the +Company’s results of operations and financial position. +14 +Table of Contents +Failure of the Company’s international licensees and +distributors to meet sales goals or to make timely payments on +amounts owed to the Company could adversely affect the +Company’s financial performance. +In many international markets, independent licensees or +distributors sell the Company’s products. Failure by the +Company’s licensees or distributors to meet planned annual +sales goals or to make timely payments on amounts owed to the +Company could have an adverse effect on the Company’s +business, results of operations and financial position, and it +may be difficult and costly to locate an acceptable substitute +distributor or licensee. If a change in licensee or distributor +becomes necessary, the Company may experience increased costs, +as well as substantial disruption and a resulting loss of sales +and brand equity in the market where such licensee or +distributor operates. +The Company’s reputation and competitive position are +dependent on its third-party manufacturers, distributors, +licensees and others complying with applicable laws and the +Company’s ethical standards. +The Company requires its independent contract manufacturers, +distributors, licensees and others with which it does business +to comply with the Company’s ethical standards and +applicable laws relating to working conditions and other +matters. If a party with whom the Company does business is found +to have violated the Company’s ethical standards or +applicable laws, the Company could receive negative publicity +that could damage its reputation and negatively affect the value +of its brands. +Global political and economic uncertainty could adversely +impact the Company’s business. +Concerns regarding acts of terrorism and international conflict +have created significant global economic and political +uncertainties that may have material and adverse effects on +consumer demand, acceptance of U.S. brands in international +markets, foreign sourcing of products, shipping and +transportation, product imports and exports and the sale of +products in foreign markets, any of which could adversely affect +the Company’s ability to source, manufacture, distribute +and sell its products. The Company is subject to risks of doing +business in developing countries and economically volatile +areas. These risks include social, political and economic +instability; nationalization of the Company’s assets and +operations in a developing country by local government +authorities; slower payment of invoices; and restrictions on the +Company’s ability to repatriate foreign currency. In +addition, commercial laws in these areas may not be +well-developed or consistently administered, and new laws may be +retroactively applied. Any of these risks could have an adverse +impact on the Company’s prospects and results of operations +in these areas. +Unsuccessful efforts by the Company to establish and protect +its intellectual property could adversely affect the value of +its brands. +The Company invests significant resources to develop and protect +its intellectual property, and believes that its trademarks and +other intellectual property rights are important to its future +success. The Company’s ability to remain competitive is +dependent upon its continued ability to secure and protect +trademarks, patents and other intellectual property rights in +the United States and internationally for all of its lines of +business. The Company relies on a combination of trade secret, +patent, trademark, copyright and other laws, license agreements +and other contractual provisions and technical measures to +protect its intellectual property rights; however, some +countries’ laws do not protect intellectual property rights +to the same extent as do U.S. laws. The Company’s +business could be significantly harmed if it is not able to +protect its intellectual property, or if a court found that the +Company was infringing on other persons’ intellectual +property rights. Any intellectual property lawsuits or +threatened lawsuits in which the Company is involved, either as +a plaintiff or as a defendant, could cost the Company a +significant amount of time and money and distract +management’s attention from operating the Company’s +business. In addition, if the Company does not prevail on any +intellectual property claims, the Company may have to change its +manufacturing processes, products or trade names, any of which +could reduce its profitability. +In addition, some of the Company’s branded footwear +operations are operated pursuant to licensing agreements with +third-party trademark owners. These agreements are subject to +early termination for breach. Expiration or early +15 +Table of Contents +termination of any of these license agreements by the licensor +could have a material adverse effect on the Company’s +business, results of operations and financial position. +The Company periodically discovers products that are counterfeit +reproductions of its products or that otherwise infringe on its +intellectual property rights. The Company has not always been +able to stop production and sales of counterfeit products and +infringement of the Company’s intellectual property rights. +The actions the Company takes to establish and protect +trademarks, patents and other intellectual property rights both +inside and outside of the United States may not be adequate to +prevent imitation of its products by others. If the Company is +unsuccessful in challenging a party’s products on the basis +of infringement of the Company’s intellectual property +rights, continued sales of these products could adversely affect +the Company’s sales, devalue its brands and result in the +shift of consumer preference away from the Company’s +products. +The Company’s inability to attract and retain executive +managers and other key employees, or the loss of one or more +executive managers or other key employees, could adversely +affect the Company’s business. +The Company depends on its executive management and other key +employees. In the footwear, apparel and consumer-direct +industries, competition for qualified employees is intense, and +the Company’s failure to identify, attract or retain +executive managers or other key employees could adversely affect +its business. The Company must offer and maintain competitive +compensation packages to effectively recruit and retain such +individuals. Further, the loss of one or more executive managers +or other key employees, or the Company’s failure to +successfully implement succession planning, could adversely +affect the Company, its results of operations or financial +position. +Inflationary and other pressures may lead to higher +employment and pension costs for the Company. +General inflationary pressures, changes in employment laws and +regulations, and other factors could increase the Company’s +overall employment costs. The Company’s employment costs +include costs relating to health care benefits and benefits +under the Company’s retirement plans, including a +U.S.-based +defined benefit plan. The annual cost of benefits can vary +significantly depending on a number of factors, including +changes in the assumed or actual rate of return on pension plan +assets, a change in the discount rate used to determine the +present value of pension obligations, a change in method or +timing of meeting pension funding obligations and the rate of +health care cost inflation. Increases in the Company’s +overall employment and pension costs could have an adverse +effect on the Company’s business, results of operations and +financial position. +Disruption of the Company’s technology systems could +adversely affect the Company’s business. +The Company’s technology systems are critical to the +operations of its business. Any interruption, impairment or loss +of data integrity or malfunction of these systems could severely +impact the Company’s business, including delays in product +fulfillment and reduced efficiency in operations. In addition, +costs and potential problems and interruptions associated with +the implementation of new or upgraded systems, or with +maintenance or adequate support of existing systems could +disrupt or reduce the efficiency of the Company’s +operations. +The Company faces risks associated with its growth strategy +and acquiring or disposing of businesses. +The Company may make strategic acquisitions in the future, and +the Company cannot provide assurance that it will be able to +successfully integrate the operations of these newly-acquired +businesses into the Company’s operations. Acquisitions +involve numerous risks, including risks inherent in entering new +markets in which the Company may not have prior experience; +potential loss of significant customers or key personnel of the +acquired business; managing geographically-remote operations; +and potential diversion of management’s attention from +other aspects of the Company’s business operations. +Acquisitions may also result in incurrence of debt, dilutive +issuances of the Company’s equity securities and write-offs +of goodwill and substantial amortization expenses of other +intangible assets. The failure to integrate newly-acquired +businesses or the inability to make suitable strategic +acquisitions in the future could have an adverse effect on the +Company’s results of operations and financial position. +16 +Table of Contents +Maintenance and growth of the Company’s business depends +upon the availability of adequate capital. +The maintenance and growth of the Company’s business +depends on the availability of adequate capital, which in turn +depends in large part on cash flow generated by its business and +the availability of equity and debt financing. The Company +cannot provide assurance that its operations will generate +positive cash flow or that it will be able to obtain equity or +debt financing on acceptable terms or at all. Further, the +Company cannot provide assurance that it will be able to finance +any expansion plans. +Expanding the Company’s brands into new markets may be +difficult and costly, and unsuccessful efforts to do so may +adversely affect the Company’s brands or business. +As part of its growth strategy, the Company seeks to enhance the +positioning of its brands, to extend its brands into +complementary product categories, to expand geographically, to +expand its owned consumer-direct operations and to improve +operational performance. There can be no assurance that the +Company will be able to successfully implement any or all of +these growth strategies, which could have an adverse effect on +the Company’s results of operations and financial position. +Changes in government regulation may increase the costs of +compliance. +The Company’s business is affected by changes in government +and regulatory policies in the United States and in foreign +jurisdictions. New requirements relating to product safety and +testing and new environmental requirements, as well as changes +in tax laws, duties, tariffs and quotas could have a negative +impact on the Company’s ability to produce and market +footwear at competitive prices. +The disruption, expense, and potential liability associated +with existing and future litigation against the Company could +adversely affect the Company’s reputation, financial +position or results of operations. +The Company is a defendant from time to time in lawsuits and +regulatory actions relating to its business. Due to the inherent +uncertainties of litigation and regulatory proceedings, the +Company cannot accurately predict the ultimate outcome of any +such proceedings. An unfavorable outcome could have an adverse +impact on the Company’s business, financial position and +results of operations. In addition, regardless of the outcome of +any litigation or regulatory proceedings, such proceedings are +expensive and may require that the Company devote substantial +resources and executive time to defend the Company. +Provisions of Delaware law and the Company’s certificate +of incorporation and bylaws could prevent or delay a change in +control or change in management that could be beneficial to the +Company’s stockholders. +Provisions of the Company’s certificate of incorporation +and bylaws, as well as provisions of Delaware law, could +discourage, delay or prevent a merger, acquisition or other +change in control of the Company. These provisions are intended +to protect stockholders’ interests by providing the Board +of Directors a means to attempt to deny coercive takeover +attempts or to negotiate with a potential acquirer in order to +obtain more favorable terms. Such provisions include a board of +directors that is classified so that only one-third of directors +stand for election each year. These provisions could also +discourage proxy contests and make it more difficult for +stockholders to elect directors and take other corporate actions. +There are risks, including stock market volatility, inherent +in owning the Company’s common stock. +The market price and volume of the Company’s common stock +have been, and may continue to be, subject to significant +fluctuations. These fluctuations may arise from general stock +market conditions, the impact of risk factors described in this +Item 1A on the Company’s financial condition and +results of operations, a change in sentiment in the market +regarding the Company’s business prospects or from other +factors, many of which may be outside the Company’s +control. Changes in the amounts and frequency of share +repurchases or dividends could adversely affect the value of the +Company’s common stock. +17 +Table of Contents +Item 1B. +Unresolved +Staff Comments +None. +Item 2. +Properties +The Company operates its domestic administration, sales and +marketing operations primarily from an owned facility of +approximately 225,000 square feet in Rockford, Michigan. +The Company’s manufacturing operations are conducted +primarily at a combination of leased and owned facilities in +Michigan and the Dominican Republic. The Company operates its +U.S. distribution operations primarily through an owned +distribution center in Rockford, Michigan, of approximately +305,000 square feet, a leased distribution center in Cedar +Springs, Michigan, of approximately 356,000 square feet and +a leased distribution center in Howard City, Michigan, of +approximately 460,000 square feet. +The Company also leases and owns various other offices and +distribution centers to meet its operational requirements. In +addition, the Company operates retail stores through leases with +various third-party landlords. The Company conducts +international operations in Canada, the United Kingdom, China, +Hong Kong and Europe through leased distribution centers, +offices +and/or +showrooms. The Company believes that its current facilities are +suitable and adequate for its current needs. +Item 3. +Legal +Proceedings +The Company is involved in litigation and various legal matters +arising in the normal course of business, including certain +environmental compliance activities. The Company has considered +facts related to legal and regulatory matters and opinions of +counsel handling these matters, and does not believe the +ultimate resolution of such proceedings will have a material +adverse effect on the Company’s financial position, results +of operations, or cash flows. +18 +Table of Contents +Supplemental +Item. Executive Officers of the Registrant +The following table lists the names and ages of the Executive +Officers of the Company and the positions presently held with +the Company. The information provided below the table lists the +business experience of each such Executive Officer for at least +the past five years. All Executive Officers serve at the +pleasure of the Board of Directors of the Company, or if not +appointed by the Board of Directors, they serve at the pleasure +of management. +Name +Age +Positions held with the +Company +Kenneth A. Grady +54 +General Counsel and Secretary +Donald T. Grimes +48 +Senior Vice President, Chief Financial Officer and Treasurer +Robin J. Kleinjans-McKee +35 +Corporate Controller +Blake W. Krueger +57 +Chairman, Chief Executive Officer and President +Pamela L. Linton +61 +Senior Vice President, Global Human Resources +Michael F. McBreen +45 +President, Global Operations Group +Michael D. Stornant +44 +Vice President, Corporate Planning and Analysis +James D. Zwiers +43 +Senior Vice President and President, Outdoor Group +Kenneth A. Grady has served the Company as General Counsel and +Secretary since October 2006. During 2006, he was President and +shareholder of the law firm K.A. Grady PC. During 2005, he +served as Vice President, General Counsel and Secretary of PC +Connection, Inc., a direct marketer of information technology +products and solutions. From 2004 to 2005, Mr. Grady served +as Executive Vice President of Administration, General Counsel +and Secretary of KB Toys, Inc., a specialty toy retailer. From +2001 to 2004, he served as Vice President, General Counsel and +Secretary of KB Toys, Inc. +Donald T. Grimes has served the Company as Senior Vice +President, Chief Financial Officer and Treasurer since May 2008. +From 2007 to 2008, he was the Executive Vice President and Chief +Financial Officer for Keystone Automotive Operations, Inc., a +distributor of automotive accessories and equipment. Prior to +Keystone, Mr. Grimes held a series of senior corporate and +divisional finance roles at Brown-Forman Corporation, a +manufacturer and marketer of premium wines and spirits. During +his employment at Brown-Forman, Mr. Grimes was Vice +President, Director of Beverage Finance from 2006 to 2007; Vice +President, Director of Corporate Planning and Analysis from 2003 +to 2006; and Senior Vice President, Chief Financial Officer of +Brown-Forman Spirits America from 1999 to 2003. +Robin J. Kleinjans-McKee has served the Company as Corporate +Controller since February 2009. From 2006 to 2009, she was the +Company’s Director of Financial Reporting. From 2004 to +2006, Ms. Kleinjans-McKee served as Assurance Senior +Manager at BDO Seidman, LLP, a professional services firm. From +1997 to 2004, Ms. Kleinjans-McKee served in various audit +positions at BDO Seidman, LLP. +Blake W. Krueger has served the Company as Chairman since +January 2010 and as Chief Executive Officer and President since +April 2007. From October 2005 to April 2007, he served as Chief +Operating Officer and President. From August 2004 to October +2005, he served as Executive Vice President and Secretary of the +Company and President of the Heritage Brands Group. From +November 2003 to August 2004, he served the Company as Executive +Vice President, Secretary, and President of Caterpillar +Footwear. From April 1996 to November 2003, he served the +Company as Executive Vice President, General Counsel and +Secretary. From 1993 to April 1996, he served as General Counsel +and Secretary. From 1985 to 1996, he was a partner with the law +firm of Warner Norcross & Judd LLP. +Pamela L. Linton has served the Company as Senior Vice +President, Global Human Resources since December 2007. From 2005 +to 2007, she was an independent consultant. From 2001 to 2005, +she was Senior Vice President, Global Human Resources of +American Greetings Corporation, a greeting card and gift wrap +company. +Michael F. McBreen has served the Company as President, Global +Operations Group of Wolverine since June 2008. From 2007 to +2008, he was Vice President, Supply Chain & Logistics +for Furniture Brands International, a home furnishings company. +Prior to Furniture Brands International, Mr. McBreen held a +series of senior supply chain roles with Nike, Inc., a marketer +of athletic footwear and apparel. During his employment at Nike, +Mr. McBreen was +19 +Table of Contents +Director, Global Apparel Operations from 2004 to 2007; Director, +Global Apparel Operations & Corporate Responsibility +from 2002 to 2004; and Director, Global Supply Chain Operations +from 2000 to 2002. +Michael D. Stornant has served the Company as Vice President, +Corporate Planning and Analysis since February 2009. He served +the Company as Corporate Controller from May 2008 until February +2009. From 2007 to 2008, he served as Senior Vice President of +Owned Operations for the Global Operations Group. From 2006 to +2007, he was Wolverine’s Vice President of Finance for the +Global Operations Group. From 2003 to 2006, he served the +Company as the Director of Internal Audit. From 1996 to 2003, he +held various finance-related positions at the Company. +James D. Zwiers has served the Company as Senior Vice President +and President, Outdoor Group since March 2009. From January 2008 +until March 2009, he served as Senior Vice President of the +Company. From October 2006 to December 2007, he served as +President of the Company’s Hush Puppies U.S. Division. +From October 2005 to October 2006, he served as the +Company’s General Counsel and Secretary. From December 2003 +to October 2005, he served as General Counsel and Assistant +Secretary. From January 1998 to December 2003, he served the +Company as Associate General Counsel and Assistant Secretary. +From 1995 to 1998, he was an attorney with the law firm of +Warner Norcross & Judd LLP. +Item 4. +(Removed +and Reserved) +PART II +Item 5. +Market +for Registrant’s Common Equity, Related Stockholder Matters +and Issuer +Purchases of Equity Securities +The Company’s common stock is traded on the New York Stock +Exchange under the symbol “WWW.” The following table +shows the high and low stock prices on the New York Stock +Exchange and dividends declared by calendar quarter for 2010 and +2009. The number of stockholders of record on February 25, +2011, was 1,612. +2010 +2009 +Stock Price +High +Low +High +Low +First quarter +$ +29.76 +$ +23.51 +$ +21.87 +$ +13.15 +Second quarter +$ +32.38 +$ +26.33 +$ +23.90 +$ +15.26 +Third quarter +$ +29.99 +$ +24.25 +$ +27.25 +$ +21.06 +Fourth quarter +$ +33.00 +$ +26.89 +$ +28.31 +$ +23.94 +Cash Dividends Declared Per +Share +2010 +2009 +First quarter +$ +0.11 +$ +0.11 +Second quarter +$ +0.11 +$ +0.11 +Third quarter +$ +0.11 +$ +0.11 +Fourth quarter +$ +0.11 +$ +0.11 +A quarterly dividend of $0.12 per share was declared during the +first quarter of fiscal 2011. The Company currently expects that +comparable cash dividends will be paid in future quarters in +2011. +The Company’s credit agreement imposes certain restrictions +on the Company’s ability to pay cash dividends. As long as +no default under the credit agreement exists or would be caused +by the payment of the dividend, the Company may pay cash +dividends (i) in an aggregate amount not to exceed +$80 million per fiscal year and (ii) in an aggregate +amount greater than $80 million per fiscal year if the +Company maintains a prescribed leverage ratio. +See Item 12 for information with respect to the +Company’s equity compensation plans. +20 +Table of Contents +Stock +Performance Graph +The following graph compares the five year cumulative total +stockholder return on Wolverine common stock to the +Standard & Poor’s Small Cap 600 Index and the +Standard & Poor’s 600 Footwear Index, assuming an +investment of $100 at the beginning of the period indicated. +Wolverine is part of the Standard & Poor’s Small +Cap 600 Index and the Standard & Poor’s Footwear +Index. This Stock Performance Graph shall not be deemed to be +incorporated by reference into the Company’s SEC filings +and shall not constitute soliciting material or otherwise be +considered filed under the Securities Act of 1933, as amended, +or the Securities Exchange Act of 1934, as amended. +21 +Table of Contents +The following table provides information regarding the +Company’s purchases of its own common stock during the +fourth quarter of fiscal 2010: +Issuer +Purchases of Equity Securities +Total Number +of Shares +Maximum +Purchased +Dollar Amount +as Part of +that +Total +Publicly +May Yet +Number of +Average +Announced +Be Purchased +Shares +Price Paid +Plans or +Under the Plans +Period +Purchased +per Share +Programs +or Programs +Period 1 (September 12, 2010 to October 9, 2010) +Common Stock Repurchase +Program (1) +– +$ – +– +$ +154,110,117 +Employee +Transactions (2) +178 +28.95 +– +Period 2 (October 10, 2010 to November 6, 2010) +Common Stock Repurchase +Program (1) +– +$ – +– +$ +154,110,117 +Employee +Transactions (2) +308 +29.55 +– +Period 3 (November 7, 2010 to December 4, 2010) +Common Stock Repurchase +Program (1) +– +$ – +– +$ +154,110,117 +Employee +Transactions (2) +3,274 +31.89 +– +Period 4 (December 5, 2010 to January 1, 2011) +Common Stock Repurchase +Program (1) +– +$ – +– +$ +154,110,117 +Employee +Transactions (2) +21,176 +31.40 +– +Total for Fourth Quarter ended January 1, 2011 +Common Stock Repurchase +Program (1) +– +$ – +– +$ +154,110,117 +Employee +Transactions (2) +24,936 +31.43 +– +(1) +The Company’s Board of Directors approved a common stock +repurchase program on February 11, 2010. This program +authorized the repurchase of up to $200.0 million of common +stock over a four-year period, commencing on the effective date +of the program. There were no shares repurchased during fourth +quarter of fiscal 2010, other than repurchases pursuant to the +“Employee Transactions” set forth above. +(2) +Employee transactions include: (1) shares delivered or +attested in satisfaction of the exercise price and/or tax +withholding obligations by holders of employee stock options who +exercised options, and (2) restricted shares withheld to +offset statutory minimum tax withholding that occurs upon +vesting of restricted shares. The Company’s employee stock +compensation plans provide that the shares delivered or attested +to, or withheld, shall be valued at the closing price of the +Company’s common stock on the date the relevant transaction +occurs. +22 +Table of Contents +Item 6. +Selected +Financial Data +Five-Year Operating and Financial Summary +(1) +2010 +2009 +2008 +2007 +2006 +(Thousands of Dollars, Except Per Share Data) +Summary of Operations +Revenue +$ +1,248,517 +$ +1,101,056 +$ +1,220,568 +$ +1,198,972 +$ +1,141,887 +Net earnings +104,470 +61,912 +95,821 +92,886 +83,647 +Per share of common stock: +Basic net +earnings (2)(3) +$ +2.15 +$ +1.26 +$ +1.94 +$ +1.75 +$ +1.50 +Diluted net +earnings (2)(3) +2.11 +1.24 +1.90 +1.70 +1.46 +Cash dividends declared +0.44 +0.44 +0.44 +0.36 +0.30 +Financial Position at Year End +Total assets +$ +786,575 +$ +712,076 +$ +664,780 +$ +638,378 +$ +671,092 +Long-term debt +1,034 +1,615 +5 +10,731 +21,471 +Notes to +Five-Year Operating and Financial Summary +(1) +This summary should be read in conjunction with the consolidated +financial statements and the related notes, which are attached +as Appendix A to this Annual Report on +Form 10-K. +(2) +Basic earnings per share are based on the weighted average +number of shares of common stock outstanding during the year +after adjustment for nonvested restricted common stock. Diluted +earnings per share assume the exercise of dilutive stock options +and the vesting of all outstanding restricted stock. +(3) +Basic and diluted net earnings per share have been retroactively +adjusted to reflect the adoption of FASB ASC Topic 260, +Earnings Per Share on January 4, 2009 , for +participating securities which represent unvested restricted +common stock which contain nonforfeitable rights to dividends or +dividend equivalents. +23 +Table of Contents +Item 7. +Management’s +Discussion and Analysis of Financial Condition and Results of +Operations +OVERVIEW +BUSINESS OVERVIEW +Wolverine World Wide, Inc. (the “Company”) is a +leading global designer, manufacturer and marketer of branded +footwear, apparel and accessories. The Company’s stated +mission is to “ Excite Consumers Around the World with +Innovative Footwear and Apparel that Bring Style to +Purpose .” The Company pursues this mission by offering +innovative products and compelling brand propositions, +delivering supply chain excellence, complementing its footwear +brands with strong apparel and accessories offerings and +building a more substantial global consumer-direct footprint. +The Company’s portfolio consists of 12 brands that were +marketed in approximately 190 countries and territories as of +January 1, 2011. This diverse portfolio and broad +geographic reach position the Company for robust organic growth. +The Company controls distribution of its brands into the retail +channel via subsidiary operations in the United States, Canada, +the United Kingdom and certain other countries in continental +Europe. In other markets, the Company relies on a network of +third-party distributors and licensees to market its brands. The +Company also owned and operated 88 +brick-and-mortar +retail stores in the United States, Canada and the United +Kingdom and operated 38 consumer-direct internet sites at the +end of fiscal 2010. +2010 +FINANCIAL OVERVIEW +• +The Company ended 2010 with $150.4 million of cash and cash +equivalents and interest-bearing debt of only $1.0 million. +• +Revenue for 2010 was $1.249 billion, 13.4% above 2009 +revenue of $1.101 billion, reflecting strong organic growth +from all of the Company’s operating divisions. +• +Accounts receivable increased 20.0% in 2010 compared to 2009, +driven primarily by the 23.2% increase in fourth quarter +revenue. Days sales outstanding decreased from 63.3 days in +2009 to 60.5 days in 2010. +• +Inventory increased $50.6 million, or 32.0%, in 2010 +compared to 2009, reflecting both the excellent outlook for the +first half of 2011 and strategic purchases ahead of announced +price increases from +third-party +suppliers. +• +Diluted earnings per share for 2010 were $2.11 per share +compared to $1.24 per share for 2009, including the impact of +$0.06 and $0.53 per share of restructuring and other transition +costs in 2010 and 2009, respectively. +• +The full year effective tax rate decreased to 27.1% from 27.8% +in 2009, reflecting the net benefit from adjustments and the +settlement of a foreign tax audit. +• +The Company declared cash dividends of $0.44 per share in 2010, +equal to the total dividends declared in 2009. +• +The Company repurchased approximately 1,795,000 shares of +common stock in 2010 for approximately $51.2 million and +repurchased approximately 406,000 shares in 2009 for +approximately $5.6 million, both of which lowered the +average shares outstanding. +2010 +DEVELOPMENTS +Strategic +Restructuring Plan +On January 7, 2009, the Board of Directors of the Company +approved a strategic restructuring plan designed to create +significant operating efficiencies, improve the Company’s +supply chain and create a stronger global platform. On +October 7, 2009, the Company announced that two initiatives +in its restructuring plan had been expanded to enable the +consolidation of two domestic manufacturing facilities into one +and to finalize realignment of certain product creation +organizations. The strategic restructuring plan and all actions +under the plan, except for certain cash payments, were completed +as of June 19, 2010. +24 +Table of Contents +OUTLOOK +FOR 2011 +Fiscal year 2011 revenue is expected to increase based on +continued positive momentum across all brands. Based on the +favorable outlook for the business, the Company anticipates +revenue growth in the high single digits to low teens. +The Company expects the fiscal 2011 gross margin to be +similar to the fiscal 2010 gross margin of 39.5%, as higher +product costs are expected to be offset by strategic price +increases and anticipated favorable product mix. The Company +anticipates modest operating expense leverage, a full year +effective tax rate of 29.0% and fully diluted earnings per share +growth in the high single digits to mid teens. +The following is a discussion of the Company’s results of +operations and liquidity and capital resources. This section +should be read in conjunction with the Company’s +consolidated financial statements and related notes included +elsewhere in this Annual Report. +RESULTS +OF OPERATIONS – FISCAL 2010 COMPARED TO FISCAL +2009 +FINANCIAL +SUMMARY – 2010 VERSUS 2009 +2010 +2009 +Change +(Millions of Dollars, Except Per Share Data) +% of +% of +$ +Total +$ +Total +$ +% +Revenue +Branded footwear, apparel and licensing +$ +1,117.6 +89 +.5% +$ +991.2 +90 +.0% +$ +126 +.4 +12 +.8% +Other business units +130.9 +10 +.5% +109.9 +10 +.0% +21 +.0 +19 +.1% +Total Revenue +$ +1,248.5 +100 +.0% +$ +1,101.1 +100 +.0% +$ +147 +.4 +13 +.4% +% of +% of +$ +Revenue +$ +Revenue +$ +% +Gross Profit +Branded footwear, apparel and licensing +$ +440.1 +39 +.4% +$ +390.8 +39 +.4% +$ +49 +.3 +12 +.6% +Other business units +52.5 +40 +.1% +40.9 +37 +.2% +11 +.6 +28 +.4% +Total Gross Profit +$ +492.6 +39 +.5% +$ +431.7 +39 +.2% +$ +60 +.9 +14 +.1% +Selling, general and administrative expenses +$ +347.5 +27 +.8% +$ +316.4 +28 +.7% +$ +31 +.1 +9 +.8% +Restructuring and other transition costs +2.8 +0 +.2% +29.7 +2 +.7% +(26 +.9) +(90 +.6%) +Total Operating Expenses +$ +350.3 +28 +.1% +$ +346.1 +31 +.4% +$ +4 +.2 +1 +.2% +Interest expense – net +$ +0.4 +0 +.0% +$ +0.1 +0 +.0% +$ +0 +.3 +300 +.0% +Other (income) – net +(1.3 +) +0 +.1% +(0.2 +) +0 +.0% +1 +.1 +550 +.0% +Earnings before income taxes +143.2 +11 +.5% +85.7 +7 +.8% +57 +.5 +67 +.1% +Net Earnings +$ +104.5 +8 +.4% +$ +61.9 +5 +.6% +$ +42 +.6 +68 +.8% +Diluted earnings per share +$ +2.11 +- +$ +1.24 +- +$ +0 +.87 +70 +.2% +25 +Table of Contents +The Company has one reportable segment that is engaged in +designing, manufacturing, sourcing, marketing, licensing and +distributing branded footwear, apparel and accessories. In +fiscal 2010 and fiscal 2009, this reportable segment was +organized into four primary wholesale operating segments: +• +Outdoor Group , consisting of +Merrell ® , +Chaco ® +and +Patagonia ® +footwear, and +Merrell ® +brand apparel; +• +Wolverine Footwear Group , consisting of +Bates ® , +HyTest ® , +and +Wolverine ® +boots and shoes and +Wolverine ® +brand apparel; +• +Heritage Brands Group , consisting of +Cat ® +footwear, +Harley-Davidson ® +footwear and +Sebago ® +footwear and apparel; and +• +Hush Puppies Group , consisting of Hush +Puppies ® , +Soft +Style ® +and +Cushe ® . +The Company’s other operating segments, which do not +collectively comprise a separate reportable segment, consisted +of: Wolverine Retail, the Company’s consumer-direct +business; Wolverine Leathers, which markets pigskin leather; and +Wolverine Procurement, which includes pigskin procurement +operations. +The following is supplemental information on total revenue: +TOTAL +REVENUE +2010 +2009 +Change +% of +% of +$ +Total +$ +Total +$ +% +(Millions of Dollars) +Outdoor Group +$ +467.6 +37.5% +$ +416.2 +37.8% +$ +51.4 +12.3% +Wolverine Footwear Group +274.9 +22.0% +233.2 +21.2% +41.7 +17.9% +Heritage Brands Group +222.3 +17.8% +198.3 +18.0% +24.0 +12.1% +Hush Puppies Group +140.3 +11.2% +131.6 +12.0% +8.7 +6.6% +Other +12.5 +1.0% +11.9 +1.1% +0.6 +5.0% +Total branded footwear, apparel +and licensing revenue +$ +1,117.6 +89.5% +$ +991.2 +90.0% +$ +126.4 +12.8% +Other business units +130.9 +10.5% +109.9 +10.0% +21.0 +19.1% +Total Revenue +$ +1,248.5 +100.0% +$ +1,101.1 +100.0% +$ +147.4 +13.4% +REVENUE +Revenue for 2010 increased $147.4 million from 2009, to +$1.249 billion. Strong organic growth in unit volume and +higher average selling price for the branded footwear, apparel +and licensing operations resulted in $122.1 million of the +increase with every significant region delivering double digit +revenue growth in 2010 compared to 2009. Changes in foreign +exchange rates increased reported revenue by $4.3 million. +Revenue from the other business units increased +$21.0 million, led by strong organic growth in the +consumer-direct business and strong demand for proprietary +leather from customers of the Wolverine Leathers business. +International revenue represented 38.4% of total revenue in 2010 +compared to 37.3% in 2009. +The Outdoor Group generated revenue of $467.6 million in +2010, a $51.4 million increase from 2009. The +Merrell ® +brand’s revenue increased at a rate in the low teens +compared to 2009, primarily as a result of increased market +penetration in every geography, category and channel and +successful at-once programs. +Patagonia ® +Footwear’s revenue increased at a rate in the mid thirties +in 2010 compared to 2009, due to continued strong demand from +key outdoor retailers. The +Chaco ® +brand grew at a rate in the high teens compared to 2009, due +primarily to the brand’s expanded distribution in the +U.S. and the introduction of closed-toe product designed to +evolve the brand into a four-season offering. +The Wolverine Footwear Group recorded revenue of +$274.9 million in 2010, a $41.7 million increase from +2009. Revenue for the +Wolverine ® +brand increased at a rate in the low twenties due primarily to +continued growth in the brand’s core work business as well +as significant growth in the rugged casual business. The +Bates ® +footwear business +26 +Table of Contents +grew revenue at a high single digit rate as it began shipping +military boots under a major contract awarded in the third +quarter of 2010. +HyTest ® ’s +revenue increased at a rate in the low thirties due to a rebound +in the safety footwear market. +The Heritage Brands Group generated revenue of +$222.3 million during 2010, a $24.0 million increase +over 2009. +Cat ® +Footwear’s revenue increased at a rate in the mid teens +compared to 2009, reflecting stronger sales in both the +U.S. and European markets and an increase in sales to +premium retailers. +Harley-Davidson ® +Footwear revenue increased at a mid single digit rate compared +to 2009 due primarily to organic growth in the European market. +The +Sebago ® +brand experienced an increase in revenue at a rate in the mid +teens for 2010 as a result of solid organic growth in the +European and third-party distributor markets, driven by +investments designed to increase brand awareness. +The Hush Puppies Group recorded revenue of $140.3 million +in 2010, an $8.7 million increase from 2009. Hush +Puppies ® +revenue increased at a low single digit rate as growth in the +United States and the third-party licensing business was +partially offset by declines in the Canadian and European +markets. The Soft +Style ® +brand grew its revenue at a mid single digit rate as a result of +growth in the department store channel, independent retailers +and +e-commerce. +The +Cushe ® +brand more than doubled compared to 2009, driven by the +excellent placement the brand has secured in specialty, outdoor +and surf retail venues along with the addition of more +international distributors and independent retailers. +Within the Company’s other business units, Wolverine Retail +reported a sales increase in the mid teens compared to 2009 as a +result of growth from the Company’s +e-commerce +channel and mid single-digit growth in comparable store sales +from Company-owned stores. Wolverine Retail operated 88 retail +stores worldwide at the end of both 2010 and 2009, with 7 new +store openings in 2010 offset by the Company’s decision to +close 7 underperforming locations in order to improve financial +results. The Wolverine Leathers business reported a revenue +increase at a rate in the low thirties, primarily due to strong +demand for Wolverine’s proprietary pigskin leather from +third-party customers. +GROSS MARGIN +Gross margin in 2010 of 39.5% was 30 basis points higher +than the prior year. The increase primarily resulted from +restructuring and other transition costs included in the cost of +sales of $1.4 million compared to $5.9 million in the +prior year, positive shift in product mix and selected selling +price increases, which were partially offset by the +year-end +LIFO adjustment and higher +year-over-year +product and freight costs. +OPERATING +EXPENSES +Operating expenses of $350.3 million in 2010 increased +$4.2 million from $346.1 million in 2009. The increase +was related primarily to increases in advertising and marketing +expenses designed to increase brand awareness; increases in +operating expenses that vary with revenue, such as selling +commissions and distribution costs; and higher compensation +costs. These increases were partially offset by continued +discipline in lowering general and administrative expenses and a +$26.9 million dollar reduction in restructuring and other +transition costs. +INTEREST, +OTHER AND TAXES +The increase in net interest expense reflected increased +facility fees under the new credit agreement and increased +amortization of closing costs offset by a reduction in revolver +borrowings in 2010. +The increase in other income is primarily related to the sale of +Wolverine Procurement assets in the fourth quarter of 2010, +which resulted in a $1.1 million gain and the change in +realized gains or losses on foreign denominated assets and +liabilities. +The Company’s full year effective tax rate in fiscal year +2010 was 27.1%, compared to 27.8% in fiscal year 2009. The lower +effective tax rate reflects benefits from the favorable +settlement of a foreign tax audit and a higher percentage of the +Company’s earnings being attributable to foreign +jurisdictions where tax rates are lower than in the U.S. or +nontaxable based on specific tax rulings and legislation. +27 +Table of Contents +NET +EARNINGS AND EARNINGS PER SHARE +As a result of the revenue, gross margin and expense changes +discussed above, the Company had net earnings of +$104.5 million in 2010 compared to $61.9 million in +2009, an increase of $42.6 million. +Diluted net earnings per share increased 70.2% in 2010 to $2.11 +from $1.24 in 2009. The increase was primarily attributable to +increased revenues, improved gross margin and lower +restructuring and other transition costs. The Company +repurchased approximately 1,795,000 shares of common stock +in 2010 for approximately $51.2 million and repurchased +approximately 406,000 shares in 2009 for approximately +$5.6 million, both of which lowered the average shares +outstanding. +Inflation did not have a significant impact on revenue or net +earnings. +RESULTS +OF OPERATIONS – FISCAL 2009 COMPARED TO FISCAL +2008 +FINANCIAL +SUMMARY – 2009 VERSUS 2008 +2009 +2008 +Change +(Millions of Dollars, Except Per Share Data) +% of +% of +$ +Total +$ +Total +$ +% +Revenue +Branded footwear, apparel and licensing +$ +991.2 +90.0% +$ +1,106.1 +90.6% +$ +(114.9 +) +(10.4% +) +Other business units +109.9 +10.0% +114.5 +9.4% +(4.6 +) +(4.0% +) +Total Revenue +$ +1,101.1 +100.0% +$ +1,220.6 +100.0% +$ +(119.5 +) +(9.8% +) +% of +% of +$ +Revenue +$ +Revenue +$ +% +Gross Profit +Branded footwear, apparel and licensing +$ +390.8 +39.4% +$ +444.7 +40.2% +$ +(53.9 +) +(12.1% +) +Other business units +40.9 +37.2% +41.3 +36.1% +(0.4 +) +(0.9% +) +Total Gross Profit +$ +431.7 +39.2% +$ +486.0 +39.8% +$ +(54.3 +) +(11.2% +) +Selling, general and administrative expenses +$ +316.4 +28.7% +$ +345.2 +28.3% +$ +(28.8 +) +(8.3% +) +Restructuring and other transition costs +29.7 +2.7% +- +0.0% +29.7 +100.0% +Total Operating Expenses +$ +346.1 +31.4% +$ +345.2 +28.3% +$ +0.9 +0.3% +Interest expense – net +$ +0.1 +0.0% +$ +1.1 +0.1% +$ +(1.0 +) +(89.8% +) +Other (income) – net +(0.2 +) +0.0% +(0.9 +) +0.1% +0.7 +78.3% +Earnings before income taxes +85.7 +7.8% +140.6 +11.5% +(54.9 +) +(39.0% +) +Net Earnings +$ +61.9 +5.6% +$ +95.8 +7.9% +$ +(33.9 +) +(35.4% +) +Diluted earnings per share +$ +1.24 +- +$ +1.90 +- +$ +(0.66 +) +(34.7% +) +28 +Table of Contents +The following is supplemental information on total revenue: +TOTAL +REVENUE +2009 +2008 +Change +% of +% of +$ +Total +$ +Total +$ +% +(Millions of Dollars) +Outdoor Group +$ +416.2 +37.8% +$ +428.4 +35.1% +$ +(12.2 +) +(2.8% +) +Wolverine Footwear Group +233.2 +21.2% +261.9 +21.5% +(28.7 +) +(10.9% +) +Heritage Brands Group +198.3 +18.0% +242.3 +19.8% +(44.0 +) +(18.2% +) +Hush Puppies Group +131.6 +12.0% +160.9 +13.2% +(29.3 +) +(18.2% +) +Other +11.9 +1.1% +12.6 +1.0% +(0.7 +) +(6.1% +) +Total branded footwear, apparel and licensing revenue +$ +991.2 +90.0% +$ +1,106.1 +90.6% +$ +(114.9 +) +(10.4% +) +Other business units +109.9 +10.0% +114.5 +9.4% +(4.6 +) +(4.0% +) +Total Revenue +$ +1,101.1 +100.0% +$ +1,220.6 +100.0% +$ +(119.5 +) +(9.8% +) +REVENUE +Revenue for 2009 decreased $119.5 million from 2008, to +$1,101.1 million. Declines in unit volume for the branded +footwear, apparel and licensing operations were primarily due to +tough market conditions brought about by the global recession. +These declines were only partially offset by price increases for +selected brands, causing revenue to decrease $76.7 million. +Changes in foreign exchange rates decreased revenue by +$38.2 million. Revenue from the other business units +decreased $4.6 million. International revenue represented +37.3% of total reported revenue in 2009 compared to 40.2% in +2008, with the decline resulting primarily from the stronger +U.S. dollar. +The Outdoor Group generated revenue of $416.2 million for +2009, a $12.2 million decrease from 2008. The +Merrell ® +brand’s revenue decreased at a mid single-digit rate over +the prior year, primarily as a result of the strengthening of +the U.S. dollar and tough economic conditions in the +brand’s international markets. +Patagonia ® +Footwear’s revenue decreased at a rate in the low +single-digits in 2009 compared to 2008, due primarily to tough +economic conditions. The addition and successful integration of +the +Chaco ® +brand early in the fiscal year contributed to the group’s +overall revenue performance in 2009. +The Wolverine Footwear Group recorded revenue of +$233.2 million in 2009, a $28.7 million decrease from +2008. Revenue for the +Wolverine ® +brand declined at a high single-digit rate due primarily to +negative economic conditions in the U.S. work sector. The +Bates ® +uniform footwear business realized a decrease in revenue at a +rate in the low teens, due primarily to planned reduction in +purchases by the U.S. Department of Defense. +HyTest ® ’s +revenue declined at a rate in the low thirties due to factory +closures and high unemployment rates among the brand’s +target consumers. +The Heritage Brands Group recorded revenue of +$198.3 million during 2009, a $44.0 million decrease +over 2008. +Cat ® +Footwear’s revenue decreased at a rate in the low twenties +compared to 2008, reflecting challenging economic conditions in +many of the brand’s major markets and the impact of the +stronger U.S. dollar. +Harley-Davidson ® +Footwear revenue decreased at rate in the mid teens due +primarily to declines in the dealer and retail market. The +Sebago ® +brand experienced a decline in revenue at a rate in the low +teens for 2009 as a result of tough economic conditions in many +of the brand’s most important markets and the stronger +U.S. dollar. +The Hush Puppies Group recorded revenue of $131.6 million +in 2009, a $29.3 million decrease from 2008. +Hush Puppies ® +revenue decreased at a rate in the high teens due primarily to +continued retail consolidation in Europe caused by weaker +consumer spending and the strengthening of the U.S. dollar +compared to 2008. The Soft +Style ® +brand experienced a decline in revenue at a rate in the mid +thirties as a result of a weak retail environment and +29 +Table of Contents +production delays at third-party factories. Revenue generated by +the +Cushe ® +brand, acquired in early fiscal 2009, partially offset these +revenue declines. +Within the Company’s other business units, Wolverine Retail +reported a high single-digit sales increase versus 2008 as a +result of growth from the Company’s +e-commerce +channel and low single-digit growth in comparable store sales +from Company-owned stores. Wolverine Retail operated 88 retail +stores worldwide at the end of 2009 compared to 90 at the end of +2008, as 9 new store openings were more than offset by the +Company’s decision to close 11 underperforming locations in +order to improve financial results. The Wolverine Leathers +business reported a revenue decline at a rate in the mid +twenties for 2009, primarily due to a decline in demand for its +proprietary products and a significant decline in the market +price for finished leather. +GROSS +MARGIN +Gross margin in 2009 of 39.2% was 60 basis points lower +than the prior year. Restructuring and other transition costs of +$5.9 million included in cost of goods sold in 2009 +accounted for 50 basis points of the decline, with the +remainder of the decrease resulting from the negative impact of +foreign exchange, increases in product costs and a higher mix of +lower margin product sales in 2009. +OPERATING +EXPENSES +Operating expenses of $346.1 million in 2009 increased +$0.9 million from $345.2 million in 2008. The increase +was related to restructuring and other transition costs of +$29.7 million, operating expenses associated with recently +acquired brands of $6.9 million and increased pension +expense of $8.8 million. These increases were offset by the +favorable impact of foreign exchange of $8.6 million, lower +general and administrative costs as a result of the +Company’s restructuring and cost-savings initiatives and +decreases in certain operating expenses that vary with revenue, +such as selling commissions and distribution costs. +INTEREST, +OTHER AND TAXES +The decrease in net interest expense reflected lower outstanding +debt as a result of the repayment in full of the Company’s +senior notes during the fourth quarter of 2008 and lower average +balances outstanding on the Company’s revolving line of +credit during 2009. +The decrease in other income is related primarily to the change +in realized gains or losses on foreign denominated assets and +liabilities. +The Company’s full year effective tax rate for fiscal year +2009 was 27.8%, compared to 31.8% for fiscal year 2008. The +lower effective tax rate reflects benefits from the +Company’s strategic restructuring plan, the cumulative full +year benefits from various tax planning strategies related +primarily to the Company’s international operations and a +higher percentage of the Company’s earnings being +attributable to foreign jurisdictions where tax rates are lower +than in the U.S. or nontaxable based on specific tax +rulings and legislation. +NET +EARNINGS AND EARNINGS PER SHARE +As a result of the revenue, gross margin and expense changes +discussed above, the Company had net earnings of +$61.9 million in 2009 compared to $95.8 million in +2008, a decrease of $33.9 million. +Diluted net earnings per share decreased 34.7% in 2009 to $1.24 +from $1.90 in 2008. The decrease was primarily attributable to +the global recession, restructuring and other transition costs, +increased pension expense and the negative effect of foreign +exchange rates. +Inflation did not have a significant impact on revenue or net +earnings. +30 +Table of Contents +LIQUIDITY +AND CAPITAL RESOURCES +January 1, +January 2, +Change +2011 +2010 +$ +% +(Millions of Dollars) +Cash and cash equivalents +$ +150.4 +$ +160.4 +$ +(10 +.0) +(6 +.2%) +Accounts receivable +196.5 +163.8 +32 +.7 +20 +.0% +Inventories +208.7 +158.1 +50 +.6 +32 +.0% +Accounts payable +64.1 +42.3 +21 +.8 +51 +.5% +Current accrued liabilities +77.1 +86.3 +(9 +.2) +(10 +.7%) +Interest-bearing debt +1.0 +1.6 +(0 +.6) +(37 +.5%) +Cash provided by operating activities +67.9 +168.6 +(100 +.7) +(59 +.7%) +Additions to property, plant and equipment +16.4 +11.7 +4 +.7 +40 +.2% +Depreciation and amortization +16.2 +17.6 +(1 +.4) +(8 +.0%) +Cash and cash equivalents was $150.4 million as of +January 1, 2011 a decrease of $10.0 million versus the +balance at January 2, 2010, due primarily to incremental +investments in working capital and other operating assets to +support future growth, partially offset by improved revenue and +profit. Accounts receivable increased 20.0% compared to the end +of fiscal year 2009 on a 23.2% increase in fourth quarter +revenue. No single customer accounted for more than 10% of the +outstanding accounts receivable balance at January 1, 2011. +As expected, inventory levels at year end increased +substantially from 2009, up 32.0%. The increase is primarily due +to the strong outlook for the first half of 2011 and strategic +purchases ahead of announced cost increases on core product. +The increase in accounts payable as of January 1, 2011 +compared to January 2, 2010 was primarily attributable to +the increase in inventory levels and the timing of cash payments +to vendors. The decrease in current accrued liabilities was due +primarily to decreased restructuring accruals and changes in +timing of payments, which resulted in a decrease in taxes +payable and liabilities related to foreign exchange contracts. +These decreases were partially offset by increases in incentive +compensation and advertising accruals. +The Company’s credit agreement with a bank syndicate +provides the Company with access to capital under a revolving +credit facility, including a swing-line facility and letter of +credit facility, in an initial aggregate amount of up to +$150.0 million. This amount is subject to increase up to a +maximum aggregate amount of $225.0 million under certain +circumstances. The revolving credit facility is used to support +working capital requirements and other business needs. There +were no amounts outstanding at January 1, 2011 under the +current revolving credit facility or at January 2, 2010 +under the Company’s previous revolving credit facility. The +Company considers balances drawn on the revolving credit +facility, if any, to be short-term in nature. The Company was in +compliance with all debt covenant requirements at +January 1, 2011 under the current revolving credit facility +and at January 2, 2010 under the Company’s previous +revolving credit facility. Proceeds from the revolving credit +facility, along with cash flows from operations, are expected to +be sufficient to meet working capital needs for the foreseeable +future. Any excess cash flows from operating activities are +expected to be used to purchase property, plant and equipment, +pay down debt, fund internal and external growth initiatives, +pay dividends or repurchase the Company’s common stock. +Net cash provided by operating activities in fiscal 2010 was +$67.9 million versus $168.6 million in fiscal 2009, a +decrease of $100.7 million. Stronger earnings performance +and lower cash payments for restructuring were more than offset +by additional investments in working capital and the timing of +tax and operating expense payments. +The majority of capital expenditures for the year were for +information system enhancements, manufacturing equipment and +building improvements. The Company leases machinery, equipment +and certain warehouse, office and retail store space under +operating lease agreements that expire at various dates through +2023. +The Company’s Board of Directors approved a common stock +repurchase program on April 19, 2007. The program +authorized the repurchase of up to 7.0 million shares of +common stock over a +36-month +period beginning on the +31 +Table of Contents +effective date of the program. The Company repurchased +199,996 shares at an average price of $26.52 per share +during the first quarter of 2010, which exhausted the number of +shares authorized for repurchase under the program. The +Company’s Board of Directors approved a new common stock +repurchase program on February 11, 2010. This program +authorizes the repurchase of up to $200.0 million in common +stock over a four-year period. The Company repurchased +683,808 shares at an average price of $28.18 in the first +quarter of 2010, 752,643 shares at an average price of +$29.99 per share during the second quarter of 2010, +158,700 shares at an average price of $25.51 per share +during the third quarter and repurchased no shares during the +fourth quarter of 2010 under this new program. The primary +purpose of the stock repurchase programs is to increase +stockholder value. The Company intends to continue to repurchase +shares of its common stock under the new program from time to +time in open market or privately negotiated transactions, +depending upon market conditions and other factors. +2010 +2009 +Cumulative +(Thousands of Dollars, Except Share Data) +Market price +Market price +Market price +Authorization +Shares +of shares +Shares +of shares +Shares +of shares +effective date +repurchased +repurchased +repurchased +repurchased +repurchased +repurchased +April 19, 2007 +199,996 +$ +5,304 +406,200 +$ +5,593 +7,000,000 +$ +180,802 +February 11, 2010 +1,595,151 +$ +45,890 +- +$ +- +1,595,151 +$ +45,890 +The Company declared total dividends of $0.44 per share for +fiscal years 2010 and 2009. On February 11, 2011, the +Company declared a quarterly cash dividend of $0.12 per share of +common stock, to be paid on May 2, 2011 to shareholders of +record on April 1, 2011. +NEW +ACCOUNTING STANDARDS +In January 2010, the Financial Accounting Standards Board (FASB) +issued Accounting Standard Update (ASU) +No. 2010-06, +Fair Value Measurements and Disclosures (Topic 820): +Improving Disclosures about Fair Value Measurements +(“ASU +No. 2010-06”). +ASU +No. 2010-06 +amends existing disclosure requirements under ASC 820 by +adding required disclosures about items transferring into and +out of Levels 1 and 2 in the fair value hierarchy; adding +separate disclosures about purchases, sales, issuances and +settlements relative to Level 3 measurements; and +clarifying the existing fair value disclosures about the level +of disaggregation. ASU +No. 2010-06 +was effective for financial statements issued for interim and +annual periods beginning after December 15, 2009 (first +quarter 2010 for the Company), except for the requirement to +provide Level 3 activity, which is effective for fiscal +years beginning after December 15, 2010 (first quarter 2011 +for the Company). The Company adopted the applicable disclosure +requirements of this ASU in the first quarter of 2010, and the +adoption did not affect the Company’s consolidated +financial position, results of operations or cash flows. +In February 2010, the FASB issued ASU +No. 2010-09, +Subsequent Events (Topic 855): Amendments to Certain +Recognition and Disclosure Requirements . This ASU, which was +effective immediately, removed the requirement for an SEC filer +to disclose a date through which subsequent events have been +evaluated. The Company adopted this standard in the first +quarter of 2010. +In December 2010, the FASB issued ASU +2010-28, +Goodwill and Other (Topic 350): When to Perform Step 2 of the +Goodwill Impairment Test for Reporting Units with Zero or +Negative Carrying Amounts . ASU +2010-28 +modifies Step 1 of the goodwill impairment test for reporting +units with zero or negative carrying amounts. For those +reporting units, an entity is required to perform Step 2 of the +goodwill impairment test if it is more likely than not that a +goodwill impairment exists. In determining whether it is more +likely than not that goodwill impairment exists, an entity must +consider whether there are any adverse qualitative factors +indicating an impairment may exist. ASU +2010-28 is +effective for fiscal years, and interim periods within those +years, beginning December 15, 2010 (the first quarter of +fiscal 2011 for the Company). The adoption of this ASU is not +expected to have a material impact on the Company’s +goodwill impairment evaluation as the Company does not currently +have reporting units with zero or negative carrying amounts. +In December 2010, the FASB issued ASU +2010-29, +Business Combinations (Topic 805): Disclosure of +Supplementary Pro Forma Information for Business +Combinations . ASU +2010-29 +requires that if a public entity presents comparative financial +statements, the entity should disclose revenue and earnings of +the +32 +Table of Contents +combined entity as though the business combination(s) that +occurred during the current year had occurred as of the +beginning of the comparable prior annual reporting period only. +This ASU also expands the supplemental pro forma adjustments to +include a description of the nature and amount of material, +nonrecurring pro forma adjustments directly attributable to the +business combination included in the reported pro forma revenue +and earnings. ASU +2010-29 is +effective prospectively for business combinations for which the +acquisition date is on or after the first annual reporting +period beginning on or after December 15, 2010 (fiscal 2011 +for the Company). The Company will provide the supplementary pro +forma information when completing future business combinations. +CRITICAL +ACCOUNTING POLICIES +The preparation of the Company’s consolidated financial +statements, which have been prepared in accordance with +accounting principles generally accepted in the United States, +requires management to make estimates and assumptions that +affect the amounts reported in the financial statements and +accompanying notes. On an ongoing basis, management evaluates +these estimates. Estimates are based on historical experience +and on various other assumptions that are believed to be +reasonable under the circumstances, the results of which form +the basis for making judgments about the carrying values of +assets and liabilities that are not readily apparent from other +sources. Historically, actual results have not been materially +different from the Company’s estimates. However, actual +results may differ materially from these estimates under +different assumptions or conditions. +The Company has identified the following critical accounting +policies used in determining estimates and assumptions in the +amounts reported. Management believes that an understanding of +these policies is important to an overall understanding of the +Company’s consolidated financial statements. +REVENUE +RECOGNITION +Revenue is recognized on the sale of products manufactured or +sourced by the Company when the related goods have been shipped, +legal title has passed to the customer and collectability is +reasonably assured. Revenue generated through programs with +licensees and distributors involving products bearing the +Company’s trademarks is recognized as earned according to +stated contractual terms upon either the purchase or shipment of +branded products by licensees and distributors. +The Company records provisions against gross revenue for +estimated returns and cash discounts in the period when the +related revenue is recorded. These estimates are based on +factors that include, but are not limited to, historical returns +experiences, historical discounts taken and analysis of credit +memorandum activity. The actual amount of customer returns or +allowances may differ from the Company’s estimates. The +Company records either an increase or decrease to gross sales in +the period in which it determines an adjustment to be +appropriate. +ACCOUNTS +RECEIVABLE +The Company maintains an allowance for uncollectible accounts +receivable for estimated losses resulting from its +customers’ inability to make required payments. Company +management evaluates the allowance for uncollectible accounts +receivable based on a review of current customer status and +historical collection experience. Historically, losses have been +within the Company’s expectations. Adjustments to these +estimates may be required if the financial condition of the +Company’s customers were to change. If the Company were to +determine that increases or decreases to the allowance for +uncollectible accounts were appropriate, the Company would +record either an increase or decrease to general and +administrative expenses in the period in which the Company made +such a determination. At January 1, 2011 and +January 2, 2010, management believed that it had provided +sufficient reserves to address future collection uncertainties. +INVENTORY +The Company values its inventory at the lower of cost or market. +Cost is determined by the +last-in, +first-out (“LIFO”) method for all domestic raw +materials and +work-in-process +inventories and certain domestic finished goods inventories. +Cost is determined using the +first-in, +first-out (“FIFO”) method for all raw materials, +work-in-process +and finished goods inventories in foreign countries. The FIFO +method is also used for all finished goods inventories of the +Company’s retail business, due to the unique nature of +those operations, and for certain domestic finished goods +inventories. The Company has applied these inventory cost +valuation methods consistently from year to year. +33 +Table of Contents +The Company reduces the carrying value of its inventories to the +lower of cost or market for excess or obsolete inventories based +upon assumptions about future demand and market conditions. If +the Company were to determine that the estimated market value of +its inventory is less than the carrying value of such inventory, +the Company would provide a reserve for such difference as a +charge to cost of sales. If actual market conditions are +different from those projected, adjustments to those inventory +reserves may be required. The adjustments would increase or +decrease the Company’s cost of sales and net income in the +period in which they were realized or recorded. Inventory +quantities are verified at various times throughout the year by +performing physical inventory observations and perpetual +inventory cycle count procedures. If the Company determines that +adjustments to the inventory quantities are appropriate, an +increase or decrease to the Company’s cost of sales and +inventory is recorded in the period in which such determination +was made. At January 1, 2011 and January 2, 2010, +management believed that it had provided sufficient reserves for +excess or obsolete inventories. +GOODWILL +AND OTHER +NON-AMORTIZABLE +INTANGIBLES +Goodwill and intangible assets deemed to have indefinite lives +are not amortized, but are subject to impairment tests at least +annually or when indicators of impairment exist. The first step +of the goodwill impairment test requires that the estimated fair +value of the applicable reporting unit be compared with its +recorded value. The Company establishes fair value by +calculating the present value of the expected future cash flows +of the reporting unit and by completing a market analysis. The +Company uses assumptions about expected future operating +performance in determining estimates of those cash flows, which +may differ from actual cash flows. If the recorded values of +these assets are not recoverable, based on the discounted cash +flow and market approach analyses, management performs the next +step, which compares the fair value of the reporting unit +calculated in step one to the fair value of the tangible and +intangible assets of the reporting unit, which results in an +implied fair value of goodwill. Goodwill is reduced by any +shortfall of implied goodwill to its carrying value. Impairment +tests for other +non-amortizable +intangibles require the determination of the fair value of the +intangible asset. The carrying value is reduced by any excess +over fair value. The Company reviewed the carrying amounts of +goodwill and other +non-amortizable +intangible assets and determined that there was no impairment +for the years ended January 1, 2011 and January 2, +2010. +INCOME +TAXES +The Company operates in multiple tax jurisdictions, both inside +and outside the United States. Accordingly, management must +determine the appropriate allocation of income in accordance +with local law for each of these jurisdictions. Income tax +audits associated with the allocation of this income and other +complex issues may require an extended period of time to resolve +and may result in income tax adjustments if changes to the +income allocation are required between jurisdictions with +different income tax rates. Because income tax adjustments in +certain jurisdictions can be significant, the Company records +accruals representing management’s best estimate of the +resolution of these matters. To the extent additional +information becomes available, such accruals are adjusted to +reflect the revised estimated outcome. The Company believes its +tax accruals are adequate to cover exposures related to changes +in income allocation between tax jurisdictions. The carrying +value of the Company’s deferred tax assets assumes that the +Company will be able to generate sufficient taxable income in +future years to utilize these deferred tax assets. If these +assumptions change, the Company may be required to record +valuation allowances against its gross deferred tax assets in +future years, which would cause the Company to record additional +income tax expense in the Company’s consolidated statements +of operations. Management evaluates the potential the Company +will be able to realize its gross deferred tax assets and +assesses the need for valuation allowances on a quarterly basis. +On a periodic basis, the Company estimates what the effective +tax rate will be for the full fiscal year and records a +quarterly income tax provision in accordance with the +anticipated annual rate. As the fiscal year progresses, that +estimate is refined based upon actual events and the +distribution of earnings in each tax jurisdiction during the +year. This continual estimation process periodically results in +a change to the expected effective tax rate for the fiscal year. +When this occurs, the Company adjusts the income tax provision +during the quarter in which the change in estimate occurs so +that the +year-to-date +provision reflects the revised anticipated annual rate. +RETIREMENT +BENEFITS +The determination of the obligation and expense for retirement +benefits is dependent on the selection of certain actuarial +assumptions used in calculating such amounts. These assumptions +include, among others, the discount +34 +Table of Contents +rate, expected long-term rate of return on plan assets and rates +of increase in compensation. These assumptions are reviewed with +the Company’s actuaries and updated annually based on +relevant external and internal factors and information, +including but not limited to, long-term expected asset returns, +rates of termination, regulatory requirements and plan changes. +The Company utilizes a bond matching calculation to determine +the discount rate used to calculate its year-end pension +liability and subsequent year pension expense. A hypothetical +bond portfolio is created based on a presumed purchase of +individual bonds to settle the plan’s expected future +benefit payments. The discount rate is the resulting yield of +the hypothetical bond portfolio. The bonds selected are rated +AA- or higher by at least two recognized ratings agency and are +non-callable, currently purchasable and non-prepayable. The +discount rate at year end 2010 was 5.94%. Pension expense is +also impacted by the expected long-term rate of return on plan +assets, which the Company determined to be 8.5% in 2010. This +determination is based on both actual historical rates of return +experienced by the pension assets and the long-term rate of +return of a composite portfolio of equity and fixed income +securities that reflects the approximate diversification of the +pension assets. +STOCK-BASED +COMPENSATION +The Company accounts for stock-based compensation in accordance +with the fair value recognition provisions of FASB ASC Topic +718, Compensation – Stock Compensation . The +Company utilizes the Black-Scholes model, which requires the +input of subjective assumptions. These assumptions include +estimating (a) the length of time employees will retain +their vested stock options before exercising them +(“expected term”), (b) the volatility of the +Company’s common stock price over the expected term and +(c) the number of options that will be forfeited. Changes +in these assumptions can materially affect the estimate of fair +value of stock-based compensation and, consequently, the related +expense amounts recognized in the consolidated statements of +operations. +QUANTITATIVE +AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +The Company faces market risk to the extent that changes in +foreign currency exchange rates affect the Company’s +foreign assets, liabilities and inventory purchase commitments +and to the extent that its long-term debt requirements are +affected by changes in interest rates. The Company manages these +risks by attempting to denominate contractual and other foreign +arrangements in U.S. dollars. The Company does not believe +that there has been a material change during 2010 in the nature +of the Company’s primary market risk exposures, including +the categories of market risk to which the Company is exposed +and the particular markets that present the primary risk of loss +to the Company. As of the date of this Annual Report on +Form 10-K, +the Company does not know of or expect there to be any material +change in the near-term in the general nature of its primary +market risk exposure. +Under the provisions of FASB ASC Topic 815, Derivatives and +Hedging , the Company is required to recognize all +derivatives on the balance sheet at fair value. Derivatives that +are not qualifying hedges must be adjusted to fair value through +earnings. If a derivative is a qualifying hedge, depending on +the nature of the hedge, changes in the fair value of +derivatives are either offset against the change in fair value +of the hedged assets, liabilities, or firm commitments through +earnings or recognized in accumulated other comprehensive income +until the hedged item is recognized in earnings. +The Company conducts wholesale operations outside of the United +States in the United Kingdom, continental Europe and Canada +where the functional currencies are primarily the British pound, +euro and Canadian dollar, respectively. The Company utilizes +foreign currency forward exchange contracts to manage the +volatility associated with U.S. dollar inventory purchases +made by +non-U.S. wholesale +operations in the normal course of business. At January 1, +2011 and January 2, 2010, the Company had outstanding +forward currency exchange contracts to purchase +$111.8 million and $69.6 million, respectively, of +U.S. dollars with maturities ranging up to 364 days. +The Company also has production facilities in the Dominican +Republic and sourcing locations in Asia, where financial +statements reflect the U.S. dollar as the functional +currency. However, operating costs are paid in the local +currency. Royalty revenue generated by the Company from +third-party foreign licensees is calculated in the +licensees’ local currencies, but paid in U.S. dollars. +Accordingly, the Company’s reported results are subject to +foreign currency exposure for this stream of revenue and +expenses. +35 +Table of Contents +Assets and liabilities outside the United States are primarily +located in the United Kingdom, Canada and the Netherlands. The +Company’s investments in foreign subsidiaries with a +functional currency other than the U.S. dollar are +generally considered long-term. Accordingly, the Company does +not hedge these net investments. For the year ended +January 1, 2011, the strengthening of the U.S. dollar +compared to foreign currencies decreased the value of these +investments in net assets by $2.9 million. For the year +ended January 2, 2010, the weakening of the +U.S. dollar compared to foreign currencies increased the +value of these investments in net assets by $15.3 million. +These changes resulted in cumulative foreign currency +translation adjustments at January 1, 2011 and +January 2, 2010 of $11.5 million and +$14.5 million, respectively, that are deferred and recorded +as a component of accumulated other comprehensive income in +stockholders’ equity. +Because the Company markets, sells and licenses its products +throughout the world, it could be affected by weak economic +conditions in foreign markets that could reduce demand for its +products. +The Company is exposed to changes in interest rates primarily as +a result of its revolving credit agreement. As of +January 1, 2011 and January 2, 2010, the Company had +no outstanding balances on its revolving credit. +The Company does not enter into contracts for speculative or +trading purposes, nor is it a party to any leveraged derivative +instruments. +OFF-BALANCE +SHEET ARRANGEMENTS +The Company has no off-balance sheet arrangements as of +January 1, 2011. +CONTRACTUAL +OBLIGATIONS +The Company has the following payments under contractual +obligations due by period: +Less than +More than +Total +1 year +1-3 years +3-5 years +5 years +(Thousands of Dollars) +Operating leases +$ +118,134 +16,926 +28,138 +23,387 +49,683 +Short- and long-term debt obligations +1,034 +517 +517 +- +- +Purchase +obligations (1) +206,889 +206,889 +- +- +- +Restructuring related obligations +441 +441 +- +- +- +Deferred compensation +738 +172 +324 +63 +179 +Pension (2) +31,800 +31,800 +- +- +- +SERP +27,048 +1,961 +3,955 +5,982 +15,150 +Dividends declared +5,925 +5,925 +- +- +- +Minimum royalties +6,275 +1,693 +1,778 +1,850 +954 +Minimum advertising +12,554 +1,941 +4,058 +4,305 +2,250 +Total (3) +$ +410,838 +$ +268,265 +$ +38,770 +$ +35,587 +$ +68,216 +(1) +Purchase obligations primarily relate to inventory and capital +expenditure commitments. +(2) +Pension obligations reflect only expected pension funding as +there are currently no required funding obligations under +government regulation. Funding amounts are calculated on an +annual basis and no required or planned funding beyond one year +has been determined. +(3) +The Company adopted FASB ASC Topic 740, Income Taxes, on +December 31, 2006. The total amount of unrecognized tax +benefits on the Consolidated Balance Sheet at January 1, +2011 is $9.7 million. At this time, the Company is unable +to make a reasonably reliable estimate of the timing of payments +in individual years beyond 12 months due to uncertainties +in the timing of tax audit outcomes. As a result, this amount is +not included in the table above. +At January 1, 2011, the Company had $150.0 million of +additional borrowing capacity available under a revolving credit +agreement with a termination date of June 7, 2014 and +$1.4 million of additional borrowing capacity under three +standby letters of credit. +36 +Table of Contents +Item 7A. +Quantitative +and Qualitative Disclosures About Market Risk +The response to this Item is set forth under the caption +“Quantitative and Qualitative Disclosures About Market +Risk” in Item 7, “Management’s Discussion +and Analysis of Financial Condition and Results of +Operations,” and is incorporated herein by reference. +Item 8. +Financial +Statements and Supplementary Data +The response to this Item is set forth in Appendix A of +this Annual Report on +Form 10-K +and is incorporated herein by reference. +Item 9. +Changes +in and Disagreements with Accountants on Accounting and +Financial Disclosure +None. +Item 9A. +Controls +and Procedures +Evaluation +of Disclosure Controls and Procedures +An evaluation was performed under the supervision and with the +participation of the Company’s management, including the +Chief Executive Officer and Chief Financial Officer, of the +effectiveness of the design and operation of the Company’s +disclosure controls and procedures. Based on and as of the time +of such evaluation, the Company’s management, including the +Chief Executive Officer and Chief Financial Officer, concluded +that the Company’s disclosure controls and procedures were +effective as of the end of the period covered by this report. +Management’s +Report on Internal Control Over Financial Reporting +Management is responsible for establishing and maintaining +adequate internal control over financial reporting, as such term +is defined in Securities Exchange Act +Rule 13a-15(f). +Under the supervision and with the participation of management, +including our Chief Executive Officer and Chief Financial +Officer, we conducted an evaluation of the effectiveness of +internal control over financial reporting as of January 1, +2011, based on the framework in Internal Control — +Integrated Framework issued by the Committee of Sponsoring +Organizations of the Treadway Commission (“COSO”). +Based on that evaluation, management concluded that internal +control over financial reporting was effective as of +January 1, 2011. +The effectiveness of the Company’s internal control over +financial reporting as of January 1, 2011, has been audited +by Ernst & Young LLP, an independent registered public +accounting firm, as stated in its report, which is included in +Appendix A and is incorporated into this Item 9A by +reference. +Changes +in Internal Control Over Financial Reporting +There was no change in the Company’s internal control over +financial reporting that occurred during the sixteen-week period +ended January 1, 2011 that has materially affected, or that +is reasonably likely to materially affect, the Company’s +internal control over financial reporting. +Item 9B. +Other +Information +None. +37 +Table of Contents +PART III +Item 10. +Directors, +Executive Officers and Corporate Governance +The Company’s Audit Committee is comprised of four Board +members, all of whom are independent under independence +standards adopted by the Board and applicable SEC regulations +and New York Stock Exchange standards (including independence +standards related specifically to Audit Committee membership). +The Audit Committee members each have financial and business +experience with companies of substantial size and complexity and +have an understanding of financial statements, internal controls +and audit committee functions. The Company’s Board of +Directors has determined that Jeffrey M. Boromisa and William K. +Gerber are audit committee financial experts, as defined by the +SEC. Additional information regarding the Audit Committee is +provided in the Definitive Proxy Statement of the Company with +respect to the Annual Meeting of Stockholders to be held on +April 21, 2011, under the caption “Corporate +Governance” under the subheading “Board of Directors +and Committees.” +The Company has adopted an Accounting and Finance Code of Ethics +that applies to the Company’s principal executive officer, +principal financial officer and principal accounting officer, +and has adopted a Code of Conduct & Compliance that +applies to the Company’s directors and employees. The +Accounting and Finance Code of Ethics and the Code of +Conduct & Compliance are available on the +Company’s website at +www.wolverineworldwide.com/investor-relations/corporate-governance . +Any waiver from the Accounting and Finance Code of Ethics or the +Code of Conduct & Compliance with respect to the +Company’s executive officers and directors will be +disclosed on the Company’s website. Any amendment to the +Accounting and Finance Code of Ethics and the Code of +Conduct & Compliance will be disclosed on the +Company’s website. +The information regarding directors of the Company contained +under the caption “Directors” in the Definitive Proxy +Statement of the Company with respect to the Annual Meeting of +Stockholders to be held on April 21, 2011, is incorporated +herein by reference. +The information regarding directors and executive officers of +the Company under the caption “Additional Information” +under the subheading “Section 16(a) Beneficial +Ownership Reporting Compliance” in the Definitive Proxy +Statement of the Company with respect to the Annual Meeting of +Stockholders to be held on April 21, 2011, is incorporated +herein by reference. +Item 11. +Executive +Compensation +The information contained under the captions “Non-Employee +Director Compensation in Fiscal Year 2010,” +“Compensation Discussion and Analysis,” +“Compensation Committee Report,” “2010 Summary +Compensation Table,” “Grants of Plan-Based Awards in +Fiscal 2010,” “Outstanding Equity Awards at 2010 +Fiscal Year-End,” “Option Exercises and Stock Vested +in Fiscal 2010,” “Pension Plans and 2010 Pension +Benefits” and “Potential Payments upon Termination or +Change in Control” in the Definitive Proxy Statement of the +Company with respect to the Annual Meeting of Stockholders to be +held on April 21, 2011, is incorporated herein by +reference. The information contained under the caption +“Corporate Governance” under the subheadings +“Risk Considerations in Compensation Programs” and +“Board of Directors and Committees” in the Definitive +Proxy Statement of the Company with respect to the Annual +Meeting of Stockholders to be held on April 21, 2011, is +also incorporated herein by reference. +Item 12. +Security +Ownership of Certain Beneficial Owners and Management and +Related Stockholder Matters +The information contained under the caption “Securities +Ownership of Officers and Directors and Certain Beneficial +Owners” contained in the Definitive Proxy Statement of the +Company with respect to the Annual Meeting of Stockholders to be +held on April 21, 2011, is incorporated herein by reference. +38 +Table of Contents +Equity +Compensation Plan Information +The following table provides information about the +Company’s equity compensation plans as of January 1, +2011: +Number of Securities +Remaining Available for +Weighted Average +Future Issuance under +Number of Securities to be +Exercise Price of +Equity Compensation +Issued Upon Exercise of +Outstanding +Plans (Excluding +Outstanding Options, +Options, Warrants +Securities Reflected in +Warrants and Rights +and Rights +Column (a)) +Plan +Category 1 +(a) +(b) +(c) +Equity compensation plans approved by security holders +4,248,910 2,3 +$ +21.47 +4,945,379 4 +Equity compensation plans not approved by security holders +- +N/A +- +Total +4,248,910 +$ +21.47 +4,945,379 +1 +Each plan for which aggregated information is provided contains +customary anti-dilution provisions that are applicable in the +event of a stock split, stock dividend or certain other changes +in the Company’s capitalization. +2 +Includes: (i) 3,822,087 stock options awarded to employees +under the 1993 Stock Incentive Plan, the 1995 Stock Incentive +Plan, the 1997 Stock Incentive Plan, the Amended and Restated +Stock Incentive Plan of 1999, the Amended and Restated Stock +Incentive Plan of 2001, the Amended and Restated Stock Incentive +Plan of 2003, the Amended and Restated Stock Incentive Plan of +2005 and the Stock Incentive Plan of 2010; and (ii) and +426,823 stock options awarded to non-employee directors under +the Stock Incentive Plan of 2010, the Amended and Restated Stock +Incentive Plan of 2005 and the Amended and Restated +Directors’ Stock Option Plan last approved by stockholders +in 2002. Column (a) does not include stock units credited +to outside directors’ fee accounts or retirement accounts +under the Outside Directors’ Deferred Compensation Plan. +Stock units do not have an exercise price. Each stock unit +credited to a director’s fee account and retirement account +under the Outside Directors’ Deferred Compensation Plan +will be converted into one share of common stock upon +distribution. Column (a) also does not include shares of +restricted or unrestricted common stock previously issued under +the Company’s equity compensation plans. +3 +Of this amount, 1,114,325 options were not exercisable as of +January 1, 2011, due to vesting restrictions. +4 +Comprised of: (i) 427,265 shares available for +issuance under the Outside Directors’ Deferred Compensation +Plan upon the retirement of the current directors or upon a +change in control; and (ii) 4,518,114 shares issuable +under the Stock Incentive Plan of 2010. +The Outside Directors’ Deferred Compensation Plan is a +supplemental, unfunded, nonqualified deferred compensation plan +for non-employee directors. Beginning in 2006, the Company began +paying an annual equity retainer to non-management directors in +the form of a contribution under the Outside Directors’ +Deferred Compensation Plan. Participation in the plan in +addition to the annual equity retainer is voluntary. The plan +allows participating directors to receive, in lieu of some or +all directors’ fees, a number of stock units equal to the +amount of the deferred directors’ fees divided by the fair +market value of the Company’s common stock on the date of +payment of the next cash dividend on the Company’s common +stock. These stock units are increased by a dividend equivalent +based on dividends paid by the Company and the amount of stock +units credited to the participating director’s fee account +and retirement account. Upon distribution, the participating +directors receive a number of shares of the Company’s +common stock equal to the number of stock units to be +distributed at that time. Distribution is triggered by +termination of service as a director or by a change in control +of the Company and can occur in a lump sum, in installments or +on another deferred basis. Of the 427,265 shares issuable +under the Outside Directors’ Deferred Compensation Plan, +211,655 shares have been issued to a trust to satisfy the +Company’s obligations when distribution is triggered and +are included in shares reported as issued and outstanding as of +the record date. +39 +Table of Contents +The Stock Incentive Plan of 2010 is an equity-based incentive +plans for officers, key employees, and directors. The Stock +Incentive Plan of 2010 authorizes awards of stock options, +restricted common stock, common stock, restricted stock units, +and/or stock +appreciation rights. The Stock Incentive Plan of 2010 provides +that each share of restricted or unrestricted common stock and +each restricted stock unit is counted as two shares against the +total number of shares authorized for issuance under the plan. +The number of securities listed as remaining available in column +(c) of the table assumes the grant of all stock options, +which count as only one share against the total number of shares +authorized for issuance under the plan. Actual shares available +under the plan will be less to the extent that the Company +awards restricted common stock, unrestricted common stock or +restricted stock units under the plan. The numbers provided in +this footnote and in column (c) will increase to the extent +that options relating to the number of shares listed in column +(a) of the table or other outstanding awards (e.g., shares +of restricted or unrestricted stock, restricted stock units or +stock appreciation rights) previously issued under the plan are +canceled, surrendered, modified, exchanged for substitutes or +expire or terminate prior to exercise or vesting because the +number of shares underlying any such awards will again become +available for issuance under the plan under which the award was +granted. +Of the total number of shares available under column (C), the +number of shares with respect to the following plans may be +issued other than upon the exercise of an option, warrant or +right outstanding as of January 1, 2011: +• +Outside Directors’ Deferred Compensation Plan: 427,265 +• +Stock Incentive Plan of 2010: 2,259,057 +Item 13. +Certain +Relationships and Related Transactions, and Director +Independence +The information contained under the caption “Related Party +Matters” under the subheadings “Certain Relationships +and Related Transactions” and “Related Person +Transactions Policy” contained in the Definitive Proxy +Statement of the Company with respect to the Annual Meeting of +Stockholders to be held on April 21, 2011, is incorporated +herein by reference. The information contained under the caption +“Corporate Governance” under the subheading +“Director Independence” contained in the Definitive +Proxy Statement of the Company with respect to the Annual +Meeting of Stockholders to be held on April 21, 2011, is +incorporated herein by reference. +Item 14. +Principal +Accountant Fees and Services +The information contained under the caption “Independent +Auditor” in the Definitive Proxy Statement of the Company +with respect to the Annual Meeting of Stockholders to be held on +April 21, 2011, is incorporated herein by reference. +40 +Table of Contents +PART IV +Item 15. +Exhibits +and Financial Statement Schedules +Item 15(a)(1). +Financial +Statements +Attached as Appendix A +The following consolidated financial statements of Wolverine +World Wide, Inc. and its subsidiaries are filed as a part of +this report: +• +Consolidated Balance Sheets as of January 1, 2011 and +January 2, 2010. +• +Consolidated Statements of Stockholders’ Equity and +Comprehensive Income for the Fiscal Years Ended January 1, +2011, January 2, 2010 and January 3, 2009. +• +Consolidated Statements of Operations for the Fiscal Years Ended +January 1, 2011, January 2, 2010 and January 3, +2009. +• +Consolidated Statements of Cash Flows for the Fiscal Years Ended +January 1, 2011, January 2, 2010 and January 3, +2009. +• +Notes to the Consolidated Financial Statements as of +January 1, 2011. +• +Reports of Independent Registered Public Accounting Firm. +Item 15(a)(2). +Financial +Statement +Schedules +Attached +as Appendix B +The following consolidated financial statement schedule of +Wolverine World Wide, Inc. and its subsidiaries is filed as a +part of this report: +• +Schedule II—Valuation and Qualifying Accounts. +All other schedules (I, III, IV, and V) for which +provision is made in the applicable accounting regulations of +the SEC are not required under the related instructions or are +inapplicable and, therefore, have been omitted. +41 +Table of Contents +Item 15(a)(3). +Exhibits +The following exhibits are filed as part of this report: +Exhibit +Number +Document +3 +.1 +Restated Certificate of Incorporation. Previously filed as +Exhibit 3.1 to the Company’s Annual Report on Form 10-K for +the period ended December 30, 2006. Here incorporated by +reference. +3 +.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.1 to +the Company’s Current Report on Form 8-K filed on December +15, 2010. Here incorporated by reference. +4 +.1 +The Registrant has other long-term debt instruments outstanding +in addition to those described in Exhibit 4.2. The authorized +amount of none of these classes of debt exceeds 10% of the +Company’s total consolidated assets. The Company agrees to +furnish copies of any agreement defining the rights of holders +of any such long-term indebtedness to the Securities and +Exchange Commission upon request. +4 +.2 +Credit Agreement, dated as of June 7, 2010, among Wolverine +World Wide, Inc., certain foreign subsidiaries of Wolverine +World Wide, Inc., JPMorgan Chase Bank, N.A., as Administrative +Agent, and the lenders party thereto. Previously filed as +Exhibit 10.1 to the Company’s Current Report on Form 8-K +filed on June 8, 2010. Here incorporated by reference. +10 +.1 +1993 Stock Incentive Plan, as amended and restated.* Previously +filed as Exhibit 10.1 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.2 +Amended and Restated 1995 Stock Incentive Plan.* Previously +filed as Exhibit 10.2 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.3 +Amended and Restated 1997 Stock Incentive Plan.* Previously +filed as Exhibit 10.3 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.4 +Amended and Restated Stock Incentive Plan of 1999.* Previously +filed as Exhibit 10.4 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.5 +Amended and Restated Stock Incentive Plan of 2001.* Previously +filed as Exhibit 10.5 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.6 +Amended and Restated Stock Incentive Plan of 2003.* Previously +filed as Exhibit 10.6 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.7 +Amended and Restated Stock Incentive Plan of 2005.* Previously +filed as Exhibit 10.7 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.8 +Amended and Restated Directors’ Stock Option Plan.* +Previously filed as Exhibit 10.8 to the Company’s Annual +Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10 +.9 +Amended and Restated Outside Directors’ Deferred +Compensation Plan.* Previously filed as Exhibit 10.9 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended December 29, 2007. Here incorporated by reference. +10 +.10 +Amended and Restated Executive Short-Term Incentive Plan (Annual +Bonus Plan).* Previously filed as Exhibit 10.10 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +10 +.11 +Amended and Restated Executive Long-Term Incentive Plan (3-Year +Bonus Plan).* Previously filed as Exhibit 10.11 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +42 +Table of Contents +Exhibit +Number +Document +10 +.12 +Amended and Restated Stock Option Loan Program.* Previously +filed as Exhibit 10.12 to the Company’s Annual Report on +Form 10-K for the fiscal year ended December 29, 2007. Here +incorporated by reference. +10 +.13 +Executive Severance Agreement.* Previously filed as Exhibit 10.3 +to the Company’s Current Report on Form 8-K filed on +December 17, 2008. Here incorporated by reference. A +participant schedule of current executive officers who are +parties to the agreement is attached as Exhibit 10.13. +10 +.14 +Form of Indemnification Agreement.* The Company has entered into +an Indemnification Agreement with each director and with Messrs. +Grady, Grimes, Krueger, McBreen and Zwiers and Ms. Linton. +Previously filed as Exhibit 10.1 to the Company’s Current +Report on Form 8-K filed on April 25, 2007. Here incorporated by +reference. +10 +.15 +Amended and Restated Benefit Trust Agreement dated April 25, +2007.* Previously filed as Exhibit 10.5 to the +Company’s Current Report on Form 8-K filed on April 25, +2007. Here incorporated by reference. +10 +.16 +Employees’ Pension Plan (Restated as amended through +November 29, 2010).* +10 +.17 +Form of Incentive Stock Option Agreement.* Previously filed as +Exhibit 10.1 to the Company’s Current Report on Form 8-K +filed on February 15, 2005. Here incorporated by reference. +10 +.18 +Form of Non-Qualified Stock Option Agreement for Blake W. +Krueger and Timothy J. O’Donovan.* Previously filed as +Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 15, 2005. Here incorporated by reference. +10 +.19 +Form of Non-Qualified Stock Option Agreement for executive +officers other than those to whom Exhibit 10.18 applies.* +Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 15, 2005. Here incorporated +by reference. +10 +.20 +Form of Restricted Stock Agreement.* Previously filed as Exhibit +10.4 to the Company’s Current Report on Form 8-K filed on +February 15, 2005. Here incorporated by reference. +10 +.21 +Form of Incentive Stock Option Agreement.* Previously filed as +Exhibit 10.1 to the Company’s Current Report on Form 8-K +filed on February 17, 2006. Here incorporated by reference. +10 +.22 +Form of Non-Qualified Stock Option Agreement for Blake W. +Krueger and Timothy J. O’Donovan.* Previously filed as +Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 17, 2006. Here incorporated by reference. +10 +.23 +Form of Non-Qualified Stock Option Agreement for executive +officers other than those to whom Exhibit 10.22 applies.* +Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 17, 2006. Here incorporated +by reference. +10 +.24 +Form of Restricted Stock Agreement.* Previously filed as Exhibit +10.4 to the Company’s Current Report on Form 8-K filed on +February 17, 2006. Here incorporated by reference. +10 +.25 +Form of Stock Option Agreement for non-employee directors.* +Previously filed as Exhibit 10.23 to the Company’s Annual +Report on Form 10-K for the fiscal year ended January 1, 2005. +Here incorporated by reference. +10 +.26 +2009 Form of Non-Qualified Stock Option Agreement for Donald T. +Grimes, Blake W. Krueger, Pamela L. Linton, Michael F. McBreen +and James D. Zwiers.* Previously filed as Exhibit 10.26 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +10 +.27 +2009 Form of Non-Qualified Stock Option Agreement for executive +officers other than those to whom Exhibit 10.26 applies.* +Previously filed as Exhibit 10.27 to the Company’s Annual +Report on +Form 10-K +for the fiscal year ended January 3, 2009. Here incorporated by +reference. +10 +.28 +Form of Performance Share Award Agreement (2009 – 2011 +performance period).* Previously filed as Exhibit 10.28 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +43 +Table of Contents +Exhibit +Number +Document +10 +.29 +Form of Performance Share Award Agreement (2010 – 2012 +performance period).* Previously filed as Exhibit 10.29 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended January 2, 2010. Here incorporated by reference. +10 +.30 +Form of Performance Share Award Agreement (2011 – 2013 +performance period).* +10 +.31 +Separation Agreement between Wolverine World Wide, Inc. and +Blake W. Krueger, dated as of March 13, 2008, as amended.* +Previously filed as Exhibit 10.1 to the Company’s Quarterly +Report on +Form 10-Q +for the period ended March 22, 2008. Here incorporated by +reference. +10 +.32 +First Amendment to Separation Agreement between Wolverine World +Wide, Inc. and Blake W. Krueger, dated as of December 11, 2008.* +Previously filed as Exhibit 10.30 to the Company’s Annual +Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10 +.33 +409A Supplemental Executive Retirement Plan.* Previously filed +as Exhibit 10.1 to the Company’s Current Report on Form 8-K +filed on December 17, 2008. Here incorporated by reference. A +participant schedule of current executive officers who +participate in this plan is attached as Exhibit 10.33. +10 +.34 +Form of 409A Supplemental Retirement Plan Participation +Agreement with Blake W. Krueger.* Previously filed as Exhibit +10.32 to the Company’s Annual Report on Form 10-K for the +fiscal year ended January 3, 2009. Here incorporated by +reference. +10 +.35 +Outside Directors’ Deferred Compensation Plan.* Previously +filed as Exhibit 10.2 to the Company’s Current Report on +Form 8-K filed on December 17, 2008. Here incorporated by +reference. +10 +.36 +Stock Incentive Plan of 2010.* Previously filed as Exhibit 10.1 +to the Company’s Registration Statement on Form S-8 filed +on March 4, 2010. Here incorporated by reference. +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31 +.1 +Certification of Chairman, Chief Executive Officer and President +under Section 302 of the Sarbanes-Oxley Act of 2002. +31 +.2 +Certification of Senior Vice President, Chief Financial Officer +and Treasurer under Section 302 of the Sarbanes-Oxley Act of +2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +101 +The following materials from the Company’s Annual Report on +Form 10-K for the fiscal year ended January 1, 2011, formatted +in XBRL (eXtensible Business Reporting Language): (i) +Consolidated Balance Sheets as of as of January 1, 2011 and +January 2, 2010, (ii) Consolidated Statements of Operations for +the fiscal years ended January 1, 2011, January 2, 2010 and +January 3, 2009, (iii) Consolidated Statements of Cash +Flows for the fiscal years ended January 1, 2011, January 2, +2010 and January 3, 2009, and (iv) Notes to the Consolidated +Financial Statements, tagged as blocks of text.** +* +Management contract or compensatory plan or arrangement. +** +Pursuant to Rule 406T of +Regulation S-T, +the Interactive Data Files on Exhibit 101 hereto are deemed +not filed or part of a registration statement or prospectus for +purposes of Sections 11 or 12 of the Securities Act of +1933, as amended, are deemed not filed for purposes of Section +18 of the Securities and Exchange Act of 1934, as amended, and +otherwise are not subject to liability under those sections. +The Company will furnish a copy of any exhibit listed above to +any stockholder without charge upon written request to +Mr. Kenneth A. Grady, General Counsel and Secretary, 9341 +Courtland Drive N.E., Rockford, Michigan 49351. +44 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the +Securities Exchange Act of 1934, the Registrant has duly caused +this report to be signed on its behalf by the undersigned, +thereunto duly authorized. +WOLVERINE WORLD WIDE, INC. +Dated: March 2, 2011 +By: +/s/ Blake +W. Krueger +Blake +W. Krueger +Chairman, Chief Executive Officer and President +(Principal Executive Officer) +Pursuant to the requirements of the Securities Exchange Act of +1934, this report has been signed below by the following persons +on behalf of the Registrant and in the capacities and on the +dates indicated. +Signature +Title +Date +/s/ Blake +W. Krueger +Blake +W. Krueger +Chairman, Chief Executive Officer and President (Principal +Executive Officer) +March 2, 2011 +/s/ Donald +T. Grimes +Donald +T. Grimes +Senior Vice President, Chief Financial Officer and Treasurer +(Principal Financial and Accounting Officer) +March 2, 2011 +* +/s/ Jeffrey +M. Boromisa +Jeffrey +M. Boromisa +Director +March 2, 2011 +* +/s/ William +K. Gerber +William +K. Gerber +Director +March 2, 2011 +* +/s/ Alberto +L. Grimoldi +Alberto +L. Grimoldi +Director +March 2, 2011 +* +/s/ Joseph +R. Gromek +Joseph +R. Gromek +Director +March 2, 2011 +* +/s/ David +T. Kollat +David +T. Kollat +Director +March 2, 2011 +/s/ Blake +W. Krueger +Blake +W. Krueger +Director +March 2, 2011 +* +/s/ Brenda +J. Lauderback +Brenda +J. Lauderback +Director +March 2, 2011 +* +/s/ David +P. Mehney +David +P. Mehney +Director +March 2, 2011 +* +/s/ Timothy +J. O’Donovan +Timothy +J. O’Donovan +Director +March 2, 2011 +* +/s/ Shirley +D. Peterson +Shirley +D. Peterson +Director +March 2, 2011 +* +/s/ Michael +A. Volkema +Michael +A. Volkema +Director +March 2, 2011 +*By +/s/ Blake +W. Krueger +Blake +W. Krueger +Attorney-in-Fact +Chairman, Chief Executive Officer and President +March 2, 2011 +45 +Table of Contents +APPENDIX A +Financial +Statements +46 +Table of Contents +CONSOLIDATED +BALANCE SHEETS +As of Fiscal Year End +2010 +2009 +(Thousands of Dollars, Except Share and Per Share Data) +ASSETS +Current assets: +Cash and cash equivalents +$ +150,400 +$ +160,439 +Accounts receivable, less allowances (2010 – +$(11,413); 2009 – $(13,946)) +196,457 +163,755 +Inventories +Finished products +188,647 +140,124 +Raw materials and +work-in-process +20,008 +17,941 +208,655 +158,065 +Deferred income taxes +13,225 +12,475 +Prepaid expenses and other current assets +11,397 +12,947 +Total current assets +580,134 +507,681 +Property, plant and equipment: +Land +826 +881 +Buildings and improvements +71,724 +80,511 +Machinery and equipment +129,707 +147,197 +Software +79,307 +74,559 +281,564 +303,148 +Accumulated depreciation +(207,167 +) +(229,196 +) +74,397 +73,952 +Other assets: +Goodwill +39,014 +39,972 +Other +non-amortizable +intangibles +16,464 +16,226 +Cash surrender value of life insurance +36,042 +35,405 +Deferred income taxes +37,602 +35,094 +Other +2,922 +3,746 +132,044 +130,443 +Total assets +$ +786,575 +$ +712,076 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable +$ +64,080 +$ +42,262 +Accrued salaries and wages +26,848 +20,751 +Income taxes +2,746 +14,634 +Taxes, other than income taxes +6,586 +4,521 +Restructuring reserve +1,314 +5,926 +Other accrued liabilities +37,046 +37,922 +Accrued pension liabilities +2,018 +2,044 +Current maturities of long-term debt +517 +538 +Total current liabilities +141,155 +128,598 +Long-term debt, less current maturities +517 +1,077 +Deferred compensation +4,410 +5,870 +Accrued pension liabilities +83,685 +84,134 +Other liabilities +12,911 +10,364 +Stockholders’ equity: +Common stock, $1 par value: authorized +160,000,000 shares; shares +issued, including treasury shares: 2010 – 63,976,387; +2009 – 62,763,924 +63,976 +62,764 +Additional paid-in capital +108,286 +81,021 +Retained earnings +789,684 +706,439 +Accumulated other comprehensive income (loss) +(41,123 +) +(42,806 +) +Cost of shares in treasury: 2010 – +14,976,835 shares; 2009 – 13,170,471 shares +(376,926 +) +(325,385 +) +Total stockholders’ equity +543,897 +482,033 +Total liabilities and stockholders’ equity +$ +786,575 +$ +712,076 +See accompanying notes to consolidated financial statements. +A-1 +Table of Contents +CONSOLIDATED +STATEMENTS OF STOCKHOLDERS’ EQUITY +AND COMPREHENSIVE INCOME +Fiscal Year +2010 +2009 +2008 +(Thousands of Dollars, Except Share and Per Share Data) +COMMON STOCK OUTSTANDING +Balance at beginning of the year +$ +62,764 +$ +61,656 +$ +61,085 +Common stock issued under stock incentive plans +(2010 – 1,212,463 shares; 2009 — +1,108,112 shares; 2008 – 570,691 shares) +1,212 +1,108 +571 +Balance at end of the year +63,976 +62,764 +61,656 +ADDITIONAL PAID-IN CAPITAL +Balance at beginning of the year +81,021 +64,696 +47,786 +Stock-based compensation expense +11,543 +8,649 +8,164 +Amounts associated with common stock issued +under stock incentive plans: +Proceeds over par value +6,289 +2,050 +5,859 +Income tax benefits +4,094 +1,427 +2,842 +Issuance of performance-based shares (2010 – +215,027 shares; +2009 286,006 shares) +5,197 +4,507 +– +Issuance of treasury shares (2010 – +25,829 shares; +2009 – 32,455 shares; 2008 – +22,842 shares) +142 +(111 +) +54 +Net change in employee notes receivable +– +(197 +) +(9 +) +Balance at end of the year +108,286 +81,021 +64,696 +RETAINED EARNINGS +Balance at beginning of the year +706,439 +666,027 +591,706 +Net earnings +104,470 +61,912 +95,821 +Cash dividends declared (2010 – $0.44 per share; +2009 – $0.44 per share; 2008 – $0.44 per +share) +(21,225 +) +(21,500 +) +(21,500 +) +Balance at end of the year +789,684 +706,439 +666,027 +ACCUMULATED OTHER COMPREHENSIVE +INCOME (LOSS) +Balance at beginning of the year +(42,806 +) +(42,834 +) +22,268 +Foreign currency translation adjustments +(2,929 +) +15,349 +(36,305 +) +Change in fair value of foreign exchange contracts, +net of taxes (2010 – $(750); 2009 – $3,482; +2008 – $(3,447)) +1,731 +(7,469 +) +5,978 +Pension adjustments, net of taxes (2010 – $(1,551); +2009 – $4,228; 2008 – $18,963) +2,881 +(7,852 +) +(34,775 +) +Balance at end of the year +(41,123 +) +(42,806 +) +(42,834 +) +COST OF SHARES IN TREASURY +Balance at beginning of the year +(325,385 +) +(319,623 +) +(244,066 +) +Common stock acquired for treasury (2010 – +1,832,193 +shares; 2009 – 454,205 shares; 2008 – +2,921,264 shares) +(52,190 +) +(6,566 +) +(76,129 +) +Issuance of treasury shares (2010 – +25,829 shares; +2009 – 32,455 shares; 2008 – +22,842 shares) +649 +804 +572 +Balance at end of the year +(376,926 +) +(325,385 +) +(319,623 +) +Total stockholders’ equity at end of the year +$ +543,897 +$ +482,033 +$ +429,922 +COMPREHENSIVE INCOME +Net earnings +$ +104,470 +$ +61,912 +$ +95,821 +Foreign currency translation adjustments +(2,929 +) +15,349 +(36,305 +) +Change in fair value of foreign exchange contracts, net +of taxes +1,731 +(7,469 +) +5,978 +) +Pension adjustments, net of taxes +2,881 +(7,852 +) +(34,775 +) +Total comprehensive income +$ +106,153 +$ +61,940 +$ +30,719 +See accompanying notes to consolidated financial statements. +A-2 +Table of Contents +CONSOLIDATED +STATEMENTS OF OPERATIONS +Fiscal Year +2010 +2009 +2008 +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +1,248,517 +$ +1,101,056 +$ +1,220,568 +Cost of goods sold +754,537 +663,461 +734,547 +Restructuring and other transition costs +1,406 +5,873 +- +Gross profit +492,574 +431,722 +486,021 +Selling, general and administrative expenses +347,499 +316,378 +345,183 +Restructuring and other transition costs +2,828 +29,723 +- +Operating profit +142,247 +85,621 +140,838 +Other expenses (income): +Interest expense +571 +494 +2,850 +Interest income +(184 +) +(383 +) +(1,757 +) +Other income - net +(1,366 +) +(182 +) +(839 +) +(979 +) +(71 +) +254 +Earnings before income taxes +143,226 +85,692 +140,584 +Income taxes +38,756 +23,780 +44,763 +Net earnings +$ +104,470 +$ +61,912 +$ +95,821 +Net earnings per share (see Note 1): +Basic +$ +2.15 +$ +1.26 +$ +1.94 +Diluted +$ +2.11 +$ +1.24 +$ +1.90 +See accompanying notes to consolidated financial statements. +A-3 +Table of Contents +CONSOLIDATED +STATEMENTS OF CASH FLOWS +Fiscal Year +2010 +2009 +2008 +(Thousands of Dollars) +OPERATING ACTIVITIES +Net earnings +$ +104,470 +$ +61,912 +$ +95,821 +Adjustments necessary to reconcile net earnings +to net cash provided by operating activities: +Depreciation +14,509 +15,932 +18,460 +Amortization +1,692 +1,689 +2,236 +Deferred income taxes +(2,747 +) +(7,845 +) +(43 +) +Stock-based compensation expense +11,543 +8,649 +8,164 +Excess tax benefits from stock-based compensation +(1,362 +) +(462 +) +(1,610 +) +Pension expense +16,286 +15,891 +6,325 +Restructuring and other transition costs +4,234 +35,596 +- +Cash payments related to restructuring and other +transition costs +(7,516 +) +(20,653 +) +- +Other +4,060 +(7,921 +) +13,966 +Changes in operating assets and liabilities: +Accounts receivable +(32,466 +) +9,817 +3,419 +Inventories +(51,173 +) +44,500 +(39,201 +) +Other operating assets +689 +3,103 +(386 +) +Accounts payable +21,672 +(7,326 +) +(5,064 +) +Income taxes +(11,888 +) +12,817 +(2,094 +) +Other operating liabilities +(4,137 +) +2,910 +(6,523 +) +Net cash provided by operating activities +67,866 +168,609 +93,470 +INVESTING ACTIVITIES +Business acquisitions +- +(7,954 +) +- +Additions to property, plant and equipment +(16,370 +) +(11,670 +) +(24,126 +) +Proceeds from sales of property, plant and equipment +1,756 +- +849 +Other +(2,424 +) +(2,679 +) +(4,982 +) +Net cash used in investing activities +(17,038 +) +(22,303 +) +(28,259 +) +FINANCING ACTIVITIES +Net borrowings (repayments) under revolver +- +(59,500 +) +59,500 +Payments of long-term debt +(538 +) +- +(10,714 +) +Payments of capital lease obligations +- +(5 +) +(12 +) +Cash dividends paid +(21,414 +) +(21,502 +) +(20,758 +) +Purchase of common stock for treasury +(52,190 +) +(6,566 +) +(76,129 +) +Proceeds from shares issued under stock incentive plans +13,631 +7,867 +7,047 +Excess tax benefits from stock-based compensation +1,362 +462 +1,610 +Net cash used in financing activities +(59,149 +) +(79,244 +) +(39,456 +) +Effect of foreign exchange rate changes +(1,718 +) +3,875 +(12,340 +) +Increase (decrease) in cash and cash equivalents +(10,039 +) +70,937 +13,415 +Cash and cash equivalents at beginning of the year +160,439 +89,502 +76,087 +Cash and cash equivalents at end of the year +$ +150,400 +$ +160,439 +$ +89,502 +OTHER CASH FLOW INFORMATION +Interest paid +$ +192 +$ +486 +$ +2,365 +Net income taxes paid +$ +30,604 +$ +7,297 +$ +35,995 +See accompanying notes to consolidated financial statements. +A-4 +Table of Contents +NOTES TO +CONSOLIDATED FINANCIAL STATEMENTS +All amounts are in thousands of dollars except share and per +share data and elsewhere as noted. +1. +SUMMARY +OF SIGNIFICANT ACCOUNTING POLICIES +Nature of +Operations +Wolverine World Wide, Inc. is a leading designer, manufacturer +and marketer of a broad range of quality casual shoes, +performance outdoor footwear and apparel, industrial work shoes, +boots and apparel, and uniform shoes and boots. The +Company’s portfolio of owned and licensed brands includes: +Bates ® , +Cat ® +Footwear, +Chaco ® , +Cushe ® , +Harley-Davidson ® +Footwear, Hush +Puppies ® , +HyTest ® , +Merrell ® , +Patagonia ® +Footwear, +Sebago ® , +Soft +Style ® +and +Wolverine ® . +Licensing and distribution arrangements with third parties +extend the global reach of the Company’s brand portfolio. +The Company also operates a consumer-direct division to market +its own brands as well as branded footwear and apparel from +other manufacturers; a leathers division that markets +Wolverine Performance +Leathers tm ; +and a pigskin procurement operation. +Principles +of Consolidation +The consolidated financial statements include the accounts of +Wolverine World Wide, Inc. and its wholly-owned subsidiaries +(collectively, the “Company”). All intercompany +accounts and transactions have been eliminated in consolidation. +Fiscal +Year +The Company’s fiscal year is the 52- or 53-week period that +ends on the Saturday nearest to December 31. Fiscal years +presented in this report include the 52-week period ended +January 1, 2011, the 52-week period ended January 2, +2010 and the 53-week period ended January 3, 2009. +Use of +Estimates +The preparation of financial statements in conformity with +accounting principles generally accepted in the +United States requires management to make estimates and +assumptions that affect the amounts reported in the consolidated +financial statements and accompanying notes. Actual results +could differ from those estimates. +Revenue +Recognition +Revenue is recognized on the sale of products manufactured or +sourced by the Company when the related goods have been shipped, +legal title has passed to the customer and collectability is +reasonably assured. Revenue generated through licensees and +distributors involving products bearing the Company’s +trademarks is recognized as earned according to stated +contractual terms upon either the purchase or shipment of +branded products by licensees and distributors. +The Company records provisions against gross revenue for +estimated stock returns and cash discounts in the period when +the related revenue is recorded. These estimates are based on +factors that include, but are not limited to, historical stock +returns, historical discounts taken and analysis of credit +memorandum activity. +Cost of +Goods Sold +Cost of goods sold for the Company’s operations include the +actual product costs, including inbound freight charges, +purchasing, sourcing, inspection and receiving costs. +Warehousing costs are included in selling, general and +administrative expenses. +Shipping +and Handling Costs +Shipping and handling costs that are charged to and reimbursed +by the customer are recognized as revenue, while the related +expenses incurred by the Company are recorded as cost of goods +sold. +A-5 +Table of Contents +Cash +Equivalents +Cash equivalents include highly liquid investments with an +original maturity of three months or less. Cash equivalents are +stated at cost, which approximates market. +Allowance +for Uncollectible Accounts +The Company maintains an allowance for uncollectible accounts +receivable for estimated losses resulting from its +customers’ inability to make required payments. Company +management evaluates the allowance for uncollectible accounts +receivable based on a review of current customer status and +historical collection experience. Adjustments to these estimates +may be required if the financial condition of the Company’s +customers were to change. +Inventories +The Company values its inventory at the lower of cost or market. +Cost is determined by the +last-in, +first-out (“LIFO”) method for all domestic raw +materials and +work-in-process +inventories and certain domestic finished goods inventories. +Cost is determined using the +first-in, +first-out (“FIFO”) method for all raw materials, +work-in-process +and finished goods inventories in foreign countries; certain +domestic finished goods inventories; and for all finished goods +inventories of the Company’s consumer-direct business, due +to the unique nature of those operations. The Company has +applied these inventory cost valuation methods consistently from +year to year. +Property, +Plant and Equipment +Property, plant and equipment are stated on the basis of cost +and include expenditures for computer hardware and software, +store furniture and fixtures, office furniture and machinery and +equipment. Normal repairs and maintenance are expensed as +incurred. +Depreciation of property, plant and equipment is computed using +the straight-line method. The depreciable lives range from five +to forty years for buildings and improvements and from three to +ten years for machinery, equipment and software. Leasehold +improvements are depreciated at the lesser of the estimated +useful life or lease term, including reasonably-assured lease +renewals as determined at lease inception. +Goodwill +and Other Intangibles +Goodwill represents the excess of the purchase price over the +fair value of net tangible and identifiable intangible assets of +acquired businesses. Other intangibles consist primarily of +trademarks and patents. Goodwill and intangible assets deemed to +have indefinite lives are not amortized, but are subject to +impairment tests at least annually in accordance with FASB +Accounting Standards Codification (ASC) Topic 350, +Intangibles – Goodwill and Other . The Company +reviews the carrying amounts of goodwill and other +non-amortizable +intangible assets at least annually, or when indicators of +impairment are present, by reporting unit to determine if such +assets may be impaired. If the carrying amounts of these assets +are not recoverable based upon discounted cash flow and market +approach analyses, the carrying amounts of such assets are +reduced by the estimated shortfall of fair value to recorded +value. +Inherent in the development of the present value of future cash +flow projections are assumptions and estimates the Company +derives from a review of its operating results, business plans, +expected growth rates, cost of capital and tax rates. The +Company also makes certain assumptions about future economic +conditions, interest rates and other market data that it relies +upon in determining the fair value of assets under the +discounted cash flow method. Many of the factors used in +assessing fair value are outside the control of the Company, and +these assumptions and estimates can change in future periods. +The market approach is the other primary method used for +estimating fair value of a reporting unit. This approach relies +on the market value (based on market capitalization) of +companies that are engaged in the same or a similar line of +business. +Other amortizable intangible assets (principally patents) are +amortized using the straight-line method over their estimated +useful lives (periods ranging from two to seven years). Other +amortizable intangible assets are included in +A-6 +Table of Contents +other assets on the consolidated balance sheets and have gross +carrying amounts of $8,614 and $8,223 for fiscal 2010 and fiscal +2009, respectively, and accumulated amortization of $6,472 and +$4,860 for fiscal 2010 and fiscal 2009, respectively. +Estimated aggregate amortization expense for such intangibles +for each of the five fiscal years subsequent to 2010 is as +follows: +2011 +2012 +2013 +2014 +2015 +Amortization expense +$ +1,245 +$ +361 +$ +233 +$ +135 +$ +63 +The Company has performed the required annual impairment tests +as of the first day of the fourth quarter and has determined +that goodwill and other +non-amortizable +intangibles were not impaired at January 1, 2011 and +January 2, 2010. +The changes in the carrying amount of goodwill and other +non-amortizable +intangibles for the years ended January 1, 2011 and +January 2, 2010 are as follows: +Goodwill +Trademarks +Total +Balance at January 3, 2009 +$ +32,310 +$ +9,257 +$ +41,567 +Intangibles acquired +5,464 +6,969 +12,433 +Foreign currency translation effects +2,198 +- +2,198 +Balance at January 2, 2010 +$ +39,972 +$ +16,226 +$ +56,198 +Intangibles acquired +- +360 +360 +Foreign currency translation effects +(958 +) +(122 +) +(1,080 +) +Balance at January 1, 2011 +$ +39,014 +$ +16,464 +$ +55,478 +Impairment +of Long-Lived Assets +The Company reviews long-lived assets for impairment whenever +events or changes in circumstances indicate that the carrying +amount of an asset or an asset group may not be recoverable. +Each impairment test is based on a comparison of the carrying +amount of the asset or asset group to the future undiscounted +net cash flows expected to be generated by the asset or asset +group. If such assets are considered to be impaired, the +impairment amount to be recognized is the amount by which the +carrying value of the assets exceeds their fair value. +Retirement +Benefits +The determination of the obligation and expense for retirement +benefits is dependent on the selection of certain actuarial +assumptions used in calculating such amounts. These assumptions +include, among others, the discount rate, expected long-term +rate of return on plan assets and rates of increase in +compensation. These assumptions are reviewed with the +Company’s actuaries and updated annually based on relevant +external and internal factors and information, including, but +not limited to, long-term expected asset returns, rates of +termination, regulatory requirements and plan changes. See +Note 6 to the consolidated financial statements for +additional information. +Stock-Based +Compensation +The Company accounts for stock-based compensation in accordance +with the fair value recognition provisions of FASB ASC Topic +718, Compensation – Stock Compensation +(“ASC 718”). The Company recognized compensation +expense of $11,543, $8,649, and $8,164 and related income tax +benefits of $3,552, $2,321, and $1,699 for grants under its +stock-based compensation plans in the statements of operations +for the years ended January 1, 2011, January 2, 2010, +and January 3, 2009, respectively. +Stock-based compensation expense recognized in the consolidated +condensed statements of operations for the years ended +January 1, 2011, January 2, 2010, and January 3, +2009, is based on awards ultimately expected to vest and, as +such, has been reduced for estimated forfeitures. ASC 718 +requires forfeitures to be estimated at the time of grant and +revised, if necessary, in subsequent periods if actual +forfeitures differ from those estimates. Forfeitures were +estimated based on historical experience. +A-7 +Table of Contents +The Company estimated the fair value of employee stock options +on the date of grant using the Black-Scholes model. The +estimated weighted-average fair value for each option granted +was $6.97, $4.40, and $5.68 per share for fiscal years 2010, +2009, and 2008, respectively, with the following +weighted-average assumptions: +2010 +2009 +2008 +Expected market price volatility +(1) +37.9% +34.8% +28.9% +Risk-free interest rate +(2) +1.9% +1.6% +2.5% +Dividend yield +(3) +1.9% +1.8% +1.6% +Expected term +(4) +4 years +4 years +4 years +(1) +Based on historical volatility of the Company’s common +stock. The expected volatility is based on the daily percentage +change in the price of the stock over the four years prior to +the grant. +(2) +Represents the U.S. Treasury yield curve in effect for the +expected term of the option at the time of grant. +(3) +Represents the Company’s cash dividend yield for the +expected term. +(4) +Represents the period of time that options granted are expected +to be outstanding. As part of the determination of the expected +term, the Company concluded that all employee groups exhibit +similar exercise and +post-vesting +termination behavior. +The Company issued 1,325,475 shares of common stock in +connection with the exercise of stock options and restricted +stock grants made during the fiscal year ended January 1, +2011. The Company cancelled 26,324 shares of common stock +issued under restricted stock awards as a result of forfeitures +during 2010. +Income +Taxes +The provision for income taxes is based on the geographic +dispersion of the earnings reported in the consolidated +financial statements. A deferred income tax asset or liability +is determined by applying currently-enacted tax laws and rates +to the cumulative temporary differences between the carrying +values of assets and liabilities for financial statement and +income tax purposes. +The Company records an increase in liabilities for income tax +accruals associated with tax benefits claimed on tax returns but +not recognized for financial statement purposes (unrecognized +tax benefits). The Company recognizes interest and penalties +related to unrecognized tax benefits through interest expense +and income tax expense, respectively. +Earnings +Per Share +The Company calculates earnings per share in accordance with +FASB ASC Topic 260, Earnings Per Share +(“ASC 260”). ASC 260 addresses whether +instruments granted in share-based payment transactions are +participating securities prior to vesting, and therefore need to +be included in the earnings allocation in computing earnings per +share under the two-class method. Under the guidance in +ASC 260, the Company’s unvested share-based payment +awards that contain nonforfeitable rights to dividends or +dividend equivalents, whether paid or unpaid, are participating +securities and must be included in the computation of earnings +per share pursuant to the two-class method. +A-8 +Table of Contents +The following table sets forth the computation of basic and +diluted earnings per share: +2010 +2009 +2008 +Numerator: +Net earnings +$ +104,470 +$ +61,912 +$ +95,821 +Adjustment for earnings allocated to nonvested restricted common +stock +(1,608 +) +(1,036 +) +(996 +) +Net earnings used to calculate basic earnings per share +102,862 +60,876 +94,825 +Adjustment for earnings reallocated to nonvested restricted +common stock +38 +8 +18 +Net earnings used to calculate diluted earnings per share +$ +102,900 +$ +60,884 +$ +94,843 +Denominator: +Weighted average shares outstanding +49,051,739 +49,192,662 +49,381,789 +Adjustment for nonvested restricted common stock +(1,206,460 +) +(921,715 +) +(513,063 +) +Shares used to calculate basic earnings per share +47,845,279 +48,270,947 +48,868,726 +Effect of dilutive stock options +1,011,731 +708,485 +1,151,565 +Shares used to calculate diluted earnings per share +48,857,010 +48,979,432 +50,020,291 +Net earnings per share: +Basic +$ +2.15 +$ +1.26 +$ +1.94 +Diluted +$ +2.11 +$ +1.24 +$ +1.90 +Options to purchase 865,072 shares of common stock in 2010, +2,353,412 shares in 2009 and 1,273,676 shares in 2008 +have not been included in the denominator for the computation of +diluted earnings per share because the related exercise prices +were greater than the average market price for the year, and +they were, therefore, anti-dilutive. +Foreign +Currency +For most of the Company’s international subsidiaries, the +local currency is the functional currency. Assets and +liabilities of these subsidiaries are translated into +U.S. dollars at the year-end exchange rate. Operating +statement amounts are translated at average exchange rates for +each period. The cumulative translation adjustments resulting +from changes in exchange rates are included in the consolidated +balance sheets as a component of accumulated other comprehensive +income (loss) in stockholders’ equity. Transaction gains +and losses are included in the consolidated statements of +operations and were not material for fiscal years 2010, 2009 and +2008. +Financial +Instruments and Risk Management +The Company follows FASB ASC Topic 820, Fair Value +Measurements and Disclosures (“ASC 820”), which +provides a consistent definition of fair value, focuses on exit +price, prioritizes the use of market-based inputs over +entity-specific inputs for measuring fair value and establishes +a three-tier hierarchy for fair value measurements. This topic +requires fair value measurements to be classified and disclosed +in one of the following three categories: +Level 1: +Fair value is measured using quoted prices (unadjusted) in +active markets for identical assets and liabilities. +Level 2: +Fair value is measured using either direct or indirect inputs, +other than quoted prices included within Level 1, which are +observable for similar assets or liabilities. +Level 3: +Fair value is measured using valuation techniques in which one +or more significant inputs are unobservable. +The Company’s financial instruments consist of cash and +cash equivalents, accounts and notes receivable, accounts +payable, foreign currency forward exchange contracts, borrowings +under the Company’s revolving credit agreement and +long-term debt. The carrying amount of the Company’s +financial instruments is historical cost, which +A-9 +Table of Contents +approximates their fair value, except for the foreign currency +exchange contracts, which are carried at fair value. The Company +does not hold or issue financial instruments for trading +purposes. +As of January 1, 2011 and January 2, 2010, liabilities +of $1,198 and $2,625, respectively, have been recognized for the +fair value of the Company’s foreign currency forward +exchange contracts. In accordance with ASC 820, these +assets and liabilities fall within Level 2 of the fair +value hierarchy. The prices for the financial instruments are +determined using prices for recently-traded financial +instruments with similar underlying terms as well as directly or +indirectly observable inputs. The Company did not have any +additional assets or liabilities that were measured at fair +value on a recurring basis at January 1, 2011 and +January 2, 2010. +The Company follows FASB ASC Topic 815, Derivatives and +Hedging , which is intended to improve transparency in +financial reporting and requires that all derivative instruments +be recorded on the consolidated balance sheets at fair value by +establishing criteria for designation and effectiveness of +hedging relationships. The Company utilizes foreign currency +forward exchange contracts to manage the volatility associated +with U.S. dollar inventory purchases made by +non-U.S. wholesale +operations in the normal course of business. At January 1, +2011 and January 2, 2010, foreign exchange contracts with a +notional value of $111,802 and $69,618, respectively, were +outstanding to purchase U.S. dollars with maturities +ranging up to 364 days. These contracts have been +designated as cash flow hedges. +The fair value of the foreign currency forward exchange +contracts represents the estimated receipts or payments +necessary to terminate the contracts. Hedge effectiveness is +evaluated by the hypothetical derivative method. Any hedge +ineffectiveness is reported within the cost of goods sold +caption of the consolidated condensed statements of operations. +Hedge ineffectiveness was not material to the Company’s +consolidated condensed financial statements for fiscal years +2010, 2009, or 2008. If, in the future, the foreign exchange +contracts are determined to be ineffective hedges or terminated +before their contractual termination dates, the Company would be +required to reclassify into earnings all or a portion of the +unrealized amounts related to the cash flow hedges that are +currently included in accumulated other comprehensive income +(loss) within stockholders’ equity. +For the fiscal years ended January 1, 2011, January 2, +2010, and January 3, 2009, the Company recognized a net +loss of $318, a net loss of $547 and a net gain of $434, +respectively, in accumulated other comprehensive income (loss) +related to the effective portion of its foreign exchange +contracts. For the fiscal years ended January 1, 2011, +January 2, 2010, and January 3, 2009, the Company +reclassified a gain of $1,274, a loss of $2,996, and a gain of +$2,132, respectively, from accumulated other comprehensive +income (loss) into cost of goods sold related to the effective +portion of its foreign exchange contracts designated and +qualifying as cash flow hedges. +Comprehensive +Income (Loss) +Comprehensive income (loss) represents net earnings and any +revenue, expenses, gains and losses that, under accounting +principles generally accepted in the United States, are excluded +from net earnings and recognized directly as a component of +stockholders’ equity. +The ending accumulated other comprehensive income (loss) is as +follows: +2010 +2009 +Foreign currency translation adjustments +$ +11,548 +$ +14,477 +Change in fair value of foreign exchange contracts, +net of taxes +(2010 – $828; 2009 – $1,578) +(1,815 +) +(3,546 +) +Pension adjustments, net of taxes +(2010 – $26,908; 2009 – $28,459) +(50,856 +) +(53,737 +) +Accumulated other comprehensive income (loss) +$ +(41,123 +) +$ +(42,806 +) +Reclassifications +Certain prior period amounts on the consolidated condensed +financial statements have been reclassified to conform to +current period presentation. These reclassifications did not +affect net earnings. +A-10 +Table of Contents +2. +INVENTORIES +Inventories of $66,370 at January 1, 2011 and $48,800 at +January 2, 2010 have been valued using the LIFO method. If +the FIFO method had been used, inventories would have been +$11,071 and $9,838 higher than reported at January 1, 2011 +and January 2, 2010, respectively. +3. +DEBT +Long-term debt consists of the following obligations: +2010 +2009 +Notes payable +$ +1,034 +$ +1,615 +Current maturities +(517 +) +(538 +) +Total long-term debt +$ +517 +$ +1,077 +In 2009, the Company entered into a $1,615 note payable in +connection with the +Cushe ® +acquisition. The note is payable over three years at a fixed +interest rate of 4.5%. +The Company’s credit agreement with a bank syndicate +provides the Company with access to capital under a revolving +credit facility, including a swing-line facility and letter of +credit facility, in an initial aggregate amount of up to +$150.0 million and is set to expire June 17, 2014. +This amount is subject to increase up to a maximum aggregate +amount of $225.0 million under certain circumstances. The +revolving credit facility is used to support working capital +requirements and other business needs. There were no amounts +outstanding at January 1, 2011 under the current revolving +credit facility and there were no amounts outstanding at +January 2, 2010 under the Company’s previous revolving +credit facility. The Company considers balances drawn on the +revolving credit facility, if any, to be short-term in nature. +The Company was in compliance with all debt covenant +requirements at January 1, 2011 under the current revolving +credit facility and January 2, 2010 under the +Company’s previous revolving credit facility. Proceeds from +the revolving credit facility, along with cash flows from +operations, are expected to be sufficient to meet working +capital needs for the foreseeable future. Any excess cash flows +from operating activities are expected to be used to purchase +property, plant and equipment, reduce debt, fund internal and +external growth initiatives, pay dividends or repurchase the +Company’s common stock. Interest is paid at a variable rate +based on one of the following options elected by the Company: +prime, LIBOR, or money market rate plus applicable spread. +4. +LEASES +The Company leases machinery, equipment, and certain warehouse, +office and retail store space under operating lease agreements +that expire at various dates through 2023. Certain leases +contain renewal provisions and generally require the Company to +pay utilities, insurance, taxes and other operating expenses. +At January 1, 2011, minimum rental payments due under all +non-cancelable leases were as follows: +2011 +2012 +2013 +2014 +2015 +Thereafter +Minimum rental payments +$ +16,926 +$ +14,730 +$ +13,408 +$ +11,985 +$ +11,402 +$ +49,683 +Rental expense under all operating leases, consisting primarily +of minimum rentals, totaled $18,919 in fiscal year 2010, $19,187 +in fiscal year 2009 and $18,255 in fiscal year 2008. +5. +CAPITAL +STOCK +The Company has 2,000,000 authorized shares of $1 par value +preferred stock, of which none was issued or outstanding as of +January 1, 2011 or January 2, 2010. The Company has +designated 150,000 shares of preferred stock as +Series A junior participating preferred stock and +500,000 shares of preferred stock as Series B junior +participating preferred stock for possible future issuance. +As of January 1, 2011, the Company had stock options +outstanding under various stock incentive plans. As of +January 1, 2011, the Company had approximately 4,518,114 +stock incentive units (stock options, stock appreciation +A-11 +Table of Contents +rights, restricted stock, restricted stock units and common +stock) available for issuance. Each option or stock appreciation +right granted counts as one stock incentive unit and all other +awards granted, including restricted stock, count as two stock +incentive units. Options granted under each plan have an +exercise price equal to the fair market value of the underlying +stock on the grant date, expire no later than ten years from the +grant date, and generally vest over three years. Restricted +stock issued under these plans is subject to certain +restrictions, including a prohibition against any sale, +transfer, or other disposition by the officer or employee during +the vesting period (except for certain transfers for estate +planning purposes for certain officers), and a requirement to +forfeit all or a certain portion of the award upon certain +terminations of employment or upon failure to achieve +performance criteria in certain instances. These restrictions +typically lapse over a three- to five-year period from the date +of the award. The Company has elected to recognize expense for +these stock-based incentive plans ratably over the vesting term +on a straight-line basis. Certain option and restricted share +awards provide for accelerated vesting under various scenarios, +including retirement and upon a change in control of the +Company. With regard to acceleration of vesting upon retirement, +employees of eligible retirement age are vested in accordance +with plan provisions and applicable stock option and restricted +stock agreements. The Company issues shares to plan participants +upon exercise or vesting of stock-based incentive awards from +either authorized, but unissued, shares or treasury shares. +A summary of the transactions under the stock option plans is as +follows: +Average +Weighted- +Remaining +Shares +Average +Contractual +Aggregate +Under +Exercise +Term +Intrinsic +Option +Price +(Years) +Value +Outstanding at December 29, 2007 +4,588,245 +$ +18.46 +5.4 +$ +31,096 +Granted +845,843 +25.21 +Exercised +(713,048 +) +15.46 +Cancelled +(148,656 +) +25.36 +Outstanding at January 3, 2009 +4,572,384 +$ +19.95 +5.6 +$ +16,155 +Granted +863,017 +17.55 +Exercised +(582,318 +) +13.56 +Cancelled +(233,737 +) +20.91 +Outstanding at January 2, 2010 +4,619,346 +$ +20.17 +5.8 +$ +34,212 +Granted +537,807 +25.55 +Exercised +(848,106 +) +16.83 +Cancelled +(60,137 +) +23.84 +Outstanding at January 1, 2011 +4,248,910 +$ +21.47 +5.7 +$ +44,254 +Estimated forfeitures +(4,827 +) +Vested or expected to vest at +January 1, 2011 +4,244,083 +$ +21.46 +5.7 +$ +44,213 +Nonvested at January 1, 2011 +and expected to vest +(1,109,498 +) +Exercisable at January 1, 2011 +3,134,585 +$ +21.24 +4.8 +$ +33,346 +The total pretax intrinsic value of options exercised during the +years ended January 1, 2011, January 2, 2010 and +January 3, 2009 was $10,407, $5,745 and $8,593, +respectively. As of January 1, 2011, there was $2,393 of +unrecognized compensation expense related to stock option awards +that is expected to be recognized over a weighted-average period +of 1.1 years. As of January 2, 2010 and +January 3, 2009, there was $2,329 and $2,851, respectively, +of unrecognized compensation expense related to stock option +awards that were expected to be recognized over a +weighted-average period of 1.2 years. +The aggregate intrinsic value in the preceding table represents +the total pretax intrinsic value, based on the Company’s +closing stock price of $31.88 as of January 1, 2011, which +would have been received by the option holders had all option +holders exercised +in-the-money +options as of that date. The total number of +in-the-money +options exercisable as of January 1, 2011 was 3,134,585 and +the weighted-average exercise price was $21.24. As of +A-12 +Table of Contents +January 2, 2010, 2,921,804 outstanding options were +exercisable and the weighted-average exercise price was $18.17. +A summary of the nonvested restricted shares issued under stock +award plans is as follows: +Weighted- +Weighted- +Average +Average +Restricted +Grant Date +Performance +Grant Date +Awards +Fair Value +Awards +Fair Value +Nonvested at December 29, 2007 +573,381 +$ +21.52 +- +- +Granted +179,755 +24.85 +- +- +Vested +(234,581 +) +18.36 +- +- +Forfeited +(46,063 +) +24.08 +- +- +Nonvested at January 3, 2009 +472,492 +$ +24.11 +- +- +Granted +350,653 +17.34 +286,006 +17.21 +Vested +(145,797 +) +20.31 +- +- +Forfeited +(36,878 +) +22.45 +(22,101 +) +17.11 +Nonvested at January 2, 2010 +640,470 +$ +21.34 +263,905 +$ +17.22 +Granted +262,342 +25.51 +215,027 +24.30 +Vested +(117,438 +) +22.71 +- +- +Forfeited +(21,828 +) +21.93 +(4,407 +) +17.11 +Nonvested at January 1, 2011 +763,546 +$ +22.55 +474,525 +$ +20.43 +Beginning in 2009, the Board of Directors has awarded an annual +grant of performance share awards to the officers of the +Company. The number of performance-based shares that will be +earned (and eligible to vest) during the performance period will +depend on the Company’s level of success in achieving two +specifically identified performance targets. Any portion of the +performance shares that are not earned by the end of the +three-year measurement period will be forfeited. The final +determination of the number of shares to be issued in respect to +an award is determined by the Compensation Committee of the +Company’s Board of Directors. +As of January 1, 2011, there was $6,194 of unrecognized +compensation expense related to nonvested share-based +compensation arrangements granted under restricted stock award +plans. That cost is expected to be recognized over a +weighted-average period of 1.6 years. The total fair value +of shares vested during the year ended January 1, 2011 was +$3,012. As of January 2, 2010, there was $4,792 of +unrecognized compensation cost related to nonvested +share-based +compensation arrangements granted under restricted stock award +plans. That cost is expected to be recognized over a +weighted-average period of 2.0 years. The total fair value +of shares vested during the year ended January 2, 2010 was +$2,761. As of January 3, 2009, there was $4,072 of +unrecognized compensation cost related to nonvested share-based +compensation arrangements granted under restricted stock award +plans. That cost is expected to be recognized over a +weighted-average period of 1.8 years. The total fair value +of shares vested during the year ended January 3, 2009 was +$6,300. +6. +RETIREMENT +PLANS +The Company has two non-contributory, defined benefit pension +plans covering a majority of its domestic employees. The +Company’s principal defined benefit pension plan provides +benefits based on the employee’s years of service and final +average earnings (as defined in the plan), while the other plan +provides benefits at a fixed rate per year of service. +The Company has a Supplemental Executive Retirement Plan (the +“SERP”) for certain current and former employees that +entitles a participating employee to receive payments from the +Company following retirement based on the employee’s years +of service and final average earnings (as defined in the SERP). +Under the SERP, the employees can elect early retirement with a +corresponding reduction in benefits. The Company also has +individual deferred compensation agreements with certain former +employees that entitle these employees to receive payments from +the Company for a period of fifteen to eighteen years following +retirement. The Company maintains life insurance policies with a +cash surrender value of $36,042 at January 1, 2011 and +$35,405 at January 2, 2010 that are intended to fund +deferred compensation benefits under the SERP and deferred +compensation agreements. +A-13 +Table of Contents +The Company has a defined contribution 401(k) plan covering +substantially all domestic employees that provides for Company +contributions based on earnings. The Company recognized expense +for its defined contribution plan of $2,061 in fiscal year 2010, +$1,919 in fiscal year 2009 and $2,245 in fiscal year 2008. +The Company has certain defined contribution plans at foreign +subsidiaries. Contributions to these plans were $858 in fiscal +year 2010, $954 in fiscal year 2009 and $1,194 in fiscal year +2008. The Company also has a defined benefit plan at a foreign +location that provides for retirement benefits based on years of +service. The obligation recorded under this plan was $3,068 at +January 1, 2011, and $2,778 at January 2, 2010 and is +recognized as a deferred compensation liability on the +accompanying balance sheet. +The following summarizes the status of and changes in the +Company’s assets and related obligations for its pension +plans (which include the Company’s defined benefit pension +plans and the SERP) for the fiscal years: +2010 +2009 +Change in projected benefit obligations: +Projected benefit obligations at beginning of the year +$ +211,670 +$ +174,970 +Service cost pertaining to benefits earned during the year +5,729 +4,543 +Interest cost on projected benefit obligations +12,719 +12,232 +Actuarial losses +10,955 +30,521 +Special termination benefits +- +139 +Benefits paid to plan participants +(10,959 +) +(10,735 +) +Projected benefit obligations at end of the year +$ +230,114 +$ +211,670 +Change in fair value of pension assets: +Fair value of pension assets at beginning of the year +$ +125,492 +$ +112,049 +Actual return on plan assets +17,549 +19,464 +Company contributions +12,329 +4,714 +Benefits paid to plan participants +(10,959 +) +(10,735 +) +Fair value of pension assets at end of the year +$ +144,411 +$ +125,492 +Funded status +$ +(85,703 +) +$ +(86,178 +) +Amounts recognized in the consolidated balance sheets: +Current liabilities +$ +(2,018 +) +$ +(2,044 +) +Non current liabilities +(83,685 +) +(84,134 +) +Net amount recognized +$ +(85,703 +) +$ +(86,178 +) +Amounts recognized in accumulated other comprehensive income +(loss): +Unrecognized net actuarial loss (net of tax: 2010 - +$(50,452); 2009 -$(53,165)) +$ +(76,258 +) +$ +(80,432 +) +Unrecognized prior service cost (net of tax: 2010 - $(404); +2009 - $(572)) +(622 +) +(880 +) +Net amount recognized +$ +(76,880 +) +$ +(81,312 +) +Funded status of pension plans and SERP (supplemental): +Funded status of qualified defined benefit plans and SERP +$ +(85,703 +) +$ +(86,178 +) +Nonqualified trust assets (cash surrender value of life +insurance) recorded in other assets and intended to satisfy the +projected benefit obligation of unfunded SERP +34,549 +33,731 +Net funded status of pension plans and SERP (supplemental) +$ +(51,154 +) +$ +(52,447 +) +The accumulated benefit obligations for all defined benefit +pension plans and the SERP were $218,949 at January 1, 2011 +and $202,428 at January 2, 2010. +A-14 +Table of Contents +The following is a summary of net pension and SERP expense +recognized by the Company: +2010 +2009 +2008 +Service cost pertaining to benefits earned during the year +$ +(5,729 +) +$ +(4,543 +) +$ +(4,859 +) +Interest cost on projected benefit obligations +(12,719 +) +(12,233 +) +(11,413 +) +Expected return on pension assets +12,467 +10,911 +13,914 +Net amortization loss +(10,305 +) +(9,275 +) +(3,967 +) +Curtailment (gain) +- +(612 +) +- +Special termination benefit charge +- +(139 +) +- +Net pension expense +$ +(16,286 +) +$ +(15,891 +) +$ +(6,325 +) +The prior service cost and actuarial loss included in +accumulated other comprehensive income (loss) and expected to be +recognized in net periodic pension expense during 2011 is $145 +($94, net of tax) and $11,931 ($7,755, net of tax), +respectively. Expense for qualified defined benefit pension +plans was $11,903 in 2010, $12,871 in 2009 and $3,601 in 2008. +2010 +2009 +Weighted-average assumptions used to determine benefit +obligations at fiscal year end: +Discount rate +5.94 +% +6.17% +Rate of compensation increase +3.25 +% +3.25% +Weighted average assumptions used to determine net periodic +benefit cost for the years ended: +Discount rate +6.17 +% +7.25% +Expected long-term rate of return on plan assets +8.50 +% +8.50% +Rate of compensation increase +3.25 +% +3.50% +Unrecognized net actuarial losses exceeding certain corridors +are amortized over a five-year period, unless the minimum +amortization method based on average remaining service periods +produces a higher amortization. The Company utilizes a bond +matching calculation to determine the discount rate. A +hypothetical bond portfolio is created based on a presumed +purchase of bonds with maturities that match the plan’s +expected future cash outflows. The discount rate is the +resulting yield of the hypothetical bond portfolio. The discount +rate is used in the calculation of the year end pension +liability and pension expense for the subsequent year. +The long-term rate of return is based on overall market +expectations for a balanced portfolio with an asset mix similar +to the Company’s, utilizing historic returns for broad +market and fixed income indices. +2010 +2009 +$ +% +$ +% +Weighted average asset allocations at fiscal year end by asset +category are as follows: +Equity securities +102,144 +70.7 +% +85,026 +67.8% +Fixed income investments +37,038 +25.7 +% +36,302 +29.0% +Cash and money market investments +5,229 +3.6 +% +4,164 +3.2% +Fair value of plan assets +144,411 +100.0 +% +125,492 +100.0% +The Company’s investment policy for plan assets uses a +blended approach of U.S. and foreign equities combined with +U.S. fixed income investments. Policy guidelines indicate +that total equities should not exceed 80% and fixed income +securities should not exceed 50%. Within the equity and fixed +income classifications, the investments are diversified. +In accordance with ASC 820, these assets fall within +Level 1 of the fair value hierarchy. Fair value is +determined using quoted prices (unadjusted) in active markets +for identical assets. +The Company expects to contribute $31,800 to its qualified +defined benefit pension plans and $1,962 to the SERP in 2011. +A-15 +Table of Contents +Expected benefit payments for the five years subsequent to 2010 +and the sum of the five years following those are as follows: +2011 +2012 +2013 +2014 +2015 +2016-2020 +Expected benefit payments +$ +11,512 +$ +11,635 +$ +12,046 +$ +13,279 +$ +13,564 +$ +74,365 +7. +INCOME +TAXES +The geographic components of earnings before income taxes are as +follows: +2010 +2009 +2008 +United States +$ +86,817 +$ +51,167 +$ +82,604 +Foreign +56,409 +34,525 +57,980 +$ +143,226 +$ +85,692 +$ +140,584 +The provisions for income taxes consist of the following: +2010 +2009 +2008 +Current expense: +Federal +$ +27,218 +$ +11,492 +$ +26,053 +State +1,866 +1,596 +483 +Foreign +12,419 +18,537 +18,270 +Deferred credit +(2,747 +) +(7,845 +) +(43 +) +$ +38,756 +$ +23,780 +$ +44,763 +A reconciliation of the Company’s total income tax expense +and the amount computed by applying the statutory federal income +tax rate of 35% to earnings before income taxes is as follows: +2010 +2009 +2008 +Income taxes at U.S. statutory rate +$ +50,129 +$ +29,992 +$ +49,204 +State income taxes, net of federal income tax +557 +324 +375 +Nontaxable earnings of foreign affiliates +(4,586 +) +(2,981 +) +(1,555 +) +Research and development credits +(600 +) +(700 +) +(875 +) +Foreign earnings taxed at rates different from +the U.S. statutory rate +(9,226 +) +(8,444 +) +(3,352 +) +Adjustments for uncertain tax positions +2,142 +4,908 +244 +Other +340 +681 +722 +$ +38,756 +$ +23,780 +$ +44,763 +A-16 +Table of Contents +Significant components of the Company’s deferred income tax +assets and liabilities as of the end of fiscal years 2010 and +2009 are as follows: +2010 +2009 +Deferred income tax assets: +Accounts receivable and inventory valuation allowances +$ +5,415 +$ +5,210 +Deferred compensation accruals +2,073 +2,466 +Accrued pension expense +29,644 +30,276 +Stock-based compensation +9,963 +4,950 +Net operating loss and foreign tax credit carryforward +1,397 +1,026 +Other amounts not deductible until paid +10,448 +10,604 +Total gross deferred income tax assets +58,940 +54,532 +Less valuation allowance +(1,397 +) +(1,026 +) +Net deferred income tax assets +57,543 +53,506 +Deferred income tax liabilities: +Tax depreciation in excess of book depreciation +(4,347 +) +(4,107 +) +Prepaid pension expense +- +(994 +) +Other +(2,369 +) +(836 +) +Total deferred income tax liabilities +(6,716 +) +(5,937 +) +Net deferred income tax assets +$ +50,827 +$ +47,569 +The valuation allowance for deferred tax assets as of +January 1, 2011 and January 2, 2010, was $1,397 and +$1,026, respectively. The net change in the total valuation +allowance for each of the years ended January 1, 2011, and +January 2, 2010, was $371 and $380, respectively. The +valuation allowance was related to foreign net operating loss +carryforwards and foreign tax credit carryforwards that, in the +judgment of management, are not more likely than not to be +realized. The ultimate realization of the carryforwards depends +on the generation of future taxable income in the foreign tax +jurisdictions. +At January 1, 2011, the Company had foreign net operating +loss carryforwards of $2,432 and foreign tax credit +carryforwards of $545, which are available for an unlimited +carryforward period to offset future foreign taxable income. +The following table summarizes the activity related to the +Company’s unrecognized tax benefits: +2010 +2009 +Beginning balance +$ +8,396 +$ +3,171 +Increases related to current year tax positions +2,645 +5,225 +Decrease due to lapse of statute +(300 +) +- +Ending balance +$ +10,741 +$ +8,396 +The portion of the unrecognized tax benefits that, if recognized +currently would reduce the annual effective tax rate was $9,731 +as of January 1, 2011, $7,588 as of January 2, 2010 +and $2,646 as of January 3, 2009. The Company recognizes +interest and penalties related to unrecognized tax benefits +through interest expense and income tax expense, respectively. +Interest accrued related to unrecognized tax benefits was $770 +as of January 1, 2011 and $681 as of January 2, 2010. +The Company is subject to periodic audits by domestic and +foreign tax authorities. Currently, the Company is undergoing +routine periodic audits in both domestic and foreign tax +jurisdictions. It is reasonably possible that the amounts of +unrecognized tax benefits could change in the next +12 months as a result of the audits; however, any payment +of tax is not expected to be significant to the consolidated +financial statements. +For the majority of tax jurisdictions, the Company is no longer +subject to U.S. federal, state and local, or +non-U.S. income +tax examinations by tax authorities for years before 2006. +A-17 +Table of Contents +No provision has been made for U.S. federal and state +income taxes or foreign taxes that may result from future +remittances of the remaining undistributed earnings of foreign +subsidiaries of $199,767 at January 1, 2011, as the Company +expects such earnings will remain invested overseas +indefinitely. At January 2, 2010, undistributed foreign +earnings were $163,664. +8. +LITIGATION +AND CONTINGENCIES +The Company is involved in various environmental claims and +other legal actions arising in the normal course of business. +The environmental claims include sites where the +U.S. Environmental Protection Agency has notified the +Company that it is a potentially responsible party with respect +to environmental remediation. These remediation claims are +subject to ongoing environmental impact studies, assessment of +remediation alternatives, allocation of costs between +responsible parties and concurrence by regulatory authorities +and have not yet advanced to a stage where the Company’s +liability is fixed. However, after taking into consideration +legal counsel’s evaluation of all actions and claims +against the Company, management is currently of the opinion that +their outcome will not have a material adverse effect on the +Company’s consolidated financial position, results of +operations or cash flows. +The Company is involved in routine litigation incidental to its +business and is a party to legal actions and claims, including, +but not limited to, those related to employment and intellectual +property. Some of the legal proceedings include claims for +compensatory as well as punitive damages. While the final +outcome of these matters cannot be predicted with certainty, +considering, among other things, the meritorious legal defenses +available and liabilities that have been recorded along with +applicable insurance, it is currently the opinion of the +Company’s management that these items will not have a +material adverse effect on the Company’s financial +position, results of operations or cash flows. +The Company has future minimum royalty and advertising +obligations due under the terms of certain licenses held by the +Company. These minimum future obligations are as follows: +2011 +2012 +2013 +2014 +2015 +Minimum royalties +1,693 +880 +898 +916 +934 +Minimum advertising +1,941 +1,999 +2,059 +2,121 +2,184 +Minimum royalties are based on both fixed obligations and +assumptions regarding the consumer price index. Royalty +obligations in excess of minimum requirements are based upon +future sales levels. In accordance with these agreements, the +Company incurred royalty expense of $3,028, $2,861 and $3,198 +for 2010, 2009 and 2008, respectively. +The terms of certain license agreements also require the Company +to make advertising expenditures based on the level of sales. In +accordance with these agreements, the Company incurred +advertising expense of $2,998, $2,682 and $3,018 for 2010, 2009 +and 2008, respectively. +The Company had commercial letters of credit outstanding of $95 +and $450 at January 1, 2011 and January 2, 2010, +respectively. +9. +BUSINESS +SEGMENTS +The Company has one reportable segment that is engaged in +designing, manufacturing, sourcing, marketing, licensing, and +distributing to the retail sector branded footwear, apparel and +accessories. Revenue earned from the operations of this segment +is derived from the sale of branded footwear, apparel and +accessories to external customers and royalty income from the +licensing of the Company’s trademarks and brand names to +third-party licensees and distributors. The operating segments +aggregated into the branded footwear, apparel and licensing +segment all manufacture, source, market and distribute products +in a similar manner. +The other business units in the following tables consist of the +Company’s retail, leather and pigskin procurement +operations. These other operations do not collectively form a +reportable segment because their respective operations are +dissimilar and they do not meet the applicable quantitative +requirements. At January 1, 2011, the Company operated 81 +retail stores in North America and 7 retail stores in the United +Kingdom that sell Company-branded products, as well as footwear, +apparel and accessories products under brands that are owned by +unaffiliated +A-18 +Table of Contents +companies. The Company also has 38 consumer-direct internet +sites that sell Company-branded products. The other business +units distribute products through retail and wholesale channels. +The Company measures segment profits as earnings before income +taxes. The accounting policies used to determine profitability +and total assets of the branded footwear, apparel and licensing +segment and other business units are the same as disclosed in +Note 1. +Business segment information is as follows: +2010 +Branded +Footwear, +Apparel +Other +and Licensing +Businesses +Corporate +Consolidated +Revenue +$ +1,117,644 +$ +130,873 +$ +- +$ +1,248,517 +Intersegment revenue +44,721 +2,789 +- +47,510 +Interest (income) expense – net +- +- +387 +387 +Depreciation expense +6,067 +3,373 +5,069 +14,509 +Earnings (loss) before income taxes +174,563 +12,987 +(44,324 +) +143,226 +Total assets +599,354 +41,980 +141,490 +782,824 +Additions to property, plant and equipment +8,282 +4,329 +3,759 +16,370 +2009 +Branded +Footwear, +Apparel, +Other +and Licensing +Businesses +Corporate +Consolidated +Revenue +$ +991,168 +$ +109,888 +$ +- +$ +1,101,056 +Intersegment revenue +55,983 +3,019 +- +59,002 +Interest (income) expense – net +- +- +111 +111 +Depreciation expense +6,501 +3,035 +6,396 +15,932 +Earnings (loss) before income taxes +116,568 +(8,092 +) +(22,784 +) +85,692 +Total assets +499,091 +34,036 +174,806 +707,933 +Additions to property, plant and equipment +3,240 +3,712 +4,718 +11,670 +2008 +Branded +Footwear, +Apparel, +Other +and Licensing +Businesses +Corporate +Consolidated +Revenue +$ +1,106,081 +$ +114,487 +$ +- +$ +1,220,568 +Intersegment revenue +47,386 +3,542 +- +50,928 +Interest (income) expense – net +- +- +1,093 +1,093 +Depreciation expense +6,823 +3,768 +7,869 +18,460 +Earnings (loss) before income taxes +158,615 +3,294 +(21,325 +) +140,584 +Total assets +483,041 +57,049 +124,690 +664,780 +Additions to property, plant and equipment +11,443 +4,654 +8,029 +24,126 +A-19 +Table of Contents +Geographic information, based on shipping destination, related +to revenue from external customers included in the consolidated +statements of operations is as follows: +2010 +2009 +2008 +United States +$ +768,594 +$ +690,269 +$ +729,826 +Foreign countries: +Europe +218,542 +198,487 +243,701 +Canada +103,374 +89,409 +90,789 +Other +158,007 +122,891 +156,252 +Total from foreign countries +479,923 +410,787 +490,742 +$ +1,248,517 +$ +1,101,056 +$ +1,220,568 +The Company’s long-lived assets (primarily property, plant +and equipment) are as follows: +2010 +2009 +United States +$ +69,545 +$ +68,883 +Foreign countries +7,774 +8,815 +$ +77,319 +$ +77,698 +The Company does not believe that it is dependent upon any +single customer because no customer accounts for more than 10% +of consolidated revenue. +The Company sources approximately 94% (based on pairs) of its +footwear products from unrelated suppliers located primarily in +the Asia-Pacific region. The remainder is produced in +Company-owned manufacturing facilities in the United States and +the Dominican Republic. All apparel and accessories are sourced +from unrelated suppliers. While changes in suppliers could cause +delays in manufacturing and a possible loss of sales, management +believes that other suppliers could provide similar products on +comparable terms. +Revenue derived from the branded footwear, apparel and licensing +segment accounted for approximately 90% of revenue in 2010, 90% +in 2009 and 91% in 2008. No other product groups account for +more than 10% of consolidated revenue. +10. +RESTRUCTURING +AND OTHER TRANSITION COSTS +On January 7, 2009, the Board of Directors of the Company +approved a strategic restructuring plan designed to create +significant operating efficiencies, improve the Company’s +supply chain and create a stronger global platform. On +October 7, 2009, the Company announced an expansion of its +restructuring plan to include the consolidation of two domestic +manufacturing facilities into one and to finalize realignment in +certain of the Company’s product creation organizations. +The strategic restructuring plan and all actions under the plan, +except for certain cash payments, were completed as of +June 19, 2010. The Company incurred restructuring and other +transition costs of $4,234 ($3,087 on an after-tax basis) and +$35,596 ($25,700 on an after-tax basis), or $0.06 and $0.53 per +diluted share, for the years ended January 1, 2011 and +January 2, 2010, respectively. There were no restructuring +and other transition costs recognized for the year ended +January 3, 2009. +Restructuring +Prior to completion of the restructuring plan, the Company +incurred restructuring charges of $2,239 ($1,632 on an after-tax +basis) and $29,083 ($20,998 on an after-tax basis) for the years +ended January 1, 2011 and January 2, 2010, +respectively. +A-20 +Table of Contents +The following is a summary of the activity with respect to a +reserve established by the Company in connection with the +restructuring plan, by category of costs: +Non-cash +Severance and +charges related +employee +to property and +Facility exit +Other related +related +equipment +costs +restructuring +Total +Balance at January 3, 2009 +$ +— +$ +— +$ +— +$ +— +$ +— +Charges incurred +15,391 +7,964 +2,473 +3,255 +29,083 +Amounts paid or utilized +(11,525 +) +(7,964 +) +(988 +) +(2,680 +) +(23,157 +) +Balance at January 2, 2010 +$ +3,866 +$ +— +$ +1,485 +$ +575 +$ +5,926 +Charges incurred +571 +715 +803 +150 +2,239 +Amounts paid or utilized +(4,150 +) +(715 +) +(1,397 +) +(589 +) +(6,851 +) +Balance at January 1, 2011 +$ +287 +$ +— +$ +891 +$ +136 +$ +1,314 +Other +Transition Costs +Incremental costs incurred related to the restructuring plan +that do not qualify as restructuring costs under the provisions +of FASB ASC Topic 420, Exit or Disposal Cost Obligations , +have been included in the Company’s consolidated condensed +statements of operations on the line items titled +“Restructuring and other transition costs”. These +primarily include costs related to closure of facilities, new +employee training and transition to outsourced services. All +costs included in this caption were solely related to the +transition and implementation of the restructuring plan and do +not include ongoing business operating costs. Other transition +costs for the years ended January 1, 2011, and +January 2, 2010, were, $1,995 ($1,454 on an after-tax +basis) and $6,513 ($4,702 on an after-tax basis), respectively. +11. +BUSINESS +ACQUISITIONS +The Company accounted for the following acquisitions under the +provisions of FASB ASC Topic 805, Business Combinations . +On January 8, 2009, the Company announced the acquisition +of the +Cushe ® +footwear brand. The purchase price consisted of $1,550 cash, a +$1,550 note payable over three years and contingent +consideration of $881. The Company acquired assets valued at +$287, consisting primarily of property, plant and equipment, +inventory, and assumed operating liabilities valued at $304, +resulting in goodwill and intangibles of $3,998 at +January 2, 2010. Amounts relating to the acquisition are +subject to changes in foreign currency exchange rates. +On January 22, 2009, the Company acquired the +Chaco ® +footwear brand and certain assets valued at $3,912, consisting +primarily of accounts receivable and inventory, for cash of +$6,910 and assumed operating liabilities valued at $4,662. The +purchase resulted in goodwill and intangibles recorded of $7,660. +Using the purchase method of accounting, the purchase price in +each of these acquisitions is allocated to the assets acquired +and liabilities assumed based on their estimated fair values as +of the effective date of the acquisition. The excess purchase +price over the assets and liabilities is recorded as goodwill. +The purchase price allocation for each acquisition was finalized +during the third quarter of 2009 and a final determination of +all purchase accounting adjustments was made upon finalization +of asset valuations and acquisition costs. Pro forma results of +operations have not been presented because the effects of these +acquisitions, individually and in the aggregate, were not +material to the Company’s consolidated results of +operations. Both of the brands have been consolidated into the +Company’s results of operations since their respective +acquisition dates. +A-21 +Table of Contents +12. +QUARTERLY +RESULTS OF OPERATIONS (UNAUDITED) +The Company reports its quarterly results of operations on the +basis of 12-week periods for each of the first three quarters +and a 16- or 17-week period for the fourth quarter. The fourth +quarters of 2010 and 2009 consist of 16 weeks. The +aggregate quarterly earnings per share amounts disclosed in the +table below may not equal the annual per share amounts due to +rounding and the fact that results for each quarter are +calculated independently of the annual period. +The Company’s unaudited quarterly results of operations are +as follows: +2010 +First +Second +Third +Fourth +Quarter +Quarter +Quarter +Quarter +Revenue +$ +284,897 +$ +258,199 +$ +320,396 +$ +385,025 +Gross profit +117,589 +103,681 +128,571 +142,733 +Net earnings +27,459 +17,222 +34,143 +25,646 +Net earnings per share: +Basic +$ +0.55 +$ +0.35 +$ +0.71 +$ +0.54 +Diluted +0.54 +0.35 +0.70 +0.52 +2009 +First +Second +Third +Fourth +Quarter +Quarter +Quarter +Quarter +Revenue +$ +255,324 +$ +246,438 +$ +286,764 +$ +312,530 +Gross profit +102,943 +92,041 +113,965 +122,773 +Net earnings +10,495 +7,885 +26,794 +16,738 +Net earnings per share: +Basic +$ +0.21 +$ +0.16 +$ +0.54 +$ +0.34 +Diluted +0.21 +0.16 +0.54 +0.33 +A-22 +Table of Contents +Report of +Independent Registered Public Accounting Firm +The Board of Directors and Shareholders of Wolverine World Wide, +Inc. +We have audited the accompanying consolidated balance sheets of +Wolverine World Wide, Inc. and subsidiaries as of +January 1, 2011 and January 2, 2010, and the related +consolidated statements of stockholders’ equity and +comprehensive income, operations, and cash flows for each of the +three fiscal years in the period ended January 1, 2011. Our +audits also included the financial statement schedule listed in +the Index at Item 15(a). These financial statements and +schedule are the responsibility of the Company’s +management. Our responsibility is to express an opinion on these +financial statements and schedule based on our audits. +We conducted our audits in accordance with the standards of the +Public Company Accounting Oversight Board (United States). Those +standards require that we plan and perform the audit to obtain +reasonable assurance about whether the financial statements are +free of material misstatement. An audit includes examining, on a +test basis, evidence supporting the amounts and disclosures in +the financial statements. An audit also includes assessing the +accounting principles used and significant estimates made by +management, as well as evaluating the overall financial +statement presentation. We believe that our audits provide a +reasonable basis for our opinion. +In our opinion, the financial statements referred to above +present fairly, in all material respects, the consolidated +financial position of Wolverine World Wide, Inc. and +subsidiaries at January 1, 2011 and January 2, 2010, +and the consolidated results of their operations and their cash +flows for each of the three fiscal years in the period ended +January 1, 2011, in conformity with U.S. generally +accepted accounting principles. Also, in our opinion, the +related financial statement schedule, when considered in +relation to the basic financial statements taken as a whole, +presents fairly in all material respects the information set +forth therein. +We also have audited, in accordance with the standards of the +Public Company Accounting Oversight Board (United States), +Wolverine World Wide, Inc.’s internal control over +financial reporting as of January 1, 2011, based on +criteria established in Internal Control-Integrated Framework +issued by the Committee of Sponsoring Organizations of the +Treadway Commission and our report dated March 2, 2011 +expressed an unqualified opinion thereon. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +March 2, 2011 +A-23 +Table of Contents +Report of +Independent Registered Public Accounting Firm +The Board of Directors and Shareholders of Wolverine World Wide, +Inc. +We have audited Wolverine World Wide, Inc.’s internal +control over financial reporting as of January 1, 2011, +based on criteria established in Internal +Control—Integrated Framework issued by the Committee of +Sponsoring Organizations of the Treadway Commission (the COSO +criteria). Wolverine World Wide, Inc.’s management is +responsible for maintaining effective internal control over +financial reporting, and for its assessment of the effectiveness +of internal control over financial reporting included in the +accompanying Management’s Report on Internal Control Over +Financial Reporting. Our responsibility is to express an opinion +on the company’s internal control over financial reporting +based on our audit. +We conducted our audit in accordance with the standards of the +Public Company Accounting Oversight Board (United States). Those +standards require that we plan and perform the audit to obtain +reasonable assurance about whether effective internal control +over financial reporting was maintained in all material +respects. Our audit included obtaining an understanding of +internal control over financial reporting, assessing the risk +that a material weakness exists, testing and evaluating the +design and operating effectiveness of internal control based on +the assessed risk, and performing such other procedures as we +considered necessary in the circumstances. We believe that our +audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a +process designed to provide reasonable assurance regarding the +reliability of financial reporting and the preparation of +financial statements for external purposes in accordance with +generally accepted accounting principles. A company’s +internal control over financial reporting includes those +policies and procedures that (1) pertain to the maintenance +of records that, in reasonable detail, accurately and fairly +reflect the transactions and dispositions of the assets of the +company; (2) provide reasonable assurance that transactions +are recorded as necessary to permit preparation of financial +statements in accordance with generally accepted accounting +principles, and that receipts and expenditures of the company +are being made only in accordance with authorizations of +management and directors of the company; and (3) provide +reasonable assurance regarding prevention or timely detection of +unauthorized acquisition, use, or disposition of the +company’s assets that could have a material effect on the +financial statements. +Because of its inherent limitations, internal control over +financial reporting may not prevent or detect misstatements. +Also, projections of any evaluation of effectiveness to future +periods are subject to the risk that controls may become +inadequate because of changes in conditions, or that the degree +of compliance with the policies or procedures may deteriorate. +In our opinion, Wolverine World Wide, Inc. maintained, in all +material respects, effective internal control over financial +reporting as of January 1, 2011, based on the COSO criteria. +We also have audited, in accordance with the standards of the +Public Company Accounting Oversight Board (United States), +the consolidated balance sheets of Wolverine World Wide, Inc. +and subsidiaries as of January 1, 2011 and January 2, +2010, and the related consolidated statements of +stockholders’ equity and comprehensive income, operations, +and cash flows for each of the three fiscal years in the period +ended January 1, 2011 of Wolverine World Wide, Inc. and our +report dated March 2, 2011 expressed an unqualified opinion +thereon. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +March 2, 2011 +A-24 +Table of Contents +APPENDIX B +Schedule II - +Valuation and Qualifying Accounts +Wolverine +World Wide, Inc. and Subsidiaries +Column A +Column B +Column C +Column D +Column E +Additions +(2) +(1) +Charged to +Balance at +Charged to +Other +Balance at +Beginning of +Costs and +Accounts +Deductions +End of +Description +Period +Expenses +(Describe) +(Describe) +Period +Fiscal year ended January 1, 2011 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +8,137,000 +$ +3,846,000 +$ +6,229,000 +(A +) +$ +5,754,000 +Allowance for sales returns +4,649,000 +29,606,000 +29,781,000 +(B +) +4,474,000 +Allowance for cash discounts +1,160,000 +10,568,000 +10,543,000 +(C +) +1,185,000 +Inventory valuation allowances +6,350,000 +8,276,000 +6,007,000 +(D +) +8,619,000 +$ +20,296,000 +$ +52,296,000 +$ +52,560,000 +$ +20,032,000 +Fiscal year ended January 2, 2010 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +8,383,000 +$ +1,733,000 +$ +1,979,000 +(A +) +$ +8,137,000 +Allowance for sales returns +5,311,000 +28,386,000 +29,048,000 +(B +) +4,649,000 +Allowance for cash discounts +1,467,000 +11,717,000 +12,024,000 +(C +) +1,160,000 +Inventory valuation allowances +8,912,000 +6,419,000 +8,981,000 +(D +) +6,350,000 +$ +24,073,000 +$ +48,255,000 +$ +52,032,000 +$ +20,296,000 +Fiscal year ended January 3, 2009 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +6,866,000 +$ +2,266,000 +$ +749,000 +(A +) +$ +8,383,000 +Allowance for sales returns +5,269,000 +31,994,000 +31,952,000 +(B +) +5,311,000 +Allowance for cash discounts +1,508,000 +14,602,000 +14,643,000 +(C +) +1,467,000 +Inventory valuation allowances +14,902,000 +9,806,000 +15,796,000 +(D +) +8,912,000 +$ +28,545,000 +$ +58,668,000 +$ +63,140,000 +$ +24,073,000 +(A) +Accounts charged off, net of recoveries. +(B) +Actual customer returns. +(C) +Discounts given to customers. +(D) +Adjustment upon disposal of related inventories. +1 +Table of Contents +EXHIBIT INDEX +Exhibit +Number +Document +3 +.1 +Restated Certificate of Incorporation. Previously filed as +Exhibit 3.1 to the Company’s Annual Report on Form 10-K for +the period ended December 30, 2006. Here incorporated by +reference. +3 +.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.1 to +the Company’s Current Report on Form 8-K filed on December +15, 2010. Here incorporated by reference. +4 +.1 +The Registrant has other long-term debt instruments outstanding +in addition to those described in Exhibit 4.2. The authorized +amount of none of these classes of debt exceeds 10% of the +Company’s total consolidated assets. The Company agrees to +furnish copies of any agreement defining the rights of holders +of any such long-term indebtedness to the Securities and +Exchange Commission upon request. +4 +.2 +Credit Agreement, dated as of June 7, 2010, among Wolverine +World Wide, Inc., certain foreign subsidiaries of Wolverine +World Wide, Inc., JPMorgan Chase Bank, N.A., as Administrative +Agent, and the lenders party thereto. Previously filed as +Exhibit 10.1 to the Company’s Current Report on Form 8-K +filed on June 8, 2010. Here incorporated by reference. +10 +.1 +1993 Stock Incentive Plan, as amended and restated.* Previously +filed as Exhibit 10.1 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.2 +Amended and Restated 1995 Stock Incentive Plan.* Previously +filed as Exhibit 10.2 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.3 +Amended and Restated 1997 Stock Incentive Plan.* Previously +filed as Exhibit 10.3 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.4 +Amended and Restated Stock Incentive Plan of 1999.* Previously +filed as Exhibit 10.4 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.5 +Amended and Restated Stock Incentive Plan of 2001.* Previously +filed as Exhibit 10.5 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.6 +Amended and Restated Stock Incentive Plan of 2003.* Previously +filed as Exhibit 10.6 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.7 +Amended and Restated Stock Incentive Plan of 2005.* Previously +filed as Exhibit 10.7 to the Company’s Annual Report on +Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10 +.8 +Amended and Restated Directors’ Stock Option Plan.* +Previously filed as Exhibit 10.8 to the Company’s Annual +Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10 +.9 +Amended and Restated Outside Directors’ Deferred +Compensation Plan.* Previously filed as Exhibit 10.9 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended December 29, 2007. Here incorporated by reference. +10 +.10 +Amended and Restated Executive Short-Term Incentive Plan (Annual +Bonus Plan).* Previously filed as Exhibit 10.10 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +10 +.11 +Amended and Restated Executive Long-Term Incentive Plan (3-Year +Bonus Plan).* Previously filed as Exhibit 10.11 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +10 +.12 +Amended and Restated Stock Option Loan Program.* Previously +filed as Exhibit 10.12 to the Company’s Annual Report on +Form 10-K for the fiscal year ended December 29, 2007. Here +incorporated by reference. +10 +.13 +Executive Severance Agreement.* Previously filed as Exhibit 10.3 +to the Company’s Current Report on Form 8-K filed on +December 17, 2008. Here incorporated by reference. A participant +schedule of current executive officers who are parties to the +agreement is attached as Exhibit 10.13. +10 +.14 +Form of Indemnification Agreement.* The Company has entered into +an Indemnification Agreement with each director and with Messrs. +Grady, Grimes, Krueger, McBreen and Zwiers and Ms. Linton. +Previously filed as Exhibit 10.1 to the Company’s Current +Report on Form 8-K filed on April 25, 2007. Here incorporated by +reference. +Table of Contents +Exhibit +Number +Document +10 +.15 +Amended and Restated Benefit Trust Agreement dated April 25, +2007.* Previously filed as Exhibit 10.5 to the Company’s +Current Report on Form 8-K filed on April 25, 2007. Here +incorporated by reference. +10 +.16 +Employees’ Pension Plan (Restated as amended through +November 29, 2010).* +10 +.17 +Form of Incentive Stock Option Agreement.* Previously filed as +Exhibit 10.1 to the Company’s Current Report on Form 8-K +filed on February 15, 2005. Here incorporated by reference. +10 +.18 +Form of Non-Qualified Stock Option Agreement for Blake W. +Krueger and Timothy J. O’Donovan.* Previously filed as +Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 15, 2005. Here incorporated by reference. +10 +.19 +Form of Non-Qualified Stock Option Agreement for executive +officers other than those to whom Exhibit 10.18 applies.* +Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 15, 2005. Here incorporated +by reference. +10 +.20 +Form of Restricted Stock Agreement.* Previously filed as Exhibit +10.4 to the Company’s Current Report on Form 8-K filed on +February 15, 2005. Here incorporated by reference. +10 +.21 +Form of Incentive Stock Option Agreement.* Previously filed as +Exhibit 10.1 to the Company’s Current Report on Form 8-K +filed on February 17, 2006. Here incorporated by reference. +10 +.22 +Form of Non-Qualified Stock Option Agreement for Blake W. +Krueger and Timothy J. O’Donovan.* Previously filed as +Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 17, 2006. Here incorporated by reference. +10 +.23 +Form of Non-Qualified Stock Option Agreement for executive +officers other than those to whom Exhibit 10.22 applies.* +Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 17, 2006. Here incorporated +by reference. +10 +.24 +Form of Restricted Stock Agreement.* Previously filed as Exhibit +10.4 to the Company’s Current Report on Form 8-K filed on +February 17, 2006. Here incorporated by reference. +10 +.25 +Form of Stock Option Agreement for non-employee directors.* +Previously filed as Exhibit 10.23 to the Company’s Annual +Report on Form 10-K for the fiscal year ended January 1, 2005. +Here incorporated by reference. +10 +.26 +2009 Form of Non-Qualified Stock Option Agreement for Donald T. +Grimes, Blake W. Krueger, Pamela L. Linton, Michael F. McBreen +and James D. Zwiers.* Previously filed as Exhibit 10.26 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +10 +.27 +2009 Form of Non-Qualified Stock Option Agreement for executive +officers other than those to whom Exhibit 10.26 applies.* +Previously filed as Exhibit 10.27 to the Company’s Annual +Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10 +.28 +Form of Performance Share Award Agreement (2009 — 2011 +performance period).* Previously filed as Exhibit 10.28 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +10 +.29 +Form of Performance Share Award Agreement (2010 — 2012 +performance period).* Previously filed as Exhibit 10.29 to the +Company’s Annual Report on Form 10-K for the fiscal year +ended January 2, 2010. Here incorporated by reference. +10 +.30 +Form of Performance Share Award Agreement (2011 — 2013 +performance period).* +10 +.31 +Separation Agreement between Wolverine World Wide, Inc. and +Blake W. Krueger, dated as of March 13, 2008, as amended.* +Previously filed as Exhibit 10.1 to the Company’s Quarterly +Report on Form 10-Q for the period ended March 22, 2008. Here +incorporated by reference. +10 +.32 +First Amendment to Separation Agreement between Wolverine World +Wide, Inc. and Blake W. Krueger, dated as of December 11, 2008.* +Previously filed as Exhibit 10.30 to the Company’s Annual +Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +Table of Contents +Exhibit +Number +Document +10 +.33 +409A Supplemental Executive Retirement Plan.* Previously filed +as Exhibit 10.1 to the Company’s Current Report on Form 8-K +filed on December 17, 2008. Here incorporated by reference. A +participant schedule of current executive officers who +participate in this plan is attached as Exhibit 10.33. +10 +.34 +Form of 409A Supplemental Retirement Plan Participation +Agreement with Blake W. Krueger.* Previously filed as Exhibit +10.32 to the Company’s Annual Report on Form 10-K for the +fiscal year ended January 3, 2009. Here incorporated by +reference. +10 +.35 +Outside Directors’ Deferred Compensation Plan.* Previously +filed as Exhibit 10.2 to the Company’s Current Report on +Form 8-K filed on December 17, 2008. Here incorporated by +reference. +10 +.36 +Stock Incentive Plan of 2010.* Previously filed as Exhibit 10.1 +to the Company’s Registration Statement on Form S-8 filed +on March 4, 2010. Here incorporated by reference. +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31 +.1 +Certification of Chairman, Chief Executive Officer and President +under Section 302 of the Sarbanes-Oxley Act of 2002. +31 +.2 +Certification of Senior Vice President, Chief Financial Officer +and Treasurer under Section 302 of the Sarbanes-Oxley Act of +2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +101 +The following materials from the Company’s Annual Report on +Form 10-K for the fiscal year ended January 1, 2011, formatted +in XBRL (eXtensible Business Reporting Language): +(i) Consolidated Balance Sheets as of as of January 1, 2011 +and January 2, 2010, (ii) Consolidated Statements of Operations +for the fiscal years ended January 1, 2011, January 2, 2010 and +January 3, 2009, (iii) Consolidated Statements of Cash +Flows for the fiscal years ended January 1, 2011, January 2, +2010 and January 3, 2009, and (iv) Notes to the Consolidated +Financial Statements, tagged as blocks of text.** +* +Management contract or compensatory plan or arrangement. +** +Pursuant to Rule 406T of +Regulation S-T, +the Interactive Data Files on Exhibit 101 hereto are deemed +not filed or part of a registration statement or prospectus for +purposes of Sections 11 or 12 of the Securities Act of +1933, as amended, are deemed not filed for purposes of +Section 18 of the Securities and Exchange Act of 1934, as +amended, and otherwise are not subject to liability under those +sections. \ No newline at end of file diff --git a/raw/filings/0000110471/2010/0000950123-11-021208/filing_metadata.csv b/raw/filings/0000110471/2010/0000950123-11-021208/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..df7ea3b8bfb624f6357f2abe2c002160ce58b6d5 --- /dev/null +++ b/raw/filings/0000110471/2010/0000950123-11-021208/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000110471,WWW,WOLVERINE WORLD WIDE INC /DE/,10-K,2011-03-02,2011-01-01,2011-03-02T20:11:37.000Z,0000950123-11-021208,k50131e10vk.htm,FORM 10-K,5303791,1,0,https://www.sec.gov/Archives/edgar/data/110471/000095012311021208/k50131e10vk.htm,https://www.sec.gov/Archives/edgar/data/110471/000095012311021208/,2010,2010,1 diff --git a/raw/filings/0000110471/2010/0000950123-11-021208/item1.txt b/raw/filings/0000110471/2010/0000950123-11-021208/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..466fcf3504b9a235b9962aa64495fce5e9c542cf --- /dev/null +++ b/raw/filings/0000110471/2010/0000950123-11-021208/item1.txt @@ -0,0 +1,858 @@ +Item 1. +Business +General +Wolverine World Wide, Inc. (the “Company”) is a +leading marketer of branded casual, active lifestyle, work, +outdoor sport and uniform footwear and apparel and accessories. +The Company, a Delaware corporation, is the successor of a +Michigan corporation of the same name, originally organized in +1906, which in turn was the successor of a footwear business +established in Grand Rapids, Michigan in 1883. +Approximately 50 million pairs/units of the Company’s +branded footwear and apparel were sold in the fiscal year ended +January 1, 2011 (“fiscal 2010”) in approximately +190 countries and territories around the world. The +Company’s products generally feature contemporary styling +with proprietary technologies designed to provide maximum +comfort and performance. The products are marketed throughout +the world under widely recognized brand names, including +Bates ® , +Cat ® +Footwear, +Chaco ® , +Cushe ® , +Harley-Davidson ® +Footwear, Hush +Puppies ® , +HyTest ® , +Merrell ® , +Patagonia ® +Footwear, +Sebago ® , +Soft +Style ® +and +Wolverine ® . +The Company believes that its primary competitive advantages are +its well-recognized brand names, its patented proprietary +designs and comfort technologies, its wide range of distribution +channels and its diversified manufacturing and sourcing base. +Cat ® +is a registered trademark of Caterpillar Inc., +Harley-Davidson ® +is a registered trademark of H-D Michigan, Inc. and +Patagonia ® +is a registered trademark of Patagonia, Inc. +The Company’s products are sold at various price points +under a variety of brand names designed to appeal to a wide +range of consumers of casual, work and outdoor footwear. The +Company’s wholesale footwear and apparel business is +organized into four operating segments: (i) the Outdoor +Group, consisting of +Merrell ® , +Patagonia ® +and +Chaco ® +footwear, and +Merrell ® +brand apparel, (ii) the Wolverine Footwear Group, +consisting of the +Bates ® , +HyTest ® +and +Wolverine ® +boots and shoes, and +Wolverine ® +brand apparel, (iii) the Heritage Brands Group, consisting +of +Cat ® +footwear, +Harley-Davidson ® +footwear and +Sebago ® +footwear and apparel, and (iv) The Hush Puppies Group, +consisting of Hush +Puppies ® +footwear, Soft +Style ® +footwear and +Cushe ® +footwear. The Company also licenses some of its brands for use +on non-footwear products. +The Company’s Global Operations Group is responsible for +manufacturing, sourcing, distribution and customer support for +the Company’s business. The Company sells products in the +United States, Canada and approximately 10 countries in Europe +to a wide range of retail customers, including department +stores, national chains, catalogs, specialty retailers, mass +merchants and Internet retailers, and to governments and +municipalities. Many of the retailers carrying Wolverine +products operate multiple storefront locations. The +Company’s products are marketed worldwide in a total of +approximately 190 countries and territories through +Company-owned wholesale and retail operations, licensees and +distributors. +For financial information regarding the Company, see the +consolidated financial statements and the accompanying notes, +which are attached as Appendix A to this +Form 10-K. +The Company has one reportable segment, branded footwear, +apparel, and licensing. The branded footwear, apparel, and +licensing segment engages in manufacturing, sourcing, licensing, +marketing and distributing branded footwear and apparel, +including casual shoes and apparel, boots, uniform shoes, work +shoes and rugged outdoor footwear and apparel. The +Company’s other operating segments consist of its +consumer-direct operations and leather and pigskin procurement +operations, which are described below. Financial information +regarding the Company’s reportable segment and other +operating segments and financial information by geographic area +is found in Note 9 to the consolidated financial statements +of the Company that are attached as Appendix A to this +Annual Report on +Form 10-K. +Branded +Footwear, Apparel and Licensing +The Company sources and markets a broad range of footwear +styles, including shoes, boots and sandals under many +recognizable brand names, including +Bates ® , +Cat ® , +Chaco ® , +Cushe ® , +Harley-Davidson ® , +Hush +Puppies ® , +HyTest ® , +Merrell ® , +Patagonia ® , +Sebago ® , +Soft +Style ® +and +Wolverine ® . +The Company combines quality materials and skilled +4 +Table of Contents +workmanship to produce footwear according to its specifications +at both Company-owned and third-party manufacturing facilities. +The Company also markets +Merrell ® , +Sebago ® , +and +Wolverine ® +brand apparel and accessories and licenses some of its brands +for use on non-footwear products, including Hush +Puppies ® +apparel, eyewear, watches, socks, handbags and plush toys and +Wolverine ® +brand eyewear and gloves. +The Company’s branded footwear, apparel, and licensing +operating segments for fiscal 2010 are described below. +1. +The Outdoor Group The Outdoor Group +consists of +Merrell ® +Footwear, +Merrell ® +Apparel and Accessories, +Patagonia ® +Footwear and +Chaco ® +Footwear. Outdoor Group products include performance outdoor and +hiking footwear, casual and after-sport footwear and performance +and casual +Merrell ® +apparel. +Merrell ® +Footwear: The +Merrell ® +footwear line consists primarily of technical hiking, rugged +outdoor and outdoor-inspired casual footwear designed for +backpacking, day hiking and everyday use. The +Merrell ® +footwear line also includes the “After-Sport” +category, incorporating +Merrell ® +footwear’s technical hiking and outdoor expertise with +Wolverine Performance +Leathers tm +and other technical materials to create footwear with unique +styling, performance and comfort features. +Merrell ® +footwear products are sold primarily through sporting goods +chains, outdoor specialty retailers, department stores, on-line +retailers and catalogs. +Merrell ® +footwear is marketed in approximately 150 countries and +territories worldwide. +Merrell ® +Apparel and Accessories: The +Merrell ® +apparel line consists primarily of technical outdoor and +outdoor-inspired casual apparel and performance socks. In +addition to +Merrell ® +apparel, the Outdoor Group markets +Merrell ® +accessories, including packs, bags and luggage. +Patagonia ® +Footwear: Pursuant to an agreement with Lost +Arrow Corporation, the Company has the exclusive footwear +marketing and distribution rights under +Patagonia ® +and other trademarks. The +Patagonia ® +footwear line focuses primarily on casual and outdoor +performance footwear. +Patagonia ® +is a registered trademark of Patagonia, Inc. +Chaco ® +Footwear: The +Chaco ® +brand, which the Company acquired in January 2009, was created +to meet the needs of the whitewater enthusiast and continues to +focus primarily on performance sandals for the outdoor +enthusiast. In order to help evolve the brand into a four-season +offering, the Company introduced closed-toe products in fall +2010. +Chaco ® +footwear is sold primarily through specialty outdoor retailers +and department stores. +2. +Wolverine Footwear Group The Wolverine +Footwear Group markets footwear, apparel and accessories +products under the +Wolverine ® +brand and footwear under the +Bates ® +and +HyTest ® +brands. Wolverine Footwear Group products incorporate +performance and comfort features to serve a variety of work, +outdoor and lifestyle functions. +Wolverine ® +Footwear: The +Wolverine ® +brand offers high quality work boots and shoes that incorporate +innovative technologies to deliver comfort and durability. The +Wolverine ® +brand, which has been in existence for 128 years, markets +work and outdoor footwear in three categories: (i) work and +industrial; (ii) outdoor sport; and (iii) rugged +casual. The development of +DuraShocks ® , +MultiShox ® , +Wolverine +Fusion ® +and Wolverine +Compressor ® +technologies as well as the development of the Contour +Welt ® +line have allowed the +Wolverine ® +brand to introduce a broad line of work footwear with a focus on +comfort. The +Wolverine ® +work product line features work boots and shoes with protective +features such as toe caps, metatarsal guards and electrical +hazard protection; the target consumers for the +Wolverine ® +work product line are industrial and farm workers. The +Wolverine ® +rugged casual and outdoor sport product lines incorporate +DuraShocks ® , +Wolverine +iCS tm +and other technologies and comfort features into products +designed for casual and outdoor sport use. The target consumers +for the +5 +Table of Contents +rugged casual line products have active lifestyles. The outdoor +sport line is designed to meet the needs of hunters, fishermen +and other active outdoor sports enthusiasts. +Wolverine ® +Apparel and Licensing: The Wolverine Footwear +Group markets a line of work and rugged casual +Wolverine ® +brand apparel. In addition, the Company licenses its +Wolverine ® +brand for use on eyewear and gloves. +Bates ® +Uniform Footwear: The Bates Uniform Footwear +Division is a leader in supplying footwear to military and +civilian uniform users. The Bates Uniform Footwear Division +utilizes +DuraShocks ® , +DuraShocks +SR tm , +CoolTech , Wolverine +iCS tm +and other proprietary comfort technologies in the design of its +military-style boots and oxfords. The Bates Uniform Footwear +Division contracts with the U.S. Department of Defense and +the military branches of several foreign countries to supply +military footwear. Civilian uniform users include individuals in +police, security, postal, restaurant and other industrial +occupations. The Bates Uniform Footwear Division’s products +are also distributed through specialty retailers and catalogs. +HyTest ® +Safety Footwear: The +HyTest ® +product line consists primarily of high-quality work boots and +shoes that incorporate various specialty safety features +designed to protect against hazards of the workplace, including +steel toe, composite toe, metatarsal guards, and electrical +hazard, static dissipating and conductive footwear. +HyTest ® +footwear is distributed primarily through a network of +independently owned +Shoemobile ® +mobile truck retail outlets providing direct sales of the +Company’s occupational and work footwear brands to workers +at industrial facilities and also through direct sales +arrangements with large industrial customers. +3. +The Heritage Brands Group The Heritage +Brands Group consists of +Cat ® +Footwear, +Harley-Davidson ® +Footwear and the +Sebago ® +product line. +Cat ® +Footwear: Pursuant to a license arrangement +with Caterpillar Inc., the Company has exclusive footwear +marketing and distribution rights under +Caterpillar ® , +Cat ® , +Cat & Design, Walking +Machines ® +and other trademarks. The Company believes the association with +Cat ® +equipment encourages customers to characterize the footwear as +high-quality, rugged and durable. +Cat ® +brand footwear products include work boots and shoes, sport +boots, rugged casual and lifestyle footwear, including lines of +work and casual footwear featuring +iTechnology tm +and Hidden +Tracks ® +comfort features. +Cat ® +footwear targets work and industrial users and active lifestyle +users. +Cat ® +footwear is marketed in approximately 145 countries and +territories worldwide. +Cat ® , +Caterpillar ® , +Cat & Design and Walking +Machines ® +are registered trademarks of Caterpillar Inc. +Harley-Davidson ® +Footwear: Pursuant to a license arrangement +with the Harley-Davidson Motor Company, the Company has the +exclusive footwear marketing and distribution rights for +Harley-Davidson ® +branded footwear. +Harley-Davidson ® +branded footwear products include motorcycle, casual, fashion, +work and western footwear for men, women and children. +Harley-Davidson ® +footwear is sold globally through a network of independent +Harley-Davidson ® +dealerships, department stores and specialty retailers. +Harley-Davidson ® +is a registered trademark of H-D Michigan, Inc. +Sebago ® : The +Sebago ® +product line has been marketed since 1946 and consists primarily +of performance nautical and American-inspired casual footwear +for men and women, such as boat shoes and hand sewn loafers. +Highly recognized +Sebago ® +line extensions include Sebago +Docksides tm , +Drysides tm +and Athletic Marine. The +Sebago ® +product line is marketed in approximately 125 countries and +territories worldwide. The +Sebago ® +manufacturing and design tradition of quality components, +durability, comfort and “Americana” heritage is +further supported by targeted distribution to better-grade +independent, marine and department store retailers throughout +the world. The Company also markets a classic and marine +Sebago ® +apparel line. +6 +Table of Contents +4. +The Hush Puppies Group +Hush +Puppies ® : Since +1958, the Hush +Puppies ® +brand has been a leader in casual footwear. The brand offers +shoes, sandals and boots for men, women and children, and is +marketed in approximately 140 countries and territories. The +modern styling is complemented by a variety of comfort features +and proprietary technologies that have earned the brand its +reputation for comfort, style and value. In addition, the +Hush +Puppies ® +brand is licensed for use on certain items, including apparel, +eyewear, handbags, socks, watches and plush toys. +Soft +Style ® : The +Soft +Style ® +product line consists primarily of women’s dress and casual +footwear. +Cushe ® : The +Cushe ® +business was acquired in January 2009 and focuses on relaxed, +design-led footwear for active men and women. The +Cushe ® +Footwear business targets younger adult consumers and +better-grade retailers with products ranging from sport casual +footwear to sandals. +Cushe ® +is marketed under three primary collections: Universal Traveler, +Urban Safari and Coastal Supremacy. +Other +Businesses +In addition to its branded footwear, apparel and licensing +operations, the Company also (i) operates 81 retail stores +in North America and 7 retail stores in the United Kingdom that +feature footwear and apparel, (ii) operates a performance +leathers business through its Wolverine Leathers Division; and +(iii) purchased and cured raw pigskins for sale to various +customers through its wholly-owned subsidiary, Wolverine +Procurement, Inc. +1. +Wolverine Retail The Company’s +consumer-direct business operates 81 North American and +7 United Kingdom-based retail stores as of February 2011. +These stores are operated under the Hush +Puppies ® , +Hush Puppies and +Family SM , +Track’N +Trail ® , +Rockford Footwear +Depot ® +and +Merrell ® +names. The Rockford Footwear +Depot ® , +Track’N +Trail ® , +Hush +Puppies ® +and Hush Puppies and +Family SM +retail formats carry a large selection of Company-branded +products, featuring such brands as +Wolverine ® , +Merrell ® , +Hush +Puppies ® , +Cat ® , +Chaco ® , +Cushe ® , +Patagonia ® , +Sebago ® +and +Harley-Davidson ® . +The Company also operates +Merrell ® +concept stores and Hush +Puppies ® +concept stores, providing a platform to showcase these brands +exclusively. In addition, the Company operates 38 +consumer-direct retail websites, including, www.merrell.com, +www.wolverine.com, www.hushpuppies.com , www.chacousa.com, +www.cushe.com, www.catfootwear.com , www.sebago.com, and +www.batesfootwear.com . +2. +The Wolverine Leathers Division The +Wolverine Leathers Division markets pigskin leather primarily +for use in the footwear industry. The Company believes pigskin +leather offers superior performance and other advantages over +cowhide leather. The Company’s waterproof and stain +resistant leathers are featured in some of the Company’s +footwear lines and many products offered by the Company’s +international licensees and distributors. +3. +Wolverine Procurement, Inc . Wolverine +Procurement, Inc. performs skinning operations and purchases raw +pigskins from third parties, which it cures and sells to outside +customers for processing into pigskin leather products. +Substantially all of the assets of Wolverine Procurement, Inc. +were sold to a third-party buyer on December 29, 2010. +Marketing +The Company’s marketing strategy is to develop +brand-specific plans and related promotional materials for +U.S. and international markets to foster a consistent +message for each of the Company’s core brands. Each brand +group has dedicated marketing personnel who develop the +marketing strategy for brands within that group. Marketing +campaigns and strategies vary by brand and are designed to +target accounts +and/or end +users as the brand groups +7 +Table of Contents +strive to increase awareness of, and affinity for, the +Company’s brands. The Company’s advertisements +typically emphasize fashion, comfort, quality, durability, +functionality and other performance and lifestyle aspects of the +Company’s products. Components of the brand-specific plans +vary and may include print, radio and television advertising, +social networking sites, event sponsorships, in-store +point-of-purchase +displays, promotional materials, and sales and technical +assistance. +The Company’s brand groups provide its licensees and +distributors with creative direction, brand images and other +materials to convey consistent brand messaging, including +(i) direction on the categories of footwear to be promoted, +(ii) photography and layouts, (iii) broadcast +advertising, including commercials and film footage, +(iv) point-of-purchase +presentation specifications, blueprints and packaging, +(v) sales materials and (vi) consulting services +regarding retail store layout and design. The Company believes +its brand names provide it with a competitive advantage and the +Company makes significant expenditures on marketing and +promotion to support the position of its products and enhance +brand awareness. +Domestic +Sales and Distribution +The Company uses a wide variety of domestic distribution +channels and strategies to distribute its branded products: +• +The Company uses a dedicated sales force and customer service +team, advertising and +point-of-purchase +support and maintains in-stock inventories to service +consumer-direct business, department stores, national chains, +specialty retailers, catalogs, independent retailers and uniform +outlets. +• +Volume direct programs ship products directly to the retail +customer without going through a Company distribution center and +provide products at competitive prices with limited marketing +support. The Company uses these programs to service major +retail, catalogs, mass merchant and government customers. +• +A network of independent +Shoemobile ® +distribution outlets distributes the Company’s work and +occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military +and submits bids for contracts to supply specific footwear +products. Such contracts typically contain future purchase +options that are not required to be exercised. +In addition to its wholesale activities, the Company also +operates a consumer-direct business as described above. The +Company continues to develop new programs, both independently +and in conjunction with its consumer-direct customers, for the +distribution of its products. +A broad distribution base insulates the Company from dependence +on any one customer. No customer of the Company accounted for +more than 10% of the Company’s revenue in fiscal 2010. +The Company experiences moderate fluctuations in sales volume +during the year as reflected in quarterly revenue (and taking +into consideration the 16 weeks or 17 weeks included +in the Company’s fourth accounting quarter versus the +12 weeks included in the first three accounting quarters). +The Company expects current seasonal sales patterns to continue +in future years. The Company also experiences some fluctuation +in its levels of working capital, typically including an +increase in working capital requirements near the end of the +first and third quarters. The Company meets its working capital +requirements through effective cash generation and, as needed, a +revolving credit agreement. +International +Operations and Global Licensing +The Company’s foreign-sourced revenue is generated from a +combination of (i) sales of branded footwear and apparel +through the Company’s owned operations in Canada, the +United Kingdom and approximately eight branch offices in Europe; +(ii) sales to third-party distributors for certain markets +and businesses; and (iii) royalty income from a network of +third-party licensees and distributors. The Company’s owned +operations are located in markets where the Company believes it +can gain a strategic advantage by directly controlling the sale +of its products into +8 +Table of Contents +retail accounts. License and distribution arrangements enable +the Company to develop sales in other markets without the +capital commitment required to maintain related foreign +operations, employees, inventories or localized marketing +programs. +The Company continues to develop its network of licensees and +distributors to market its branded products. The Company assists +its licensees in designing products that are appropriate to each +foreign market, but consistent with the global brand position. +Pursuant to distribution or license agreements, third-party +licensees and distributors either purchase goods from the +Company or authorized third-party manufacturers or manufacture +branded products consistent with Company standards. Distributors +and licensees are responsible for independently marketing and +distributing Company branded products in their respective +territories, with product and marketing support from the Company. +Manufacturing +and Sourcing +The Company directly controls the majority of the units of +footwear and apparel manufactured or sourced under the +Company’s brand names. The balance is controlled directly +by the Company’s licensees. A substantial majority of the +units sourced +and/or +manufactured by the Company are purchased or sourced from third +parties, with the remainder produced at Company-owned +facilities. The Company sources a majority of its footwear from +numerous third-party manufacturers in the Asia-Pacific region, +South America and India. The Company maintains offices in the +Asia-Pacific region to facilitate and develop strategies for the +sourcing and importation of quality footwear and apparel. The +Company has established guidelines for each of its third-party +manufacturers in order to monitor product quality, labor +practices and financial viability. The Company has adopted +“Engagement Criteria for Partners & +Sources,” a policy that requires that the Company’s +domestic and foreign manufacturers, licensees and distributors +use ethical business standards; comply with all applicable +health and safety laws and regulations; commit to use +environmentally safe practices; treat employees fairly with +respect to wages, benefits and working conditions; and not use +child or prison labor. Footwear produced by the Company is +manufactured at Company-operated facilities located in Michigan +and the Dominican Republic. +The Company’s owned manufacturing operations allow the +Company to (i) reduce its production lead time, enabling it +to more quickly respond to market demand and reduce inventory +risk, (ii) lower freight, shipping and duty costs for sales +to certain markets, and (iii) more closely monitor product +quality. The Company’s third-party sourcing strategy allows +the Company to (i) benefit from lower manufacturing costs +and +state-of-the-art +manufacturing facilities, (ii) source high quality raw +materials from around the world, and (iii) avoid capital +expenditures necessary for additional owned factories. The +Company believes that its overall global manufacturing strategy +provides the flexibility to properly balance the need for timely +shipments, high quality products and competitive pricing. +The Company’s principal required raw material is quality +leather, which it purchases from a select group of domestic and +foreign suppliers. The global availability of common upper +materials and specialty leathers eliminates any reliance by the +Company on a sole supplier. +The Company currently purchases all of the raw pigskins used for +its Wolverine Leathers Division from one domestic source, which +has been a reliable and consistent supplier for over +30 years. Alternative sources of raw pigskin are available, +but with less advantageous pricing, quality and compatibility +with the Company’s processing method. The Company purchases +all of its other raw materials and component parts from a +variety of sources and does not believe that any of these +sources are a dominant supplier. +The Company is subject to the normal risks of doing business +abroad due to its international operations, including the risk +of expropriation, acts of war or terrorism, political +disturbances and similar events, the imposition of trade +barriers, quotas, tariffs and duties, loss of most favored +nation trading status and currency and exchange rate +fluctuations. With respect to international sourcing activities, +management believes that over a period of time, it could arrange +adequate alternative sources of supply for the products +currently obtained from its foreign suppliers, but that a +sustained disruption of such sources of supply could have an +adverse impact on the Company’s results of operations and +financial position. +9 +Table of Contents +Trademarks, +Licenses and Patents +The Company holds a significant portfolio of registered and +common law trademarks that identify its branded products. The +Company’s owned trademarks include Hush +Puppies ® , +Wolverine ® , +Bates ® , +Cushe ® , +Chaco ® , +Soft +Style ® , +Wolverine +Fusion ® , +DuraShocks ® , +MultiShox ® , +Wolverine +Compressor ® , +Hidden +Tracks ® , +iTechnology tm , +Bounce ® , +Comfort +Curve ® , +HyTest ® , +Merrell ® , +M Circle Design (registered design trademark), +Continuum ® , +Sebago ® , +Q +Form ® +and Track ’N +Trail ® . +The Company’s Wolverine Leathers Division markets its +pigskin leathers under the trademarks Wolverine Warrior +Leather ® , +Weather +Tight ® +and All Season Weather +Leathers tm . +The Company has exclusive footwear marketing and distribution +rights under the +Cat ® , +Harley-Davidson ® and +Patagonia ® +trademarks pursuant to license arrangements with the respective +trademark owners. The +Cat ® , +Harley-Davidson ® , +and +Patagonia ® +licenses extend for five or more years and are subject to early +termination for breach. +The Company believes that consumers identify its products by the +Company’s trademarks and that its trademarks are valuable +assets. The Company is not aware of any infringing uses or any +prior claims of ownership of its trademarks that could +materially affect its current business. The Company has a policy +of registering its primary trademarks and vigorously defending +its trademarks against infringement or other threats whenever +practicable. The Company also holds many design and utility +patents, copyrights and various other proprietary rights. The +Company vigorously protects its proprietary rights under +applicable laws. +Order +Backlog +At February 19, 2011, the Company had an order backlog of +approximately $628 million compared to an order backlog of +approximately $424 million at February 20, 2010, +determined on a consistent basis. All of the backlog relates to +orders for products expected to be shipped in 2011. Orders in +the backlog are subject to cancellation by customers and to +changes in planned customer demand or at-once orders. The +backlog at any particular time is affected by a number of +factors, including seasonality, retail conditions, expected +customer demand, product availability and the schedule for the +manufacture and shipment of products. Accordingly, a comparison +of backlog from period to period is not necessarily meaningful +and may not be predictive of eventual actual shipments. +Competition +The Company markets its footwear and apparel lines in a highly +competitive and fragmented environment. The Company competes +with numerous domestic and international marketers and +importers, some of which are larger and have greater resources +than the Company. The Company has at least forty major +competitors for its brands of footwear and apparel. Product +performance and quality, including technological improvements, +product identity, competitive pricing and ability to control +costs, and the ability to adapt to style changes are all +important elements of competition in the footwear and apparel +markets served by the Company. The footwear and apparel +industries in general are subject to changes in consumer +preferences. The Company strives to maintain its competitive +position through promotions designed to increase brand +awareness, manufacturing and sourcing efficiencies, and the +style, comfort and value of its products. Future sales by the +Company will be affected by its continued ability to sell its +products at competitive prices and to meet shifts in consumer +preferences. +Because of the lack of reliable published statistics, the +Company is unable to state with certainty its competitive +position in the footwear and apparel industries. Market shares +in the non-athletic footwear and apparel industry are highly +fragmented and no one company has a dominant market position. +Research +and Development +In addition to normal and recurring product development, design +and styling activities, the Company engages in research and +development activities related to the development of new +production techniques and to the improvement of the function, +performance, reliability and quality of its branded footwear and +other products. For example, the Company’s continuing +relationship with the Biomechanics Evaluation Laboratory at +Michigan +10 +Table of Contents +State University has helped validate and refine specific +biomechanical design concepts, such as +Bounce ® , +DuraShocks ® +and Hidden +Tracks ® +comfort technologies, which have been incorporated in the +Company’s footwear. While the Company expects to continue +to be a leading developer of footwear innovations, research and +development costs do not represent a material portion of +operating expenses. +Environmental +Matters +Compliance with domestic and foreign federal, state and local +requirements regulating the discharge of materials into the +environment, or otherwise relating to the protection of the +environment have not had, nor are they expected to have, any +material effect on the capital expenditures, earnings or +competitive position of the Company. The Company uses and +generates certain substances and wastes that are regulated or +may be deemed hazardous under certain federal, state and local +regulations with respect to the environment. The Company works +with domestic and foreign federal, state and local agencies from +time to time to resolve cleanup issues at various waste sites +and other regulatory issues. +Employees +As of January 1, 2011, the Company had approximately 4,139 +domestic and foreign production, office and sales employees. +Approximately 51 employees were covered by a single union +contract that expires on March 31, 2011. The Company +presently considers its employee relations to be good. +Available +Information +Information about the Company, including the Company’s Code +of Conduct & Compliance, Corporate Governance +Guidelines, Director Independence Standards, Accounting and +Finance Code of Ethics, Audit Committee Charter, Compensation +Committee Charter, and Governance Committee Charter, is +available at its website at +www.wolverineworldwide.com/investor-relations/corporate-governance . +Printed copies of the documents listed above are available, +without charge, by writing to the Company at 9341 Courtland +Drive, N.E., Rockford, Michigan 49351, Attention: General +Counsel. +The Company also makes available on or through its website, free +of charge, the Company’s Annual Report on +Form 10-K, +quarterly reports on +Form 10-Q +and current reports on +Form 8-K, +and amendments to those reports (along with certain other +Company filings with the Securities and Exchange Commission +(“SEC”)) as soon as reasonably practicable after +electronically filing such material with, or furnishing it to, +the SEC. These materials are also accessible on the SEC’s +website at www.sec.gov . \ No newline at end of file diff --git a/raw/filings/0000110471/2010/0000950123-11-021208/item13.txt b/raw/filings/0000110471/2010/0000950123-11-021208/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..0fbe257ee67e8bb9c057ca4fa2ced94ff6b0643b --- /dev/null +++ b/raw/filings/0000110471/2010/0000950123-11-021208/item13.txt @@ -0,0 +1,16 @@ +Item 13. +Certain +Relationships and Related Transactions, and Director +Independence +The information contained under the caption “Related Party +Matters” under the subheadings “Certain Relationships +and Related Transactions” and “Related Person +Transactions Policy” contained in the Definitive Proxy +Statement of the Company with respect to the Annual Meeting of +Stockholders to be held on April 21, 2011, is incorporated +herein by reference. The information contained under the caption +“Corporate Governance” under the subheading +“Director Independence” contained in the Definitive +Proxy Statement of the Company with respect to the Annual +Meeting of Stockholders to be held on April 21, 2011, is +incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000110471/2010/0000950123-11-021208/item9a.txt b/raw/filings/0000110471/2010/0000950123-11-021208/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..5576269c4223ba01d4daf21ac871000940933c53 --- /dev/null +++ b/raw/filings/0000110471/2010/0000950123-11-021208/item9a.txt @@ -0,0 +1,43 @@ +Item 9A. +Controls +and Procedures +Evaluation +of Disclosure Controls and Procedures +An evaluation was performed under the supervision and with the +participation of the Company’s management, including the +Chief Executive Officer and Chief Financial Officer, of the +effectiveness of the design and operation of the Company’s +disclosure controls and procedures. Based on and as of the time +of such evaluation, the Company’s management, including the +Chief Executive Officer and Chief Financial Officer, concluded +that the Company’s disclosure controls and procedures were +effective as of the end of the period covered by this report. +Management’s +Report on Internal Control Over Financial Reporting +Management is responsible for establishing and maintaining +adequate internal control over financial reporting, as such term +is defined in Securities Exchange Act +Rule 13a-15(f). +Under the supervision and with the participation of management, +including our Chief Executive Officer and Chief Financial +Officer, we conducted an evaluation of the effectiveness of +internal control over financial reporting as of January 1, +2011, based on the framework in Internal Control — +Integrated Framework issued by the Committee of Sponsoring +Organizations of the Treadway Commission (“COSO”). +Based on that evaluation, management concluded that internal +control over financial reporting was effective as of +January 1, 2011. +The effectiveness of the Company’s internal control over +financial reporting as of January 1, 2011, has been audited +by Ernst & Young LLP, an independent registered public +accounting firm, as stated in its report, which is included in +Appendix A and is incorporated into this Item 9A by +reference. +Changes +in Internal Control Over Financial Reporting +There was no change in the Company’s internal control over +financial reporting that occurred during the sixteen-week period +ended January 1, 2011 that has materially affected, or that +is reasonably likely to materially affect, the Company’s +internal control over financial reporting. \ No newline at end of file diff --git a/raw/filings/0000110471/2010/0000950123-11-021208/rp_note.txt b/raw/filings/0000110471/2010/0000950123-11-021208/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000110471/2010/0000950123-11-021208/rpt_disclosure.txt b/raw/filings/0000110471/2010/0000950123-11-021208/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..1ab27e11481d9b32c84442691142a1096910f62b --- /dev/null +++ b/raw/filings/0000110471/2010/0000950123-11-021208/rpt_disclosure.txt @@ -0,0 +1,55 @@ +Certain Relationships and Related Transactions +Wolverine Worldwide has entered into agreements with Grimoldi, S.A., an Argentinean corporation of which Mr. Alberto L. Grimoldi, a +director of Wolverine Worldwide, is chairman and a 35% shareholder. The agreements grant Grimoldi, S.A. the exclusive rights to distribute and sell footwear products in Argentina under the Hush Puppies ® , Caterpillar ® , and Patagonia ® brand names, and footwear and apparel under the Merrell ® brand name. Grimoldi, S.A. or its subsidiary purchases products, samples, footwear components, advertising materials and miscellaneous items from Wolverine Worldwide +or pays Wolverine Worldwide royalties and certain sublicense fees based on sales or purchases of products in Argentina. Grimoldi, S.A. was obligated to pay Wolverine Worldwide purchase prices, royalties, sublicense fees, service fees and interest +relating to purchases made or royalties and fees incurred in fiscal year 2011 totaling $5,462,805. All of the transactions described above occurred pursuant to continuing contractual arrangements between Wolverine Worldwide and Grimoldi, S.A. +Wolverine Worldwide expects similar transactions to occur between Grimoldi, S.A. and Wolverine Worldwide and its subsidiaries during 2012. +In the +ordinary course of its business, Wolverine Worldwide purchases promotional merchandise for use in connection with the sale of its products. In fiscal year 2011, Wolverine Worldwide purchased promotional merchandise from Bullseye Group, LLC totaling +$217,863. One-third of Bullseye Group, LLC is owned by Daniel Mehney, the son of David P. Mehney, a director of Wolverine Worldwide. Wolverine Worldwide anticipates purchasing promotional materials from Bullseye Group, LLC in 2012. +The Governance Committee reviewed and approved or ratified each of these transactions in accordance with Wolverine Worldwide’s related person transactions +policy, as described below. +Related Person Transactions Policy +Wolverine Worldwide’s Board adopted written policies and procedures regarding related person transactions. They require the Governance Committee to review and either approve or disapprove the Company entering +into any Interested Transactions (defined below). If advance approval is not feasible, then the Governance Committee must review and ratify the Interested Transaction at its next meeting. +Interested Transaction +Any transaction, arrangement or relationship or series of similar +transactions, arrangements or relationships (including any indebtedness or guarantee of indebtedness) in which: +(1) the aggregate amount involved is or is expected +to exceed $100,000 since the beginning of Wolverine Worldwide’s last completed fiscal year; +(2) Wolverine Worldwide is a participant; +and +(3) any Related Person (defined +below) has or will have a direct or indirect interest (other than solely as a result of being a director or less than ten percent beneficial owner of another entity). +Related Person +Any: +(a) person who is or was at any point during the +last fiscal year for which Wolverine Worldwide filed a Form 10-K and proxy statement, an executive officer, director or nominee for election as a director; +(b) greater than five percent beneficial owner of +Wolverine Worldwide’s common stock; or +(c) immediate family member * of any of the foregoing. +* +Immediate family member includes a person’s spouse, parents, stepparents, children, stepchildren, siblings, mothers- and fathers-in- law, sons- and daughters-in-law, and +brothers- and sisters-in-law and anyone residing in such person’s home (other than a tenant or employee). +The Governance Committee +considers whether the Interested Transaction is on terms no less favorable than terms generally available to an unaffiliated third-party under the same or similar circumstances, the extent of the Related Person’s interest in the +Page 63 +Table of Contents +Wolverine Worldwide Notice of 2012 Annual Meeting of Stockholders and Proxy Statement +transaction, and other factors that it deems relevant. No director participates in any discussion or approval of an Interested Transaction for which he or she is a Related Person, except to +provide all material information to the Governance Committee. +The following Interested Transactions are pre-approved under the policies and procedures: +(a) +any transaction with another company where a Related Person’s only relationship is as an employee, director or beneficial owner of less than ten percent of that +company’s shares, if the aggregate amount involved does not exceed the greater of $1,000,000, or two percent of that company’s total revenues. +(b) +any charitable contribution by Wolverine Worldwide to a charitable organization where a Related Person is an employee, if the aggregate amount involved does not exceed the lesser +of $100,000, or two percent of the charitable organization’s total annual receipts. +ADDITIONAL +INFORMATION +Stockholders List +A list of stockholders entitled to vote at the meeting will be available for review by Wolverine Worldwide stockholders at the office of R. Paul Guerre, Secretary, +Wolverine World Wide, Inc., 9341 Courtland Drive, N.E., Rockford, Michigan 49351, during ordinary business hours for the 10-day period before the meeting. +Director and Officer Indemnification +The Company indemnifies its directors and NEOs to the fullest extent +permitted by law so that they will be free from undue concern about personal liability in connection with their service to the Company. \ No newline at end of file diff --git a/raw/filings/0000110471/2011/0001193125-12-089426/filing.txt b/raw/filings/0000110471/2011/0001193125-12-089426/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..d398b2eaec2a2dd1178573399ee34db2e932f0c2 --- /dev/null +++ b/raw/filings/0000110471/2011/0001193125-12-089426/filing.txt @@ -0,0 +1,5023 @@ +10-K +1 +d268216d10k.htm +FORM 10-K +Form 10-K +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +þ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2011 +¨ +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: +001-6024 +WOLVERINE WORLD WIDE, INC. +(Exact name of registrant as specified in its charter) +Delaware +38-1185150 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer +Identification No.) +9341 Courtland Drive N.E., +Rockford, Michigan +49351 +(Address of principal executive offices) +(Zip Code) +Registrant’s telephone number, including area code: (616) 866-5500 +Securities registered pursuant to Section 12(b) of the Securities Exchange Act: +Title of each class +Name of each exchange on which registered +Common Stock, $1 Par Value +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities +Act. Yes þ No ¨ +Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the +Act. Yes ¨ No þ +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 þ 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 þ No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will +not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ +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 +þ +Accelerated filer +¨ +Non-accelerated filer +¨ (Do not check if a smaller reporting company) +Smaller reporting company +¨ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the +Act). Yes ¨ No þ +The aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant based on the closing price on +the New York Stock Exchange on June 17, 2011, the last business day of the registrant’s most recently completed second fiscal quarter: $1,851,731,010. Number of shares outstanding of the registrant’s Common Stock, $1 par value as of +February 24, 2012: 48,662,725. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the definitive proxy statement for the registrant’s annual stockholders’ meeting to be held April 19, 2012 are incorporated by reference into Part III of this report. +Table of Contents +Table of Contents +PART I +4 +Item 1. +Business +4 +Item 1A. +Risk Factors +11 +Item 1B. +Unresolved Staff Comments +18 +Item 2. +Properties +18 +Item 3. +Legal Proceedings +19 +Supplemental Item. +Executive Officers of the Registrant +19 +Item 4. +Mine Safety Disclosures +20 +PART II +20 +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +20 +Item 6. +Selected Financial Data +22 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +23 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +37 +Item 8. +Financial Statements and Supplementary Data +37 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +37 +Item 9A. +Controls and Procedures +37 +Item 9B. +Other Information +38 +PART III +38 +Item 10. +Directors, Executive Officers and Corporate Governance +38 +Item 11. +Executive Compensation +38 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +39 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +40 +Item 14. +Principal Accountant Fees and Services +40 +PART IV +41 +Item 15. +Exhibits and Financial Statement Schedules +41 +SIGNATURES +46 +2 +Table of Contents +FORWARD-LOOKING STATEMENTS +This document contains “forward-looking statements,” which are statements relating to future, not past, events. In this context, forward-looking statements often address management’s +current beliefs, assumptions, expectations, estimates and projections about future business and financial performance, global political, economic and market conditions, and the Company itself. Such statements often contain words such as +“anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “plans,” “predicts,” “projects,” “should,” +“will,” variations of such words, and similar expressions. Forward-looking statements, by their nature, address matters that are, to varying degrees, uncertain. Uncertainties that could cause the Company’s performance to differ +materially from what is expressed in forward-looking statements include, but are not limited to, the following: +• +changes in national, regional or global economic and market conditions; +• +the impact of financial and credit markets on the Company, its suppliers and customers; +• +changes in interest rates, tax laws, duties, tariffs, quotas or applicable assessments in countries of import and export; +• +the impact of regulation, regulatory and legal proceedings, and legal compliance risks; +• +currency fluctuations; +• +changes in future pension funding requirements or pension expenses; +• +the risks of doing business in developing countries, and politically or economically volatile areas; +• +the ability to secure and protect owned intellectual property or use licensed intellectual property; +• +changes in consumer preferences, spending patterns, buying patterns, price sensitivity or demand for the Company’s products; +• +changes in relationships with, including the loss of, significant customers; +• +the cancellation of orders for future delivery; +• +the failure of the Department of Defense to exercise future purchase options or award new contracts, or the cancellation or modification of existing +contracts by the Department of Defense or other military purchasers; +• +the cost, availability and management of raw materials, inventories, services and labor for owned and contract manufacturers; +• +service interruptions at shipping and receiving ports; +• +the inability for any reason to effectively compete in global footwear, apparel and consumer-direct markets; +• +strategic actions, including new initiatives and ventures, acquisitions and dispositions, and our success in integrating acquired businesses and +implementing new initiatives and ventures; and +• +many other matters of national, regional and global scale, including those of a political, environmental, economic, business and competitive nature. +These uncertainties could cause a material difference between a forward-looking statement and an actual outcome. The +uncertainties included here are not exhaustive and are described in more detail in Part I, Item 1A, “Risk Factors” of this Annual Report on Form 10-K. The Company does not undertake an obligation to update, amend or clarify +forward-looking statements, whether as a result of new information, future events or otherwise. +3 +Table of Contents +PART I +Item 1. Business +General +Wolverine World Wide, Inc. (the “Company”) is a leading designer, +manufacturer and marketer of a broad range of quality casual footwear and apparel, performance outdoor footwear and apparel, industrial work shoes, boots and apparel, and uniform shoes and boots. The Company, a Delaware corporation, is the successor +of a Michigan corporation of the same name, originally organized in 1906, which, in turn, was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Approximately 52 million pairs/units of the Company’s branded footwear and apparel were sold in the fiscal year ended +December 31, 2011 (“fiscal year 2011”) in more than 190 countries and territories around the world. The Company’s products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort +and performance. The products are marketed under widely recognized brand names, including Bates ® , +Cat ® Footwear, Chaco ® , Cushe ® , +Harley-Davidson ® Footwear, Hush Puppies ® , HyTest ® , +Merrell ® , Patagonia ® Footwear, Sebago ® , +Soft Style ® and Wolverine ® . The Company believes that its primary competitive advantages are its well-recognized brand names, its patented proprietary designs and comfort technologies, its wide +range of distribution channels and its diversified manufacturing and sourcing base. Cat ® is a registered +trademark of Caterpillar, Inc., Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. and +Patagonia ® is a registered trademark of Patagonia, Inc. +The Company’s brands are sold at various price points targeting a wide range of consumers of casual, work and outdoor footwear +and apparel. The Company also licenses some of its brands for use on products other than footwear or apparel. The Company has one reportable segment that is engaged in designing, manufacturing, sourcing, marketing, licensing and distributing branded +footwear, apparel and accessories. In January 2011, the Company realigned the operating groups included in the branded footwear, apparel and licensing reportable segment. As a result, the Company now identifies three operating groups within its +reportable segment: (i) the Outdoor Group , consisting of Merrell ® , Patagonia ® and Chaco ® footwear, and Merrell ® +brand apparel and accessories, (ii) the Heritage Group , consisting of Wolverine ® boots and +shoes and Wolverine ® brand apparel, and Cat ® footwear, Bates ® , +Harley-Davidson ® footwear and HyTest ® footwear, and (iii) the Lifestyle Group , consisting of Hush Puppies ® footwear and apparel, +Sebago ® footwear and apparel, and Cushe ® and Soft Style ® +footwear. +The Company’s Global Operations Group is responsible for manufacturing, sourcing, distribution and customer +support. The Company directly sells its products in the United States, Canada and certain countries in Europe to a wide range of retail customers, including department stores, national chains, catalogs, specialty retailers, mass merchants and +Internet retailers, and to governments and municipalities. Many of the retailers carrying Wolverine products operate multiple storefront locations. The Company’s products are marketed worldwide in more than 190 countries and territories through +Company-owned wholesale and retail operations, licensees and distributors. +For financial information regarding the Company, see the +consolidated financial statements and the accompanying notes, which are attached as Appendix A to this Annual Report on Form 10-K. As described above, the Company has one reportable segment, branded footwear, apparel and licensing. The +Company’s other operating groups consist of its consumer-direct operations and leathers operations, which are described below. Financial information regarding the Company’s reportable segment and other operating groups and financial +information by geographic area is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Annual Report on Form 10-K. +4 +Table of Contents +Branded Footwear, Apparel and Licensing +The Company sources and markets a broad range of footwear styles, including shoes, boots and sandals under many recognizable brand +names, including Bates ® , Cat ® , Chaco ® , Cushe ® , Harley-Davidson ® , Hush Puppies ® , +HyTest ® , Merrell ® , Patagonia ® , +Sebago ® , Soft Style ® and Wolverine ® . The +Company combines quality materials and skilled workmanship to produce footwear according to its specifications at both Company-owned and third-party manufacturing facilities. The Company also markets Merrell ® , Sebago ® , and Wolverine ® brand +apparel and accessories and licenses some of its brands for use on non-footwear products, including Hush +Puppies ® apparel, eyewear, watches, socks, handbags and plush toys and Wolverine ® brand eyewear and gloves. +The Company’s branded footwear, apparel and licensing operating groups for fiscal year 2011 are described below. +1. +The Outdoor Group The Outdoor Group consists of Merrell ® footwear, Merrell ® +apparel and accessories, Patagonia ® footwear and Chaco ® footwear. +Merrell ® Footwear: +Merrell ® footwear is designed to inspire and encourage everyone to increase participation in the +outdoors. Known for quality, durability and comfort, the Merrell ® footwear line uses a variety of +proprietary designs and technologies to create footwear with unique styling, performance and comfort features for the trail or the town. Merrell ® footwear products offer a wide range of styles from technical hiking, multi-sport footwear and the minimalist +Merrell ® Barefoot Collection to versatile, lifestyle product for more casual outdoor adventures for men, women +and kids. Merrell ® footwear products are sold primarily through outdoor specialty retailers, sporting +goods chains, department stores, on-line retailers and catalogs. Merrell ® footwear is marketed in +approximately 150 countries and territories worldwide. +Merrell ® Apparel and Accessories: The Merrell ® apparel line extends the +Merrell ® commitment to an active outdoor lifestyle with a versatile line of apparel built for the summit +or the street. The apparel line features stylized lifestyle silhouettes built with the technical, high performance, weather fighting materials that consumers expect from an outdoor brand. In addition to Merrell ® apparel, the Outdoor Group markets Merrell ® accessories, including packs, bags and luggage for men and women. +Patagonia ® Footwear: Pursuant to an agreement with +Lost Arrow Corporation, the Company has the exclusive footwear marketing and distribution rights under +Patagonia ® and other trademarks. The Patagonia ® footwear line focuses primarily on casual and outdoor performance footwear. Patagonia ® is a registered trademark of Patagonia, Inc. +Chaco ® Footwear: The Chaco ® footwear line focuses primarily on performance sandals and closed-toe products for the outdoor enthusiast. +2. +The Heritage Group The Heritage Group markets footwear, apparel and accessories products under the Wolverine ® brand and footwear under the Cat ® , Bates ® , +Harley-Davidson ® and HyTest ® brands. +Wolverine ® Footwear: +The Wolverine ® brand offers high quality boots and shoes that incorporate innovative technologies to +deliver comfort and durability. The Wolverine ® brand, which has been in existence for 129 years, markets +footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® , MultiShox ® , +Wolverine Fusion ® and Wolverine Compressor ® technologies, as well as the development of the Contour Welt ® line, have allowed the +Wolverine ® brand to offer a broad +5 +Table of Contents +line of work footwear with a focus on comfort. The +Wolverine ® work product line, whose target consumers are industrial workers, features work boots and shoes +with protective features such as toe caps, metatarsal guards and electrical hazard protection. The +Wolverine ® rugged casual and outdoor sport product lines incorporate DuraShocks ® , Wolverine iCS TM and other technologies and comfort features into products designed for casual and outdoor sport use. The target +consumers for the rugged casual line products have active lifestyles. The outdoor sport line is designed to meet the needs of hunters, fishermen and other active outdoor sports enthusiasts. +Wolverine ® Apparel and Licensing: The Heritage Group markets a line of work and rugged casual Wolverine ® brand apparel. In addition, the Company licenses its Wolverine ® brand for use on eyewear and gloves. +Cat ® Footwear: Pursuant to a license arrangement with Caterpillar, Inc., the Company has exclusive footwear marketing and distribution rights under +Caterpillar ® , Cat ® , Cat & Design, Walking +Machines ® and other trademarks. The Company believes the association with Cat ® equipment encourages customers to view the footwear as high-quality, rugged and durable. Cat ® brand footwear products include work boots and shoes, sport boots, rugged casual and lifestyle footwear, including +lines of work and casual footwear featuring iTechnology ™ and Hidden Tracks ® comfort features. +Cat ® footwear targets work and industrial users and active lifestyle users. Cat ® footwear is marketed in approximately 145 countries and territories worldwide. Cat ® , Caterpillar ® , Cat & Design and Walking Machines ® are registered trademarks of Caterpillar Inc. +Bates ® Uniform Footwear: +The Bates ® brand is a leader in supplying footwear to military and civilian uniform users. +Bates ® utilizes DuraShocks ® , DuraShocks SR ™ , +CoolTech, Wolverine iCS ™ and other proprietary comfort technologies in the design of its military-style +boots and oxford shoes. Bates ® contracts with the United States Department of Defense and the military +branches of several foreign countries to supply military footwear. Civilian uniform users include individuals in police, security, postal, restaurant and other industrial occupations. Bates ® products are also distributed through specialty retailers and catalogs. +Harley-Davidson ® Footwear: +Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has footwear marketing and distribution rights for Harley-Davidson ® branded footwear. +Harley-Davidson ® branded footwear products include motorcycle, casual, fashion, work and western footwear +for men, women and children. Harley-Davidson ® footwear is sold globally through a network of +independent Harley-Davidson ® dealerships and other retail outlets. Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. +HyTest ® Safety Footwear: The HyTest ® product line consists primarily of high-quality work boots and shoes that incorporate various specialty safety features designed to protect against hazards of the +workplace, including steel toe, composite toe, metatarsal guards, and electrical hazard, static dissipating and conductive footwear. HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company’s occupational and work footwear brands to workers at industrial facilities and also through +direct sales arrangements with large industrial customers. +3. +The Lifestyle Group The Lifestyle Group consists of Hush Puppies ® footwear and apparel, +Sebago ® footwear and apparel, and Cushe ® and Soft Style ® +footwear. +Hush Puppies ® : Since 1958, the Hush +Puppies ® brand has been a leader in casual footwear. The brand offers shoes, sandals and boots for men, +women and children, and is marketed in +6 +Table of Contents +approximately 140 countries and territories. The modern styling is complemented by a variety of comfort features and proprietary technologies that have earned the brand its reputation for +comfort, style and value. In addition, the Hush Puppies ® brand is licensed for use on certain items, +including apparel, eyewear, handbags, socks, watches and plush toys. +Sebago ® : The Sebago ® product line has been marketed since 1946 and consists primarily of performance nautical and American-inspired casual footwear for men and women, such as boat shoes +and hand sewn loafers. Highly recognized Sebago ® line extensions include Sebago Docksides ™ , Drysides ™ and Athletic Marine. The +Sebago ® product line is marketed in approximately 125 countries and territories worldwide. The Sebago ® manufacturing and design tradition of quality components, durability, comfort and “Americana” heritage is +further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. The Company also markets a classic and marine Sebago ® apparel line. +Cushe ® : The +Cushe ® business focuses on relaxed, design-led footwear for active men and women. The Cushe ® Footwear business targets younger adult consumers and better-grade retailers with products ranging from sport casual +footwear to sandals. Cushe ® is marketed under three primary collections: Universal Traveler, Urban Safari +and Coastal Supremacy. +Soft Style ® : The Soft +Style ® product line consists primarily of women’s dress and casual footwear. +Other Businesses +In addition to its +branded footwear, apparel and licensing operations, the Company also (i) operates 89 retail stores in North America and 12 retail stores in the United Kingdom that feature footwear and apparel; and (ii) operates a performance leathers +business through its Wolverine Leathers Division. +1. +Wolverine Retail The Company’s consumer-direct business operates 89 North American and 12 United Kingdom-based retail stores at +December 31, 2011. These stores are operated under the Hush Puppies ® , Hush Puppies and +Family SM , Track’N Trail ® , Sebago ® , Wolverine Company Store, Rockford Footwear Depot ® and Merrell ® names. +The Rockford Footwear Depot ® , Track’N +Trail ® , Hush Puppies ® and Hush Puppies and Family SM +retail formats carry a large selection of Company-branded products, featuring such brands as Wolverine ® , Merrell ® , Hush +Puppies ® , Cat ® , Chaco ® , Cushe ® , Patagonia ® , Sebago ® and +Harley-Davidson ® . The Company also operates +Merrell ® concept stores, Hush Puppies ® concept stores and +Sebago ® concept stores, providing a platform to showcase these brands exclusively. In addition, the +Company operates 42 consumer-direct retail websites, including www.merrell.com, www.wolverine.com, www.cushe.com, www.hushpuppies.com , www.chacos.com, www.catfootwear.com , www.sebago.com and www.batesfootwear.com . +2. +The Wolverine Leathers Division The Wolverine Leathers Division markets pigskin leather for use primarily in the footwear industry. The Company believes +pigskin leather offers superior performance and other advantages over cowhide leather. The Company’s waterproof and stain resistant leathers are featured in some of the Company’s footwear lines and many products offered by the +Company’s international licensees and distributors. +Marketing +The Company’s marketing strategy is to develop brand-specific plans and related promotional materials for U.S. and international markets to foster a +consistent message for each of the Company’s core brands. Each brand +7 +Table of Contents +operating group has dedicated marketing personnel who develop the marketing strategy for brands within that group. Marketing campaigns and strategies vary by brand and are designed to target +accounts and/or end users as the brand operating groups strive to increase awareness of, and affinity for, the Company’s brands. The Company’s advertisements typically emphasize fashion, comfort, quality, durability, functionality and +other performance and lifestyle aspects of the Company’s products. Components of the brand-specific plans vary and may include print, radio and television advertising, search engine optimization, social networking sites, event sponsorships, +in-store point-of-purchase displays, promotional materials, and sales and technical assistance. +The Company’s brand operating groups +provide its licensees and distributors with creative direction, brand images and other materials to convey consistent brand messaging, including (i) direction on the categories of footwear to be promoted, (ii) photography and layouts, +(iii) broadcast advertising, including commercials and film footage, (iv) point-of-purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting services regarding retail store layout and +design. The Company believes its brand names represent a competitive advantage, and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution +The +Company uses a wide variety of domestic distribution channels and strategies to distribute its branded products: +• +The Company uses a dedicated sales force and customer service team, advertising and point-of-purchase support and maintains in-stock inventories to +service department stores, national chains, specialty retailers, catalogs, independent retailers, uniform outlets and its own consumer direct business. +• +Volume direct programs ship products directly to the retail customer without going through a Company distribution center and provide products at +competitive prices with limited marketing support. The Company uses these programs to service major retail, catalog, mass merchant and government customers. +• +A network of independent Shoemobile ® distribution outlets distributes the Company’s work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and submits bids for contracts to supply specific footwear products. Such contracts +typically contain future purchase options that may or may not be exercised. +In addition to its wholesale activities, the +Company also operates a consumer-direct business as described above. The Company continues to develop new programs, both independently and in conjunction with its retail customers, for the distribution of its products. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the +Company’s revenue in fiscal year 2011. +The Company experiences moderate fluctuations in sales volume during the year as reflected in +quarterly revenue (and taking into consideration the 16 weeks or 17 weeks included in the Company’s fiscal fourth quarter versus the 12 weeks included in each of the first three fiscal quarters). The Company expects current seasonal sales +patterns to continue in future years. The Company also experiences some fluctuation in its levels of working capital, typically including an increase in working capital requirements near the end of the first and third quarters. The Company meets its +working capital requirements through internal free cash flow and, as needed, a revolving credit agreement. +8 +Table of Contents +International Operations and Global Licensing +The Company’s foreign-sourced revenue is generated from a combination of (i) sales of branded footwear and apparel through the Company’s +owned operations in Canada, the United Kingdom and several branch offices in Europe; (ii) sales to third-party distributors for certain markets and businesses; and (iii) royalty income from a network of third-party licensees and +distributors. The Company’s owned operations are located in markets where the Company believes it can gain a strategic advantage by directly controlling the sale of its products into retail accounts. License and distribution arrangements enable +the Company to develop sales in other markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. +The Company continues to develop its network of licensees and distributors to market its branded products. The Company assists its licensees in designing products that are appropriate to each foreign +market, but consistent with the global brand position. Pursuant to distribution or license agreements, third-party licensees and distributors either purchase goods directly from the Company and authorized third-party manufacturers or manufacture +branded products themselves, consistent with Company standards. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and marketing support from +the Company. +Manufacturing and Sourcing +The Company directly controls the majority of the units of footwear and apparel manufactured or sourced under the Company’s brand names. The balance is controlled directly by the Company’s +licensees. A substantial majority of the units sourced and/or manufactured by the Company are purchased or sourced from third parties, with the remainder produced at Company-owned facilities. The Company sources a majority of its footwear from +numerous third-party manufacturers in the Asia Pacific region, South America and India. The Company maintains offices in the Asia Pacific region to facilitate and develop strategies for the sourcing and importation of quality footwear and apparel. +The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. The Company has adopted “Engagement Criteria for Partners & Sources,” a +policy that requires that the Company’s domestic and foreign manufacturers, licensees and distributors use ethical business standards; comply with all applicable health and safety laws and regulations; commit to use environmentally safe +practices; treat employees fairly with respect to wages, benefits and working conditions; and not use child or prison labor. Footwear produced by the Company is manufactured at Company-operated facilities located in Michigan and the Dominican +Republic. +The Company’s owned manufacturing operations allow the Company to (i) reduce its production lead time, to more quickly +respond to market demand and reduce inventory risk, (ii) lower freight, shipping and duty costs for sales to certain markets, and (iii) more closely monitor product quality. The Company’s third-party sourcing strategy allows the +Company to (i) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (ii) source high quality raw materials from around the world, and (iii) avoid capital expenditures necessary for additional owned +factories. The Company believes that its overall global manufacturing strategy provides the flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company’s principal required raw material is quality leather, which it purchases from a select group of domestic and foreign suppliers. The +global availability of common upper materials and specialty leathers eliminates any reliance by the Company on a sole supplier. +The Company +currently purchases all of the raw pigskins used for its Wolverine Leathers Division from one domestic source, which has been a reliable and consistent supplier to the Company for over 40 years. Alternative sources of raw pigskin are available, but +with less advantageous pricing, quality and compatibility with the Company’s processing method. The Company purchases all of its other raw materials and component parts from a variety of sources and does not believe that any of these sources +are a dominant supplier. +9 +Table of Contents +The Company is subject to the normal risks of doing business abroad due to its international operations, +including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas, tariffs and duties, loss of most favored nation trading status and currency and exchange rate +fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers, but that a +sustained disruption of such sources of supply could have an adverse impact on the Company’s results of operations and financial position. +Trademarks, Licenses and Patents +The Company holds a significant portfolio of registered and common law trademarks that identify its branded products. The Company’s owned trademarks include Hush Puppies ® , Wolverine ® , Bates ® , Cushe ® , Chaco ® , Soft Style ® , +Wolverine Fusion ® , DuraShocks ® , MultiShox ® , +Wolverine Compressor ® , Hidden Tracks ® , iTechnology TM , Bounce ® , Comfort Curve ® , HyTest ® , Merrell ® , M Circle +Design (registered design trademark), Continuum ® , Sebago ® , Q Form ® and Track ‘N +Trail ® . The Company’s Wolverine Leathers Division markets its pigskin leathers under the trademarks +Wolverine Warrior Leather ® , Weather Tight ® and All Season Weather Leathers ™. The Company has footwear marketing and distribution rights under the Cat ® , Harley-Davidson ® and Patagonia ® +trademarks pursuant to license arrangements with the respective trademark owners. The Cat ® , Harley-Davidson ® , and Patagonia ® licenses extend for three or more years and are subject to early termination for breach. +The Company believes that consumers identify its products by the Company’s trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims +of ownership of its trademarks that could materially affect its current business. The Company has a policy of registering its primary trademarks and vigorously defending its trademarks against infringement or other threats whenever practicable. The +Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company vigorously protects its proprietary rights under applicable laws. +Order Backlog +At December 31, 2011 the Company had an order backlog of approximately +$483 million compared to an order backlog of approximately $470 million at January 1, 2011, determined on a consistent basis. A majority of the backlog relates to orders for products expected to be shipped in 2012. Orders in the backlog are +subject to cancellation by customers and to changes in planned customer demand or at-once orders. The backlog at any particular time is affected by a number of factors, including seasonality, retail conditions, expected customer demand, product +availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be predictive of eventual actual shipments. +Competition +The Company markets its +footwear and apparel lines in a highly competitive and fragmented environment. The Company competes with numerous domestic and international marketers and importers, some of which are larger and have greater resources than the Company. The Company +has at least forty major competitors for its brands of footwear and apparel. Product performance and quality, including technological improvements, product identity, competitive pricing and ability to control costs, and the ability to adapt to style +changes are all important elements of competition in the footwear and apparel markets served by the Company. The footwear and apparel industries in general are subject to changes in consumer preferences. The Company strives to maintain its +competitive position through promotions designed to increase brand awareness, manufacturing and sourcing efficiencies, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell +its products at competitive prices and to meet shifts in consumer preferences. +10 +Table of Contents +Because of the lack of reliable published statistics, the Company is unable to state with certainty its +competitive position in the overall footwear and apparel industries. Market shares in the non-athletic footwear and apparel industry are highly fragmented, and no one company has a dominant market position. +Research and Development +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development activities related to the development of new production techniques +and to the improvement of the function, performance, reliability and quality of its branded footwear and other products. For example, the Company’s continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University +has helped validate and refine specific biomechanical design concepts, such as Bounce ® , DuraShocks ® and Hidden Tracks ® comfort technologies, which have been incorporated into the Company’s footwear. While the Company expects to continue to be a leading developer of footwear +innovations, research and development costs do not represent a material portion of operating expenses. +Environmental Matters +Compliance with domestic and foreign federal, state and local requirements regulating the discharge of materials into the environment, or +otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company. The Company uses and generates certain substances +and wastes that are regulated or may be deemed hazardous to the environment under certain federal, state and local regulations. The Company works with domestic and foreign federal, state and local agencies from time to time to resolve cleanup issues +at various waste sites and other regulatory issues. +Employees +As of December 31, 2011, the Company had approximately 4,435 domestic and foreign production, office and sales employees. Approximately 54 employees were covered by a single union contract that +expires on March 31, 2013. The Company presently considers its employee relations to be good. +Available Information +Information about the Company, including the Company’s Code of Conduct & Compliance, Corporate Governance Guidelines, Director Independence +Standards, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, and Governance Committee Charter, is available at its website at www.wolverineworldwide.com/investor-relations/corporate-governance . +Printed copies of the documents listed above are available, without charge, by writing to the Company at 9341 Courtland Drive, N.E., Rockford, Michigan 49351, Attention: General Counsel. +The Company also makes available on or through its website, free of charge, the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to +those reports (along with certain other Company filings with the Securities and Exchange Commission (“SEC”)), as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These materials +are also accessible on the SEC’s website at www.sec.gov . +Item 1A. +Risk Factors +Changes in general economic conditions and other factors affecting +consumer spending could adversely affect the Company’s sales, operating results or financial position. +The Company’s global +operations depend on factors affecting consumer disposable income and spending patterns. These factors include general economic conditions, employment rates, business conditions, interest rates +11 +Table of Contents +and tax policy. Customers may defer or cancel purchases of the Company’s products due to uncertainty about global economic conditions. Consumer confidence may decline due to recessionary +economic cycles, high interest rates on consumer or business borrowings, restricted credit availability, inflation, high levels of unemployment or consumer debt, high tax rates or other economic factors. Declining consumer confidence could adversely +affect demand for the Company’s products. Changes in the amount or severity of bad weather and the growth or decline of global footwear, apparel or consumer-direct markets could affect negatively consumer spending. A decline in demand for the +Company’s products could reduce the Company’s revenues or profit margins. +General economic conditions and regulatory factors such +as those listed above, as well as increased costs of fuel, labor, commodities, insurance and health care, may increase the Company’s cost of sales and operating expenses. Such increases could adversely affect the Company’s financial +position and results of operations. +The Company operates in competitive industries and markets. +The Company competes with a large number of marketers of footwear or apparel, and consumer-direct companies. Some of these competitors are larger and +have greater resources than the Company. Important elements of such competition are product performance and quality, including technological improvements, product identity, competitive pricing and the ability to adapt to style changes. Consumer +preferences and, as a result, the popularity of particular designs and categories of footwear and apparel generally change over time. The Company strives to maintain and improve its competitive position by monitoring and responding to changes in +consumer preferences, increasing brand awareness, gaining sourcing efficiencies, and enhancing the style, comfort and perceived value of its products. The Company’s continued ability to sell its products at competitive prices and to meet shifts +in consumer preferences will affect its future sales. If the Company is unable to respond effectively to competitive pressures and changes in consumer spending, its results of operations and financial position may be adversely affected. +Many of the Company’s competitors have more developed consumer and customer bases, lower prices, or greater financial, technical or marketing +resources than the Company, particularly in the apparel and consumer-direct businesses. The Company’s competitors may implement more effective marketing campaigns; adopt more aggressive pricing policies; make more attractive offers to potential +employees, distribution partners and manufacturers; or respond more quickly to changes in consumer preferences, than the Company. The Company’s results of operations and financial position could be adversely affected if the Company’s +businesses are not successful. +The Company’s operating results depend on effectively managing inventory levels. +The Company’s ability to manage its inventories effectively is an important factor in its operations. Inventory shortages can impede the +Company’s ability to meet orders, adversely affect the timing of shipments to customers, and, consequently, diminish brand loyalty. Conversely, excess inventories can result in lower gross margins if the Company lowers prices in order to +liquidate excess inventories. The Company’s business, results of operations and financial position could be adversely affected if the Company is unable to effectively manage its inventory. +Increases or changes in duties, quotas, tariffs and other trade restrictions could adversely impact the Company’s sales and profitability. +All of the Company’s products manufactured overseas and imported into the U.S., the European Union and other countries are subject +to customs duties collected by customs authorities. Customs information submitted by the Company is routinely subject to review by customs authorities. Additional U.S. or foreign customs duties, quotas, tariffs, anti-dumping duties, safeguard +measures, cargo restrictions to prevent terrorism or other trade restrictions may be imposed on the importation of the Company’s products in the future. The imposition of such +12 +Table of Contents +costs or restrictions in foreign countries where the Company operates, as well as in countries where the Company’s third-party distributors and licensees operate, could result in increases +in the cost of the Company’s products generally and could adversely affect the sales and profitability of the Company. +Foreign +currency exchange rate fluctuations could adversely impact the Company’s business. +Foreign currency fluctuations affect the +Company’s reported revenue and profitability. In addition, because the Company may employ hedging strategies over time, changes in currency exchange rates may impact the Company’s financial results positively or negatively in one period +and not another, which may make it difficult to compare the Company’s operating results from different periods. Currency exchange rate fluctuations may also adversely impact third parties who manufacture the Company’s products by making +their costs of raw materials or other production costs more expensive and more difficult to finance, thereby raising prices for the Company, its distributors and licensees. For a more detailed discussion of risk relating to foreign currency +fluctuation, see Item 7A, Quantitative and Qualitative Disclosures About Market Risk. +Significant raw material shortages, +supplier capacity constraints, supplier production disruptions, supplier quality issues or price increases could increase the Company’s operating costs and adversely impact the competitive position of the Company’s products. +The Company currently sources most of its products from third-party manufacturers in foreign countries, predominantly China. As is common +in the industry, the Company does not have long-term contracts with its third-party suppliers. There can be no assurance that the Company will not experience difficulties with such suppliers, including reduction in the availability of production +capacity, failure to meet production deadlines or increases in manufacturing costs. The Company’s future results will depend partly on its ability to maintain positive working relationships with third-party suppliers. +Foreign manufacturing is subject to a number of risks, including work stoppages, transportation delays and interruptions, political instability, foreign +currency fluctuations, changing economic conditions, expropriation, nationalization, the imposition of tariffs, import and export controls and other non-tariff barriers and changes in governmental policies. Various factors could significantly +interfere with the Company’s ability to source its products, including adverse developments in trade or political relations with China or other countries where the Company sources its products, or a shift in China’s manufacturing capacity +away from footwear and apparel to other industries. Any of these events could have an adverse effect on the Company’s business, results of operations and financial position and, in particular, on the Company’s ability to meet customer +demands and produce its products in a cost-effective manner. +The Company’s ability to competitively price its products depends on the +cost of components, services, labor, equipment and raw materials, including leather and materials used in the production of footwear outsoles. The cost of services and materials is subject to change based on availability and market conditions that +are difficult to predict. Various conditions, such as diseases affecting the availability of leather, affect the cost of the footwear marketed by the Company. In addition, fuel prices and numerous other factors, such as the possibility of service +interruptions at shipping and receiving ports, affect the Company’s shipping costs. Increases in cost for services and materials used in production could have a negative impact on the Company’s results of operations and financial position. +The Company purchases raw pigskins for its leathers operations from a single domestic source pursuant to short-term contracts. Although this +source has been a reliable and consistent supplier for over 40 years, there are no assurances that it will continue as a supplier. Failure of this source to continue to supply the Company with raw pigskin or to supply the Company with raw pigskin on +less favorable terms could increase the Company’s cost of raw materials for its leathers operations and, as a result, have a negative impact on the Company’s results of operations and financial position. +13 +Table of Contents +A significant reduction in customer purchases of the Company’s products or failure of customers to +pay for the Company’s products in a timely manner could adversely affect the Company’s business. +The Company’s financial +success is directly related to its customers continuing to purchase its products. The Company does not typically have long-term contracts with its customers. Sales to the Company’s customers are generally on an order-by-order basis and are +subject to rights of cancellation and rescheduling by the customers. Failure to fill customers’ orders in a timely manner could harm the Company’s relationships with its customers. Furthermore, if any of the Company’s major customers +experience a significant downturn in its business, or fail to remain committed to the Company’s products or brands, they may reduce or discontinue purchases from the Company, which could have an adverse effect on the Company’s results of +operations and financial position. +The Company sells its products to customers and extends credit based on an evaluation of each +customer’s financial condition. The financial difficulties of a customer could cause the Company to stop doing business with that customer or reduce its business with that customer. The Company’s inability to collect from its customers or +a cessation or reduction of sales to certain customers because of credit concerns could have an adverse effect on the Company’s business, results of operations and financial position. +The general trend toward consolidation in retail and specialty retail could lead to fewer customers, customers seeking more favorable price, payment or other terms from the Company and a decrease in the +number of stores that carry the Company’s products. In addition, changes in the channels of distribution, such as the continued growth of Internet commerce and the trend toward the sale of private label products by major retailers, could have +an adverse effect on the Company’s results of operations and financial position. +The Company has been awarded a +number of U.S. Department of Defense contracts that include future purchase options for +Bates ® footwear. Failure by the Department of Defense to exercise these purchase options or the +failure of the Company to secure future U.S. Department of Defense contracts could have an adverse effect on the Company’s results of operations and financial position. +Changes in the credit markets could adversely affect the Company’s financial success. +Changes in the credit markets could adversely impact the Company’s future results of operations and financial position. If the Company’s +third-party distributors, suppliers and retailers are not able to obtain financing on favorable terms, or at all, they may delay or cancel orders for the Company’s products, or fail to meet their obligations to the Company in a timely manner, +either of which could adversely impact the Company’s sales, cash flow and operating results. In addition, the lack of available credit and/or the increased cost of credit may significantly impair the Company’s ability to obtain additional +credit to finance future expansion plans, or refinance existing credit, on favorable terms, or at all. +Unfavorable findings resulting from +a government audit could subject the Company to a variety of penalties and sanctions, and could negatively impact the Company’s future revenues. +The federal government has the right to audit the Company’s performance under its government contracts. If a government audit discovers improper or illegal activities, the Company could be subject to +civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines, and suspension or debarment from doing business with U.S. federal government agencies. The Company +could also suffer serious harm to its reputation if the government alleges that the Company acted in an improper or illegal manner, whether or not any such allegations have merit. If, as the result of an audit or for any other reason, the Company is +suspended or barred from contracting with the federal government generally, or any specific agency, if the Company’s reputation or relationship with government agencies is impaired, or if the government otherwise ceases doing business with the +Company or significantly decreases the amount of business it does with the Company, the Company’s revenue and profitability could decrease. The Company is also subject to customs and other audits in various jurisdictions where it operates. +Negative audit findings could have an adverse effect on the Company’s results of operations and financial position. +14 +Table of Contents +An increase in the Company’s effective tax rate or negative determinations by domestic or foreign +tax authorities could have a material adverse effect on the Company’s results of operations and financial position. +A significant +amount of the Company’s earnings are generated by its Canadian, European and Asia Pacific subsidiaries and, to a lesser extent, in jurisdictions that are not subject to income tax and free trade zones where the Company owns manufacturing +operations. As a result, the Company’s income tax expense has historically differed from the tax computed at the U.S. federal statutory income tax rate due to discrete items and because the Company does not provide for U.S. taxes on earnings +the Company considers permanently reinvested in foreign operations. The Company’s future effective tax rates could be unfavorably affected by factors including: changes in the tax rates in jurisdictions in which the Company generates income; +changes in, or in the interpretation of, tax rules and regulations in the jurisdictions in which the Company does business; decreases in the amount of earnings in countries with low statutory tax rates; or if the Company repatriates foreign earnings +for which no provision for U.S. taxes has previously been made. An increase in the Company’s effective tax rate could have a material adverse effect on the Company’s after-tax results of operations and financial position. +In addition, the Company’s income tax returns are subject to examination by the Internal Revenue Service and other domestic and foreign tax +authorities. The Company regularly assesses the likelihood of outcomes resulting from these examinations to determine the adequacy of the Company’s provision for income taxes and establishes reserves for potential adjustments that may result +from these examinations. While the Company believes the estimates used to establish these reserves are reasonable, there can be no assurance that the final determination of any of these examinations will not have an adverse effect on the +Company’s results of operations and financial position. +Failure of the Company’s international licensees and distributors to +meet sales goals or to make timely payments on amounts owed to the Company could adversely affect the Company’s financial performance. +In many international markets, independent licensees or distributors sell the Company’s products. Failure by the Company’s licensees or +distributors to meet planned annual sales goals or to make timely payments on amounts owed to the Company could have an adverse effect on the Company’s business, results of operations and financial position, and it may be difficult and costly +to locate an acceptable substitute distributor or licensee. If a change in licensee or distributor becomes necessary, the Company may experience increased costs, as well as substantial disruption and a resulting loss of sales and brand equity in the +market where such licensee or distributor operates. +The Company’s reputation and competitive position are dependent on its +third-party manufacturers, distributors, licensees and others complying with applicable laws and the Company’s ethical standards. +The Company requires its independent contract manufacturers, distributors, licensees and others with which it does business to comply with the +Company’s ethical standards and applicable laws relating to working conditions and other matters. If a party with whom the Company does business is found to have violated the Company’s ethical standards or applicable laws, the Company +could receive negative publicity that could damage its reputation and negatively affect the value of its brands. +Global political and +economic uncertainty could adversely impact the Company’s business. +Concerns regarding acts of terrorism and international conflict +have created significant global economic and political uncertainties that may have material and adverse effects on consumer demand, acceptance of U.S. brands in international markets, foreign sourcing of products, shipping and transportation, +product imports and exports and the sale of products in foreign markets, any of which could adversely affect the Company’s ability to source, manufacture, distribute and sell its products. The Company is subject to risks of doing business in +developing countries and economically volatile areas. These risks include social, political and economic +15 +Table of Contents +instability; nationalization of the Company’s, or the Company’s distributors and licensees, assets and operations by local government authorities; slower payment of invoices; and +restrictions on the Company’s ability to repatriate foreign currency or receive payment of amounts owed by third party distributors and licensees. In addition, commercial laws in these areas may not be well developed or consistently +administered, and new laws may be retroactively applied. Any of these risks could have an adverse impact on the Company’s prospects and results of operations in these areas. +Unsuccessful efforts by the Company to establish and protect its intellectual property could adversely affect the value of its brands. +The Company invests significant resources to develop and protect its intellectual property, and believes that its trademarks and other intellectual property rights are important to its future success. The +Company’s ability to remain competitive is dependent upon its continued ability to secure and protect trademarks, patents and other intellectual property rights in the United States and internationally for all of its lines of business. The +Company relies on a combination of trade secret, patent, trademark, copyright and other laws, license agreements and other contractual provisions and technical measures to protect its intellectual property rights; however, some countries’ laws +do not protect intellectual property rights to the same extent as do U.S. laws. The Company’s business could be significantly harmed if it is not able to protect its intellectual property, or if a court found that the Company was infringing on +other persons’ intellectual property rights. Any intellectual property lawsuits or threatened lawsuits in which the Company is involved, either as a plaintiff or as a defendant, could cost the Company a significant amount of time and money and +distract management’s attention from operating the Company’s business. In addition, if the Company does not prevail on any intellectual property claims, the Company may have to change its manufacturing processes, products or trade names, +any of which could reduce its profitability. +In addition, some of the Company’s branded footwear operations are operated pursuant to +licensing agreements with third-party trademark owners. These agreements are subject to early termination for breach. Expiration or early termination of any of these license agreements by the licensor could have a material adverse effect on the +Company’s business, results of operations and financial position. +The Company periodically discovers products that are counterfeit +reproductions of its products or that the Company believes otherwise infringe on its intellectual property rights. The Company has not always been able to stop production and sales of counterfeit products and infringement of the Company’s +intellectual property rights. The actions the Company takes to establish and protect trademarks, patents and other intellectual property rights both inside and outside of the United States may not be adequate to prevent imitation of its products by +others. Continued sales of products that infringe the Company’s intellectual property rights could adversely affect the Company’s sales, devalue its brands and result in the shift of consumer preference away from the Company’s +products. +The Company’s inability to attract and retain executive managers and other key employees, or the loss of one or more +executive managers or other key employees, could adversely affect the Company’s business. +The Company depends on its executive +management and other key employees. In the footwear, apparel and consumer-direct industries, competition for key executive talent is intense, and the Company’s failure to identify, attract or retain executive managers or other key employees +could adversely affect its business. The Company must offer and maintain competitive compensation packages to effectively recruit and retain such individuals. Further, the loss of one or more executive managers or other key employees, or the +Company’s failure to successfully implement succession planning, could adversely affect the Company, its results of operations or financial position. +Market interest rates, inflationary pressures and other pressures may lead to higher employment and pension costs for the Company. +General inflationary pressures, changes in employment laws and regulations, and other factors could increase the Company’s overall employment costs. The Company’s employment costs include costs +relating to health care +16 +Table of Contents +benefits and benefits under the Company’s retirement plans, including a U.S.-based defined benefit plan. The annual cost of benefits can vary significantly depending on a number of factors, +including changes in the assumed or actual rate of return on pension plan assets, a change in the discount rate used to determine the annual service cost related to the defined benefit plans, a change in method or timing of meeting pension funding +obligations and the rate of health care cost inflation. Increases in the Company’s overall employment and pension costs could have an adverse effect on the Company’s business, results of operations and financial position. +Disruption of the Company’s information technology systems could adversely affect the Company’s business. +The Company’s information technology systems are critical to the operations of its business. Any interruption, unauthorized access, impairment or +loss of data integrity or malfunction of these systems could severely impact the Company’s business, including delays in product fulfillment and reduced efficiency in operations. In addition, costs and potential problems and interruptions +associated with the implementation of new or upgraded systems, or with maintenance or adequate support of existing systems, could disrupt or reduce the efficiency of the Company’s operations. +The Company faces risks associated with its growth strategy and acquiring businesses. +The Company has expanded its products and markets in part through strategic acquisitions, and it may continue to do so in the future, depending on its ability to identify and successfully pursue suitable +acquisition candidates. Acquisitions involve numerous risks, including risks inherent in entering new markets in which the Company may not have prior experience; potential loss of significant customers or key personnel of the acquired business; +managing geographically-remote operations; and potential diversion of management’s attention from other aspects of the Company’s business operations. Acquisitions may also cause the Company to incur debt, dilutive issuances of the +Company’s equity securities and write-offs of goodwill and substantial amortization expenses of other intangible assets. The Company may not be able to obtain financing that may be necessary to finance future acquisitions, on favorable terms, +making any such acquisitions more expensive. Any such financing may have onerous terms that restrict the Company’s operations. The Company cannot provide assurance that it will be able to successfully integrate the operations of any +acquired businesses into the Company’s operations and achieve the expected benefits of any acquisitions. The failure to successfully integrate newly-acquired businesses or achieve the expected benefits of strategic acquisitions in the future +could have an adverse effect on the Company’s results of operations and financial position. The Company may also incur costs in the preliminary stages of an acquisition that it cannot recover, but the Company may not consummate the potential +acquisition for a variety of reasons. +Maintenance and growth of the Company’s business depends upon the availability of adequate +capital. +The maintenance and growth of the Company’s business depends on the availability of adequate capital, which in turn depends +in large part on cash flow generated by its business and the availability of equity and debt financing. The Company cannot provide assurance that its operations will generate positive cash flow or that it will be able to obtain equity or debt +financing on acceptable terms or at all. Further, the Company cannot provide assurance that it will be able to finance any expansion plans. +Expanding the Company’s brands into new markets may be difficult and costly, and unsuccessful efforts to do so may adversely affect the +Company’s brands or business. +As part of its growth strategy, the Company seeks to enhance the positioning of its brands, to extend +its brands into complementary product categories, to expand geographically, and to expand its owned consumer-direct operations. There can be no assurance that the Company will be able to successfully implement any or all of these growth strategies, +which could have an adverse effect on the Company’s results of operations and financial position. +17 +Table of Contents +Changes in government regulation may increase the costs of compliance. +The Company’s business is affected by changes in government and regulatory policies in the United States and in foreign jurisdictions. New +requirements relating to product safety and testing and new environmental requirements, as well as changes in tax laws, duties, tariffs and quotas, could have a negative impact on the Company’s ability to produce and market footwear at +competitive prices. +The disruption, expense, and potential liability associated with existing and future litigation against the Company +could adversely affect the Company’s reputation, financial position or results of operations. +The Company is a defendant from time +to time in lawsuits and regulatory actions relating to its business. Due to the inherent uncertainties of litigation and regulatory proceedings, the Company cannot accurately predict the ultimate outcome of any such proceedings. An unfavorable +outcome could have an adverse impact on the Company’s business, financial position and results of operations. In addition, regardless of the outcome of any litigation or regulatory proceedings, such proceedings are expensive and may require +that the Company devote substantial resources and executive time to defend the Company. +Provisions of Delaware law and the Company’s +certificate of incorporation and bylaws could prevent or delay a change in control or change in management that could be beneficial to the Company’s stockholders. +Provisions of the Company’s certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay or prevent a merger, acquisition or other change in control of the +Company. These provisions are intended to protect stockholders’ interests by providing the Board of Directors a means to attempt to deny coercive takeover attempts or to negotiate with a potential acquirer in order to obtain more favorable +terms. Such provisions include a board of directors that is classified so that only one-third of directors stand for election each year. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect +directors and take other corporate actions. +There are risks, including stock market volatility, inherent in owning the Company’s +common stock. +The market price and volume of the Company’s common stock have been, and may continue to be, subject to significant +fluctuations. These fluctuations may arise from general stock market conditions, the impact of risk factors described in this Item 1A on the Company’s financial position and results of operations, a change in sentiment in the market +regarding the Company’s business prospects or other factors, many of which may be outside the Company’s immediate control. Changes in the amounts and frequency of share repurchases or dividends could adversely affect the value of the +Company’s common stock. +Item 1B. Unresolved Staff +Comments +None. +Item 2. Properties +The Company operates its domestic administration, +sales and marketing operations primarily from an owned facility of approximately 225,000 square feet in Rockford, Michigan. The Company’s manufacturing operations are conducted primarily at a combination of leased and owned facilities in +Michigan and the Dominican Republic. The Company operates its U.S. distribution operations primarily through an owned distribution center in Rockford, Michigan, of approximately 305,000 square feet, a leased distribution center in Cedar Springs, +Michigan, of approximately 356,000 square feet and a leased distribution center in Howard City, Michigan, of approximately 460,000 square feet. +18 +Table of Contents +The Company also leases and owns various other offices and distribution centers to meet its operational +requirements. In addition, the Company operates retail stores through leases with various third-party landlords. The Company conducts international operations in Canada, the United Kingdom, China, Hong Kong and continental Europe through leased +distribution centers, offices and/or showrooms. The Company believes that its current facilities are suitable and adequate to meet its current needs. The Company intends to expand its U.S. and European distribution infrastructure and its +brick-and-mortar retail stores to sustain future growth. +Item 3. Legal Proceedings +The Company is involved in litigation and various legal matters arising in the normal course of business, including certain environmental compliance +activities. The Company has considered facts related to legal and regulatory matters and advice of counsel handling these matters, and does not believe the ultimate resolution of such proceedings will have a material adverse effect on the +Company’s financial position, results of operations, or cash flows. +Supplemental +Item. Executive Officers of the Registrant +The following table lists the names and +ages of the executive officers of the Company and the positions held with the Company as of February 29, 2012. The information provided below the table lists the business experience of each such Executive Officer for at least the past five years. +All Executive Officers serve at the pleasure of the Board of Directors of the Company, or, if not appointed by the Board of Directors, they serve at the pleasure of management. +Name +Age +Positions held with the Company +Kenneth A. Grady +55 +General Counsel and Secretary +Donald T. Grimes +49 +Senior Vice President, Chief Financial Officer and Treasurer +Michael Jeppesen +52 +President, Global Operations Group +Douglas M. Jones +46 +Corporate Controller +Robin J. Kleinjans-McKee +36 +Vice President, Corporate Planning and Analysis +Blake W. Krueger +58 +Chairman, Chief Executive Officer and President +Pamela L. Linton +62 +Senior Vice President, Global Human Resources +James D. Zwiers +44 +Senior Vice President and President, Outdoor Group +Kenneth A. Grady has served the Company as General Counsel and Secretary since October 2006. During 2006, he was +President and shareholder of the law firm K.A. Grady PC. During 2005, he served as Vice President, General Counsel and Secretary of PC Connection, Inc., a direct marketer of information technology products and solutions. From 2004 to 2005, +Mr. Grady served as Executive Vice President of Administration, General Counsel and Secretary of KB Toys, Inc., a specialty toy retailer. From 2001 to 2004, he served as Vice President, General Counsel and Secretary of KB Toys, Inc. +Donald T. Grimes has served the Company as Senior Vice President, Chief Financial Officer and Treasurer since May 2008. From 2007 to 2008, he was the +Executive Vice President and Chief Financial Officer for Keystone Automotive Operations, Inc., a distributor of automotive accessories and equipment. Prior to Keystone, Mr. Grimes held a series of senior corporate and divisional finance roles +at Brown-Forman Corporation, a manufacturer and marketer of premium wines and spirits. During his employment at Brown-Forman, Mr. Grimes was Vice President, Director of Beverage Finance from 2006 to 2007; Vice President, Director of Corporate +Planning and Analysis from 2003 to 2006; and Senior Vice President, Chief Financial Officer of Brown-Forman Spirits America from 1999 to 2003. +Michael Jeppesen has served the Company as President, Global Operations Group since January 2012. From 2005 to 2011, he was Senior Vice President, Design +and Sourcing, for Collective Brands Inc., a wholesaler and retailer of footwear and related accessories. +19 +Table of Contents +Douglas M. Jones has served the Company as Corporate Controller since September 2011. From 2009 to 2011, he +was the Company’s Director, Internal Audit. From 2006 to 2009, he was Director – Controls and Plant Financial Reporting for Indalex Inc., a manufacturer of extruded aluminum. +Robin J. Kleinjans-McKee has served the Company as Vice President, Corporate Planning and Analysis since September 2011. She served as the Company’s Corporate Controller from 2009 to September 2011. +From 2006 to 2009, Ms. Kleinjans-McKee was the Company’s Director of Financial Reporting. From 2004 to 2006, she served as Assurance Senior Manager at BDO Seidman, LLP, a professional services firm. From 1997 to 2004, +Ms. Kleinjans-McKee served in various audit positions at BDO Seidman, LLP. +Blake W. Krueger has served the Company as Chairman since +January 2010 and as Chief Executive Officer and President since April 2007. From October 2005 to April 2007, he served as Chief Operating Officer and President. From August 2004 to October 2005, he served as Executive Vice President and Secretary of +the Company and President of the Heritage Brands Group. From November 2003 to August 2004, he served the Company as Executive Vice President, Secretary, and President of Caterpillar Footwear. From April 1996 to November 2003, he served the Company +as Executive Vice President, General Counsel and Secretary. From 1993 to April 1996, he served as General Counsel and Secretary. From 1985 to 1996, he was a partner with the law firm of Warner Norcross & Judd LLP. +Pamela L. Linton has served the Company as Senior Vice President, Global Human Resources since December 2007. From 2005 to 2007, she was an independent +consultant. From 2001 to 2005, she was Senior Vice President, Global Human Resources of American Greetings Corporation, a greeting card and gift wrap company. +James D. Zwiers has served the Company as Senior Vice President and President, Outdoor Group since March 2009. From January 2008 until March 2009, he served as Senior Vice President of the Company. From +October 2006 to December 2007, he served as President of the Company’s Hush Puppies U.S. Division. From October 2005 to October 2006, he served as the Company’s General Counsel and Secretary. From December 2003 to October 2005, he served +as General Counsel and Assistant Secretary. From January 1998 to December 2003, he served the Company as Associate General Counsel and Assistant Secretary. From 1995 to 1998, he was an attorney with the law firm of Warner Norcross & Judd +LLP. +Item 4. Mine Safety Disclosures +Not applicable. +PART II +Item 5. Market +for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +The Company’s common stock is traded on the New York Stock Exchange under the symbol “WWW.” The following table shows the high and low +stock prices on the New York Stock Exchange and dividends declared by calendar quarter for 2011 and 2010. The number of stockholders of record on February 24, 2012, was 1,634. +2011 +2010 +Stock Price +High +Low +High +Low +First quarter +$ +37.52 +$ +30.31 +$ +29.76 +$ +23.51 +Second quarter +$ +40.48 +$ +35.35 +$ +32.38 +$ +26.33 +Third quarter +$ +43.36 +$ +30.77 +$ +29.99 +$ +24.25 +Fourth quarter +$ +39.48 +$ +32.77 +$ +33.00 +$ +26.89 +20 +Table of Contents +Cash Dividends Declared Per Share +2011 +2010 +First quarter +$ +0.12 +$ +0.11 +Second quarter +$ +0.12 +$ +0.11 +Third quarter +$ +0.12 +$ +0.11 +Fourth quarter +$ +0.12 +$ +0.11 +A quarterly dividend of $0.12 per share was declared during the first quarter of fiscal 2012. The Company currently +expects that comparable cash dividends will be paid in future quarters in 2012. +The Company’s credit agreement imposes certain +restrictions on the Company’s ability to pay cash dividends. As long as no default under the credit agreement exists or would be caused by the payment of the dividend, the Company may pay cash dividends (i) in an aggregate amount not to +exceed $80 million per fiscal year and (ii) in an aggregate amount greater than $80 million per fiscal year if the Company maintains a prescribed leverage ratio. +See Item 12 for information with respect to the Company’s equity compensation plans. +Stock Performance Graph +The following graph compares the five year cumulative total +stockholder return on Wolverine common stock to the Standard & Poor’s Small Cap 600 Index and the Standard & Poor’s 600 Footwear Index, assuming an investment of $100 at the beginning of the period indicated. Wolverine is +part of the Standard & Poor’s Small Cap 600 Index and the Standard & Poor’s Footwear Index. This Stock Performance Graph shall not be deemed to be incorporated by reference into the Company’s SEC filings and shall +not constitute soliciting material or otherwise be considered filed under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended. +Five Year Cumulative Total Return Summary +21 +Table of Contents +The following table provides information regarding the Company’s purchases of its own common stock +during the fourth quarter of fiscal year 2011: +Issuer Purchases of Equity Securities +Period +Total +Number of +Shares +Purchased +Average +Price +Paid per +Share +Total +Number +of Shares +Purchased +as Part of +Publicly +Announced +Plans +or +Programs +Maximum +Dollar +Amount +that +May Yet +Be +Purchased +Under +the +Plans +or +Programs +Period 1 (September 11, 2011 to October 8, 2011) +Common Stock Repurchase Program (1) +58,142 +$ +35.06 +58,142 +$ +96,276,894 +Employee Transactions (2) +319 +36.01 +– +Period 2 (October 9, 2011 to November 5, 2011) +Common Stock Repurchase Program (1) +44,940 +$ +35.86 +44,940 +$ +94,665,411 +Employee Transactions (2) +48,728 +38.08 +– +Period 3 (November 6, 2011 to December 3, 2011) +Common Stock Repurchase Program (1) +167,800 +$ +34.88 +167,800 +$ +88,813,479 +Employee Transactions (2) +1,888 +37.19 +– +Period 4 (December 4, 2011 to December 31, 2011) +Common Stock Repurchase Program (1) +– +$ +– +– +$ +88,813,479 +Employee Transactions (2) +25,295 +36.33 +– +Total for Fourth Quarter ended December 31, 2011 +Common Stock Repurchase Program (1) +270,882 +$ +35.08 +270,882 +$ +88,813,479 +Employee Transactions (2) +76,230 +37.47 +– +(1) +The Company’s Board of Directors approved a common stock repurchase program on February 11, 2010. This program authorized the repurchase of up to +$200 million of common stock over a four-year period, commencing on the effective date of the program. All shares repurchased during fourth quarter of fiscal year 2011 (other than repurchases pursuant to the “Employee Transactions” +set forth above) were purchased under this publicly announced program. +(2) +Employee transactions include: (1) shares delivered or attested in satisfaction of the exercise price and/or tax withholding obligations by holders of employee +stock options who exercised options, and (2) restricted shares withheld to offset statutory minimum tax withholding that occurs upon vesting of restricted shares. The Company’s employee stock compensation plans provide that the shares +delivered or attested to, or withheld, shall be valued at the closing price of the Company’s common stock on the date the relevant transaction occurs. +Item 6. +Selected Financial Data +Five-Year Operating and Financial Summary (1) +2011 +2010 +2009 +2008 +2007 +(Thousands of Dollars, Except Per Share Data) +Summary of Operations +Revenue +$ +1,409,068 +$ +1,248,517 +$ +1,101,056 +$ +1,220,568 +$ +1,198,972 +Net earnings +123,287 +104,470 +61,912 +95,821 +92,886 +Per share of common stock: +Basic net earnings (2)(3) +$ +2.54 +$ +2.15 +$ +1.26 +$ +1.94 +$ +1.75 +Diluted net earnings (2)(3) +2.48 +2.11 +1.24 +1.90 +1.70 +Cash dividends declared +0.48 +0.44 +0.44 +0.44 +0.36 +Financial Position at Year End +Total assets +$ +851,652 +$ +786,575 +$ +712,076 +$ +664,780 +$ +638,378 +Long-term debt +515 +1,034 +1,615 +5 +10,731 +22 +Table of Contents +Notes to Five-Year Operating and Financial Summary +(1) +This summary should be read in conjunction with the consolidated financial statements and the related notes, which are attached as Appendix A to this Annual Report on +Form 10-K. +(2) +Basic earnings per share are based on the weighted average number of shares of common stock outstanding during the year after adjustment for nonvested restricted common +stock. Diluted earnings per share assume the exercise of dilutive stock options and the vesting of all outstanding restricted stock. +(3) +Basic and diluted net earnings per share have been retroactively adjusted to reflect the adoption of FASB ASC Topic 260, Earnings Per Share on January 4, +2009 , for participating securities which represent unvested restricted common stock which contain non-forfeitable rights to dividends or dividend equivalents. +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +OVERVIEW +BUSINESS OVERVIEW +The Company is a leading global designer, manufacturer and marketer of branded footwear, apparel and accessories. The Company’s +stated mission is to “ Excite Consumers Around the World with Innovative Footwear and Apparel that Bring Style to Purpose .” The Company seeks to fulfill this mission by offering innovative products and compelling brand propositions; +delivering supply chain excellence; complementing its footwear brands with strong apparel and accessories offerings; and expanding its global consumer-direct footprint. +The Company’s portfolio consists of 12 brands that were marketed in more than 190 countries and territories at December 31, 2011. This diverse brand portfolio and broad geographic reach position +the Company for continued strong organic growth. The Company’s brands are distributed into the market via owned operations in the United States, Canada, the United Kingdom and certain countries in continental Europe. In other regions (Asia +Pacific, Latin America and certain other counties in continental Europe), the Company relies on a network of third-party distributors and licensees to market its brands. At December 31, 2011, the Company operated 101 brick-and-mortar +retail stores in the United States, Canada and the United Kingdom and operated 42 consumer-direct websites. +2011 FINANCIAL OVERVIEW +• +Revenue for fiscal year 2011 was $1.409 billion, 12.9% above fiscal year 2010 revenue of $1.249 billion, reflecting strong performance from all of the +Company’s operating divisions. +• +Gross margin for fiscal year 2011 of 39.5% was equal to the prior year, representing outstanding performance in a challenging sourcing and rising +product cost environment. +• +Operating expenses as a percentage of revenue decreased to 27.4% for fiscal year 2011 compared to 28.1% for fiscal year 2010. +• +Diluted earnings per share for fiscal year 2011 were $2.48 compared to $2.11 per share for fiscal year 2010, including the impact of $0.06 per share of +restructuring and other transition costs in fiscal year 2010. +• +Accounts receivable increased 12.0% in fiscal year 2011 compared to 2010, driven by a 5.6% increase in fourth quarter revenue. Days sales outstanding +increased slightly in 2011 to 61.6 days from 60.5 days in 2010. +• +Inventory increased $26.1 million, or 12.5%, in fiscal year 2011 compared to fiscal year 2010, due to new product offerings and increased product +costs. +23 +Table of Contents +• +The Company declared cash dividends of $0.48 per share in fiscal year 2011 compared to $0.44 per share declared in fiscal year 2010. +• +The Company repurchased approximately 1,840,000 shares of common stock in fiscal year 2011 for approximately $65.3 million and repurchased +approximately 1,795,000 shares in fiscal year 2010 for approximately $51.2 million, both of which lowered the average shares outstanding. +OUTLOOK FOR 2012 +Fiscal year 2012 revenue is expected to increase based on continued +positive momentum across the brand portfolio. The Company anticipates full year revenue growth in the mid to high single digits with revenue growth weighted towards the second half of the year. +The Company expects modest gross margin growth in fiscal year 2012, driven by continued favorable shifts in brand and channel mix, strategic selling +price increases and more moderate product costs. The Company anticipates modest full year operating expense deleverage as a result of increased pension expense, costs associated with expanding the Company’s U.S. and European distribution +infrastructure and continued growth of the Company’s brick-and-mortar retail operations. The Company expects a full year effective tax rate of approximately 28.0% and fully diluted earnings per share growth in the mid to high single digits. +The following is a discussion of the Company’s results of operations and liquidity and capital resources. This section should be read in +conjunction with the Company’s consolidated financial statements and related notes included elsewhere in this Annual Report. +RESULTS +OF OPERATIONS – FISCAL 2011 COMPARED TO FISCAL 2010 +FINANCIAL SUMMARY – 2011 VERSUS 2010 +2011 +2010 +Change +(Millions of Dollars, Except Per Share Data) +$ +% of +Total +$ +% of +Total +$ +% +Revenue +Branded footwear, apparel and licensing +$ +1,274.1 +90.4% +$ +1,117.6 +89.5% +$ +156.5 +14.0% +Other business units +135.0 +9.6% +130.9 +10.5% +4.1 +3.1% +Total Revenue +$ +1,409.1 +100.0% +$ +1,248.5 +100.0% +$ +160.6 +12.9% +$ +% of +Revenue +$ +% of +Revenue +$ +% +Gross Profit +Branded footwear, apparel and licensing +$ +497.4 +39.0% +$ +440.1 +39.4% +$ +57.3 +13.0% +Other business units +59.4 +44.0% +52.5 +40.1% +6.9 +13.1% +Total Gross Profit +$ +556.8 +39.5% +$ +492.6 +39.5% +$ +64.2 +13.0% +Selling, general and administrative expenses +$ +386.5 +27.4% +$ +347.5 +27.8% +$ +39.0 +11.2% +Restructuring and other transition costs +- +- +2.8 +0.2% +(2.8 +) +(100% +) +Total Operating Expenses +$ +386.5 +27.4% +$ +350.3 +28.1% +$ +36.2 +10.3% +24 +Table of Contents +2011 +2010 +Change +(Millions of Dollars, Except Per Share Data) +$ +% of +Revenue +$ +% of +Revenue +$ +% +Interest expense – net +$ +1.1 +0.0% +$ +0.4 +0.0% +$ +0.7 +175% +Other expense (income) – net +0.3 +0.0% +(1.3 +) +0.1% +(1.6 +) +nm +Earnings before income taxes +168.9 +12.0% +143.2 +11.5% +25.7 +17.9% +Net Earnings +$ +123.3 +8.8% +$ +104.5 +8.4% +$ +18.8 +18.0% +Diluted earnings per share +$ +2.48 +- +$ +2.11 +- +$ +0.37 +17.5% +The Company has one reportable segment that is engaged in designing, manufacturing, sourcing, marketing, licensing and +distributing branded footwear, apparel and accessories. In January 2011, the Company realigned its branded operating groups, and now identifies three operating groups within its branded footwear, apparel and licensing reportable segment: +• +Outdoor Group , consisting of Merrell ® , Chaco ® and +Patagonia ® footwear and Merrell ® brand apparel; +• +Heritage Group , consisting of Wolverine ® boots and shoes and +Wolverine ® brand apparel, Cat ® footwear, Bates ® , +Harley-Davidson ® footwear , and HyTest ® ; and +• +Lifestyle Group , consisting of Hush Puppies ® footwear and apparel, +Sebago ® footwear and apparel, Cushe ® and Soft Style ® . +The Company’s other operating groups, which do not collectively comprise a separate reportable segment, consist of +Wolverine Retail (the Company’s consumer-direct business) and Wolverine Leathers (which markets pigskin leather primarily for use in the footwear industry). +The following is supplemental information on total revenue: +TOTAL REVENUE +2011 +2010 +Change +$ +% of +Total +$ +% of +Total +$ +% +(Millions of Dollars) +Outdoor Group +$ +551.8 +39.2% +$ +467.6 +37.5% +$ +84.2 +18.0% +Heritage Group +500.3 +35.5% +454.6 +36.4% +45.7 +10.1% +Lifestyle Group +206.3 +14.6% +182.9 +14.6% +23.4 +12.8% +Other +15.7 +1.1% +12.5 +1.0% +3.2 +25.6% +Total branded footwear, apparel and licensing revenue +$ +1,274.1 +90.4% +$ +1,117.6 +89.5% +$ +156.5 +14.0% +Other business units +135.0 +9.6% +130.9 +10.5% +4.1 +3.1% +Total Revenue +$ +1,409.1 +100.0% +$ +1,248.5 +100.0% +$ +160.6 +12.9% +REVENUE +Revenue for fiscal year 2011 increased $160.6 million from fiscal year 2010, to $1.409 billion. The growth was driven by double digit percentage increases +in revenue for all three branded footwear, apparel and licensing operating groups. Revenue for the other business units increased 3.1% for fiscal year 2011. Changes in foreign exchange rates increased reported revenue by $17.3 million. International +revenue represented 40.2% of total reported revenue in fiscal year 2011 compared to 38.4% in fiscal year 2010. +25 +Table of Contents +The Outdoor Group branded footwear, apparel and licensing operating group’s +revenue increased 18.0% in fiscal year 2011 compared to fiscal year 2010. Leading the group’s growth, the +Merrell ® brand footwear and apparel business enjoyed increased demand for performance products, including +its new Merrell ® Barefoot Collection. Fueling the growth for the Merrell ® branded footwear business was a mid teens percentage increase in units sold. The increase in Merrell ® brand apparel was driven by a strong double digit increase in revenue generated by the Outerwear category and a low +triple digit percentage increase in revenue generated by the Sportswear category. Patagonia ® +footwear’s revenue increased at a rate in the high teens in fiscal year 2011 due to continued strong demand from key outdoor retailers. Revenue from the Chaco ® brand grew at a rate in the high teens compared to fiscal year 2010 as the brand expanded its closed-toe product offerings for fall, extending the brand’s reach +to become a year-round footwear option for consumers. +The Heritage Group branded footwear, apparel and licensing +operating group’s revenue increased 10.1% in fiscal year 2011 compared to fiscal year 2010. Driving the revenue growth for the group was a mid twenties percentage increase in revenue from the Cat ® footwear brand and a high single digit percentage increase in revenue from Wolverine ® brand footwear and apparel. The Cat ® footwear revenue increase was driven by revenue growth in the mid-teens or higher in each of its major geographic regions compared to fiscal year 2010. The +Wolverine ® brand’s revenue grew as a result of low single digit unit volume growth in the U.S. +rugged casual and core work boot business and a growth rate in the low thirties for the Wolverine ® brand +apparel business. Harley-Davidson ® Footwear revenue decreased at a mid single digit rate compared to +fiscal year 2010 as a high single digit decline in the U.S. market was partially offset by an increase at a rate in the high seventies in the European market. +The Lifestyle Group branded footwear, apparel and licensing operating group’s revenue increased 12.8% in fiscal year 2011 compared to fiscal year 2010. Revenue from the Hush Puppies ® brand increased at a high single digit rate as a result of mid twenties percentage growth in its third-party +licensing business; growth in the European markets at a percentage rate in the mid teens; and high single digit percentage growth in the Canadian market. These increases were partially offset by a mid single digit percentage decline in Hush +Puppies ® revenue in the U.S. The Sebago ® brand generated a revenue growth rate in the mid teens in fiscal year 2011 as a result of its European market growing at a rate in the mid teens. The Cushe ® brand revenue almost doubled compared to fiscal year 2010, fueled by strong unit volume growth of over 150% in the +U.S. as the brand continues to benefit from excellent placement in specialty, outdoor and surf retail venues. +Within the Company’s other +business units, Wolverine Retail reported revenue growth in the mid teens in fiscal year 2011 compared to fiscal year 2010 as a result of a high twenties percentage growth rate in the Company’s e-commerce channel and a mid single digit +percentage growth rate in comparable store sales from Company-owned stores. Wolverine Retail operated 101 retail stores worldwide at the end of fiscal year 2011 and operated 88 retail stores at the end of fiscal year 2010, with sixteen new store +openings in fiscal year 2011 partially offset by the closure of three existing locations during fiscal year 2011. The Wolverine Leathers business reported a revenue decline at a rate in the mid twenties, as a result of soft demand from certain key +customers and the divestiture of its low-margin procurement division in the fourth quarter of 2010. +GROSS MARGIN +For fiscal year 2011, the Company’s consolidated gross margin was flat compared to fiscal year 2010. Higher product input costs and a negative +shift in the mix of product sold decreased consolidated gross margin by approximately 150 basis points and 110 basis points, respectively. These decreases were offset by the positive impact from strategic selling price increases and the effect of +foreign exchange. +OPERATING EXPENSES +Operating expenses increased $36.2 million, from $350.3 million in fiscal year 2010 to $386.5 million in fiscal year 2011. The higher operating expense was due to an increase at a rate in the mid teens in +distribution costs, which vary with revenue and advertising and marketing expenses, designed to enhance brand awareness. In addition, selling commissions, which vary with revenue, increased at a rate in the low teens and changes in +26 +Table of Contents +foreign exchange rates had a $5.0 million unfavorable impact on reported operating expenses. These increases were partially offset by a $2.8 million dollar reduction in restructuring and other +transition costs in fiscal year 2011 compared to fiscal year 2010. +INTEREST, OTHER AND TAXES +The increase in net interest expense reflects the increase in revolver borrowings for fiscal year 2011 compared to fiscal year 2010. +The decrease in other income is related to the sale of Wolverine Procurement assets in the fourth quarter of fiscal year 2010, which resulted in a $1.1 +million gain, with the remainder of the decrease due to the change in realized gains or losses on foreign denominated assets and liabilities. +The Company’s full year effective tax rate in fiscal year 2011 was 27.0%, compared to 27.1% in fiscal year 2010. The modestly lower effective tax +rate reflects the fact that a higher percentage of the Company’s earnings in fiscal year 2011 were attributable to foreign jurisdictions where tax rates are lower than in the U.S. or nontaxable based on specific tax rulings and legislation. The +Company maintains certain strategic management and operational activities in overseas subsidiaries, and its foreign earnings are taxed at rates that are generally lower than the U.S. federal statutory income tax rate. A significant amount of the +Company’s earnings are generated by its Canadian, European and Asia Pacific subsidiaries and, to a lesser extent, in jurisdictions that are not subject to income tax and free trade zones where the Company owns manufacturing operations. The +Company has not provided for U.S. taxes for earnings generated in foreign jurisdictions because it plans to reinvest these earnings indefinitely outside the U.S. However, if certain foreign earnings previously treated as permanently reinvested are +repatriated, the additional U.S. tax liability could have a material adverse effect on the Company’s after-tax results of operations and financial position. +NET EARNINGS AND EARNINGS PER SHARE +As a result of the revenue, gross margin and expense +changes discussed above, the Company had net earnings of $123.3 million in fiscal year 2011, compared to $104.5 million in fiscal year 2010, an increase of $18.8 million. +Diluted net earnings per share increased 17.5% in fiscal year 2011 to $2.48, from $2.11 in fiscal year 2010. The increase was attributable to increased revenue, stable gross margin and lower restructuring +and other transition costs, as detailed above. The Company repurchased approximately 1,840,000 shares of common stock in fiscal year 2011 for approximately $65.3 million and repurchased approximately 1,795,000 shares in fiscal year 2010 for +approximately $51.2 million, both of which lowered the average shares outstanding. +Inflation did not have a significant impact on revenue or +net earnings. +RESULTS OF OPERATIONS – FISCAL 2010 COMPARED TO FISCAL 2009 +FINANCIAL SUMMARY – 2010 VERSUS 2009 +2010 +2009 +Change +(Millions of Dollars, Except Per Share Data) +$ +% of +Total +$ +% of +Total +$ +% +Revenue +Branded footwear, apparel and licensing +$ +1,117.6 +89.5% +$ +991.2 +90.0% +$ +126.4 +12.8% +Other business units +130.9 +10.5% +109.9 +10.0% +21.0 +19.1% +Total Revenue +$ +1,248.5 +100.0% +$ +1,101.1 +100.0% +$ +147.4 +13.4% +27 +Table of Contents +2010 +2009 +Change +(Millions of Dollars, Except Per Share Data) +$ +% of +Revenue +$ +% of +Revenue +$ +% +Gross Profit +Branded footwear, apparel and licensing +$ +440.1 +39.4% +$ +390.8 +39.4% +$ +49.3 +12.6% +Other business units +52.5 +40.1% +40.9 +37.2% +11.6 +28.4% +Total Gross Profit +$ +492.6 +39.5% +$ +431.7 +39.2% +$ +60.9 +14.1% +Selling, general and administrative expenses +$ +347.5 +27.8% +$ +316.4 +28.7% +$ +31.1 +9.8% +Restructuring and other transition costs +2.8 +0.2% +29.7 +2.7% +(26.9) +(90.6% +) +Total Operating Expenses +$ +350.3 +28.1% +$ +346.1 +31.4% +$ +4.2 +1.2% +Interest expense – net +$ +0.4 +0.0% +$ +0.1 +0.0% +$ +0.3 +300.0% +Other (income) – net +(1.3 +) +0.1% +(0.2 +) +0.0% +1.1 +550.0% +Earnings before income taxes +143.2 +11.5% +85.7 +7.8% +57.5 +67.1% +Net Earnings +$ +104.5 +8.4% +$ +61.9 +5.6% +$ +42.6 +68.8% +Diluted earnings per share +$ +2.11 +- +$ +1.24 +- +$ +0.87 +70.2% +The following is supplemental information on total revenue: +TOTAL REVENUE +2010 +2009 +Change +$ +% of +Total +$ +% of +Total +$ +% +(Millions of Dollars) +Outdoor Group +$ +467.6 +37.5% +$ +416.2 +37.8% +$ +51.4 +12.3% +Heritage Group +454.6 +36.4% +394.2 +35.8% +60.4 +15.3% +Lifestyle Group +182.9 +14.6% +168.9 +15.3% +14.0 +8.3% +Other +12.5 +1.0% +11.9 +1.1% +0.6 +5.0% +Total branded footwear, apparel and licensing revenue +$ +1,117.6 +89.5% +$ +991.2 +90.0% +$ +126.4 +12.8% +Other business units +130.9 +10.5% +109.9 +10.0% +21.0 +19.1% +Total Revenue +$ +1,248.5 +100.0% +$ +1,101.1 +100.0% +$ +147.4 +13.4% +REVENUE +Revenue in fiscal year 2010 increased $147.4 million, to $1.249 billion. The growth was driven by increases in revenues for all three branded +footwear, apparel and licensing operating groups and the Company’s other business units. The Outdoor Group and Heritage Group led the revenue growth, with revenues increasing 12.3% and 15.3%, respectively, while revenues for the other +business units increased 19.1%. Changes in foreign exchange rates increased reported revenue by $4.3 million. International revenue represented 38.4% of total revenue in fiscal year 2010 compared to 37.3% in fiscal year 2009. +The Outdoor Group branded footwear, apparel and licensing operating group’s revenue increased 12.3%. Fueling growth for +the group was a mid single digit percentage increase in Merrell ® brand footwear unit sales, driven by an +increase in units at a rate in the high teens rate in the brand’s international markets. For +Merrell ® brand apparel, the increase in revenue for fiscal 2010 was driven by unit sales growth in the +mid fifties, +28 +Table of Contents +attributable to strong category presentations and improved product lines. Patagonia ® footwear’s revenue increased at a growth rate in the mid thirties in fiscal year 2010 compared to fiscal year 2009 due to continued strong demand from key +outdoor retailers. The Chaco ® brand revenue in fiscal year 2010 grew at a rate in the high teens +compared to fiscal year 2009, due to the brand’s expanded distribution in the United States. +The Heritage +Group branded footwear, apparel and licensing operating group’s revenue increased 15.3%. The growth drivers for the group were the Wolverine ® brand and Cat ® +footwear, with growth at rates in the low twenties and mid teens, respectively. The revenue increase for the +Wolverine ® brand resulted from a U.S. revenue growth rate in the mid teens for the brand’s core work +boot and rugged casual businesses. Cat ® footwear’s revenue increased at a rate in the mid teens +compared to fiscal year 2009, reflecting stronger sales in both the U.S. and European markets, with percentage increases in the mid teens and low twenties, respectively. Revenue from the +Bates ® footwear business grew at a high single digit rate as the Company began shipping military boots +under a major contract awarded in the third quarter of fiscal year 2010. Harley-Davidson ® footwear +revenue increased at a mid single digit rate compared to fiscal year 2009 due to organic growth in the European market. HyTest ® revenue increased at a rate in the low thirties due to a rebound in the safety footwear market in the United States. +The Lifestyle Group branded footwear, apparel and licensing operating group’s revenue increased 8.3%. The Hush +Puppies ® brand revenue increased at a low single digit rate as mid single digit percentage growth in the +U.S., and a growth rate in the mid teens for the third-party licensing business was partially offset by a high single digit percentage revenue decline in the Canadian market. The Sebago ® brand revenue increased at a rate in the mid teens, and the Cushe ® brand more than doubled its revenue in fiscal year 2010. The Sebago ® brand’s increase resulted from solid organic growth in European and third party distributor markets, with percentage increases in the mid twenties and mid teens, +respectively, as the brand benefitted from investments designed to increase brand awareness. The Cushe ® +brand’s growth was driven by the excellent placement secured in specialty, outdoor and surf retail venues. +Within the Company’s +other business units, Wolverine Retail reported a revenue growth rate in the mid teens compared to fiscal year 2009 as a result of growth in the Company’s e-commerce channel at a rate in the mid fifties and mid single-digit percentage growth in +comparable store sales from Company-owned stores. Wolverine Retail operated 88 retail stores worldwide at the end of both fiscal years 2010 and 2009, with seven store openings in fiscal year 2010 offset by the closure of seven existing locations +during fiscal year 2010. The Wolverine Leathers business reported a revenue percentage increase in the low thirties, due to strong demand for Wolverine’s proprietary pigskin leather from third-party customers. +GROSS MARGIN +For fiscal year 2010, the +Company’s consolidated gross margin was 30 basis points higher than the prior year. Favorable shift in the mix of product sold increased consolidated gross margin by approximately 60 basis points. This increase was partially +offset by the negative effect of higher product costs. +OPERATING EXPENSES +Operating expenses increased $4.2 million, from $346.1 million in fiscal year 2009 to $350.3 million in fiscal year 2010. The increase was related to a mid twenties percentage increase in advertising +and marketing expenses designed to increase brand awareness; a high single digit percentage increase in selling commissions, which vary with revenue; and a mid single digit percentage increase in distribution costs, which also vary with revenue. +These increases were partially offset by continued discipline in general and administrative expenses and a $26.9 million dollar reduction in restructuring and other transition costs. +INTEREST, OTHER AND TAXES +The increase in net interest expense reflected increased +facility fees under the new credit agreement and increased amortization of closing costs related to the new credit facility, offset by a reduction in revolver borrowings in fiscal year 2010. +29 +Table of Contents +The increase in other income is due to the sale of Wolverine Procurement assets in the fourth quarter of +fiscal year 2010, which resulted in a $1.1 million gain, with the remainder of the increase due to the change in realized gains or losses on foreign denominated assets and liabilities. +The Company’s full year effective tax rate in fiscal year 2010 was 27.1%, compared to 27.8% in fiscal year 2009. The lower effective tax rate reflects benefits from the favorable settlement of a +foreign tax audit and the fact that a higher percentage of the Company’s earnings in fiscal year 2010 were attributable to foreign jurisdictions where tax rates are lower than in the U.S. or nontaxable based on specific tax rulings and +legislation. The Company maintains certain strategic management and operational activities in overseas subsidiaries and its foreign earnings are taxed at rates that are generally lower than the U.S. federal statutory income tax rate. A significant +amount of the Company’s earnings are generated by its Canadian, European and Asia Pacific subsidiaries and, to a lesser extent, in jurisdictions that are not subject to income tax and free trade zones where the Company owns manufacturing +operations. The Company has not provided for U.S. taxes for earnings generated in foreign jurisdictions because it plans to reinvest these earnings indefinitely outside the U.S. However, if certain foreign earnings previously treated as +permanently reinvested are repatriated, the additional U.S. tax liability could have a material adverse effect on the Company’s after-tax results of operations and financial position. +NET EARNINGS AND EARNINGS PER SHARE +As a result of the revenue, gross margin and expense +changes discussed above, the Company had net earnings of $104.5 million in fiscal year 2010 compared to $61.9 million in fiscal year 2009, an increase of $42.6 million. +Diluted net earnings per share increased 70.2% in fiscal year 2010 to $2.11 from $1.24 in fiscal year 2009. The increase was attributable to increased revenues, improved gross margin and lower +restructuring and other transition costs as detailed above. The Company repurchased approximately 1,795,000 shares of common stock in fiscal year 2010 for approximately $51.2 million and repurchased approximately 406,000 shares in fiscal +year 2009 for approximately $5.6 million, both of which lowered the average shares outstanding. +Inflation did not have a significant +impact on revenue or net earnings. +LIQUIDITY AND CAPITAL RESOURCES +December 31, +January 1, +Change +2011 +2011 +$ +% +(Millions of Dollars) +Cash and cash equivalents +$ +140.0 +$ +150.4 +$ +(10.4) +(6.9% +) +Accounts receivable +220.0 +196.5 +23.5 +12.0% +Inventories +234.8 +208.7 +26.1 +12.5% +Accounts payable +57.1 +64.1 +(7.0) +(10.9% +) +Current accrued liabilities +80.1 +76.6 +3.5 +4.6% +Interest-bearing debt +11.5 +1.0 +10.5 +nm +Cash provided by operating activities +78.8 +67.9 +10.9 +16.1% +Additions to property, plant and equipment +19.4 +16.4 +3.0 +18.3% +Depreciation and amortization +15.9 +16.2 +(0.3) +(1.9% +) +Cash and cash equivalents of $140.0 million as of December 31, 2011 were $10.4 million lower than the balance at +January 1, 2011. The decrease was due to incremental investments in working capital and other operating assets to support future growth, partially offset by improved revenue and profit. Accounts receivable increased 12.0% compared to the end of +fiscal year 2010 on a 5.6% increase in fourth quarter revenue and a slight increase in days sales outstanding. No single customer accounted for more than 10% of the outstanding accounts +30 +Table of Contents +receivable balance at December 31, 2011. As expected, inventory levels at year end increased from 2010 year end, up 12.5%. The increase is due to new product offerings and increased product +costs. +The decrease in accounts payable as of December 31, 2011 compared to January 1, 2011 was attributable to the timing of cash +payments to vendors. Current accrued liabilities increased $3.5 million, or 4.6%, due to an increase at a rate in the mid sixties in accrued value added taxes and an increase at a rate in the low thirties in accrued royalties, partially offset by +decreases in accrued salaries and wages and a decrease in the Company’s restructuring liability. +The Company’s credit agreement +with a bank syndicate provides the Company with access to capital under a revolving credit facility, including a swing-line facility and letter of credit facility, in an initial aggregate amount of up to $150.0 million. This amount is subject to +increase up to a maximum aggregate amount of $225.0 million under certain circumstances. The revolving credit facility is used to support working capital requirements and other business needs. There was $11.0 million drawn under the revolving credit +facility at December 31, 2011 and there were no amounts outstanding at January 1, 2011. The Company considers balances drawn on the revolving credit facility, if any, to be short-term in nature. The Company was in compliance with all debt +covenant requirements under the revolving credit facility at both December 31, 2011 and January 1, 2011. Cash flows from operations, along with proceeds from the revolving credit facility, if needed, are expected to be sufficient to meet +working capital needs for the foreseeable future. Any excess cash flows from operating activities are expected to be used to purchase property, plant and equipment, pay down debt, fund internal and external growth initiatives, pay dividends or +repurchase the Company’s common stock. +Net cash provided by operating activities in fiscal year 2011 was $78.8 million versus $67.9 +million in fiscal year 2010, an increase of $10.9 million. Stronger earnings performance and lower cash payments for restructuring were partially offset by additional investments in working capital and the timing of tax and operating +expense payments. +The majority of the capital expenditures for the year were for information system enhancements, manufacturing equipment and +building improvements. The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2023. +The Company’s Board of Directors approved a common stock repurchase program on April 19, 2007. The program authorized the repurchase of up to 7.0 million shares of common stock over a +36-month period beginning on the effective date of the program. The Company repurchased 199,996 shares at an average price of $26.52 per share during the first quarter of 2010, which exhausted the number of shares authorized for repurchase under the +program. +The Company’s Board of Directors approved a common stock repurchase program on February 11, 2010 (the “February 2010 +Program”). The February 2010 Program authorizes the repurchase of up to $200.0 million in common stock over a four-year period. The Company repurchased 142,198 shares at an average price of $35.57 in the first quarter of 2011, 478,747 +shares at an average price of $37.74 in the second quarter of 2011, 948,256 shares at an average price of $34.45 in the third quarter of 2011 and 270,882 shares at an average price of $35.08 in the fourth quarter of 2011 under the February 2010 +Program. The Company repurchased 683,808 shares at an average price of $28.18 in the first quarter of 2010, 752,643 shares at an average price of $29.99 per share during the second quarter of 2010, 158,700 shares at an average price of $25.51 +per share during the third quarter and repurchased no shares during the fourth quarter of 2010 under the February 2010 Program. The primary purpose of the stock repurchase programs is to increase stockholder value. The Company intends to continue to +repurchase shares of its common stock under the February 2010 Program from time to time in open market or privately negotiated transactions, depending upon market conditions and other factors. +31 +Table of Contents +2011 +2010 +Cumulative +(Thousands of Dollars, Except Share Data) +Authorization +effective date +Shares +repurchased +Market price +of shares +repurchased +Shares +repurchased +Market price +of shares +repurchased +Shares +repurchased +Market price +of shares +repurchased +April 19, 2007 +– +$ – +199,996 +$ 5,304 +7,000,000 +$ +180,802 +February 11, 2010 +1,840,083 +$ 65,296 +1,595,151 +$ +45,890 +3,435,234 +$ +111,186 +In addition to the repurchases noted above under the Company’s Common Stock Repurchase Programs, the Company +acquired 55,810 shares at an average price of $36.48 per share during fiscal year 2011 and 37,046 shares at an average price of $25.43 per share during fiscal year 2010 related to employee transactions to offset statutory minimum tax withholding +that occurs upon vesting of restricted shares. +The Company declared total dividends of $0.48 per share for fiscal year 2011 and $0.44 for +fiscal year 2010. On February 9, 2012, the Company declared a quarterly cash dividend of $0.12 per share of common stock, to be paid on May 1, 2012 to stockholders of record on April 2, 2012. +NEW ACCOUNTING STANDARDS +In September +2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-08, Testing Goodwill for Impairment (ASU No. 2011-08). ASU No. 2011-08 amended the provisions of FASB ASC 350-20-35 by +allowing an entity the option to make a qualitative evaluation about the likelihood of goodwill impairment to determine whether it should calculate the fair value of a reporting unit. The amendments are effective for annual and interim goodwill +impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted. The Company adopted the applicable requirements of this ASU in the fourth quarter of 2011, and the adoption did not affect the +Company’s consolidated financial position, results of operations or cash flows. +In June 2011, the FASB issued ASU 2011-05, +Comprehensive Income (Topic 220), Presentation of Comprehensive Income (ASU 2011-05). ASU 2011-05 eliminates the option to present other comprehensive income (OCI) in the statement of stockholders’ equity. Under ASU 2011-05, the Company +has the option to present the total of comprehensive income, the components of net income and the components of OCI in either a continuous statement of comprehensive income or in two separate continuous statements. Earnings per share would continue +to be based on net income. Also in December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220), Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other +Comprehensive Income in Accounting Standards Update No. 2011-05 (ASU 2011-12). ASU 2011-12 defers the ASU 2011-05 requirement that companies present reclassification adjustments for each component of accumulated other comprehensive income +(AOCI) in both net income and other comprehensive income (OCI) on the face of the financial statements. The amendments in ASU 2011-05 should be applied retrospectively, and are effective for fiscal years, and interim periods within those years, +beginning after December 15, 2011 (first quarter 2012 for the Company). The adoption of ASU 2011-05 and ASU 2011-12 are not expected to have a material impact on the Company’s consolidated financial position, results of operations or +cash flows. +In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820), Amendments to achieve Common Fair Value +Measurement and Disclosure Requirements in U.S. GAAP and IFRS (ASU 2011-04). ASU 2011-04 amends the fair value measurement and disclosure guidance in ASC 820, Fair Value Measurement , to converge US GAAP and IFRS requirements for +measuring amounts at fair value as well as disclosures about these measurements. ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011 (first quarter 2012 for the Company). The adoption of this ASU is not +expected to have a material impact on the Company’s consolidated financial position, results of operations or cash flows. +32 +Table of Contents +CRITICAL ACCOUNTING POLICIES +The preparation of the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, requires management to +make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates these estimates. Estimates are based on historical experience and on various other +assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Historically, +actual results have not been materially different from the Company’s estimates. However, actual results may differ materially from these estimates under different assumptions or conditions. +The Company has identified the following critical accounting policies used in determining estimates and assumptions in the amounts reported. Management +believes that an understanding of these policies is important to an overall understanding of the Company’s consolidated financial statements. +REVENUE RECOGNITION +Revenue is recognized on the sale of products manufactured or sourced +by the Company when the related goods have been shipped, legal title has passed to the customer and collectability is reasonably assured. Revenue generated through licensees and distributors involving products bearing the Company’s trademarks +is recognized as earned according to stated contractual terms upon either the purchase or shipment of branded products by licensees and distributors. +The Company records provisions for estimated sales returns and allowances at the time of sale based on historical rates of returns and allowances and specific identification of outstanding returns not yet +received from customers. However, estimates of actual returns and allowances in any future period are inherently uncertain and actual returns and allowances for the relevant periods may differ from these estimates. If actual or expected future +returns and allowances were significantly greater or lower than established reserves, a reduction or increase to net revenues would be recorded in the period this determination was made. +ACCOUNTS RECEIVABLE +The Company maintains an allowance for uncollectible accounts +receivable for estimated losses resulting from its customers’ inability to make required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical +collection experience. Historically, losses have been within the Company’s expectations. Adjustments to these estimates may be required if the financial condition of the Company’s customers were to change. If the Company were to determine +that increases or decreases to the allowance for uncollectible accounts were appropriate, the Company would record either an increase or decrease to general and administrative expenses in the period in which the Company made such a determination. At +December 31, 2011 and January 1, 2011, management believed that it had provided sufficient reserves to address future collection uncertainties. +INVENTORY +The Company values its inventory at the lower of cost or market. Cost is +determined by the last-in, first-out (“LIFO”) method for all domestic raw materials and work-in-process inventories and certain domestic finished goods inventories. Cost is determined using the first-in, first-out (“FIFO”) method +for all raw materials, work-in-process and finished goods inventories in foreign countries. The FIFO method is also used for all finished goods inventories of the Company’s retail business, due to the unique nature of those operations, and for +certain other domestic finished goods inventories. The Company has applied these inventory cost valuation methods consistently from year to year. +The Company reduces the carrying value of its inventories to the lower of cost or market for excess or obsolete inventories based upon assumptions about future demand and market conditions. If the Company +were to determine that the estimated market value of its inventory is less than the carrying value of such inventory, the Company would provide a reserve for such difference as a charge to cost of sales. If actual market conditions are +33 +Table of Contents +different from those projected, adjustments to those inventory reserves may be required. The adjustments would increase or decrease the Company’s cost of sales and net income in the period +in which they were realized or recorded. Inventory quantities are verified at various times throughout the year by performing physical inventory observations and perpetual inventory cycle count procedures. If the Company determines that adjustments +to the inventory quantities are appropriate, an increase or decrease to the Company’s cost of sales and inventory is recorded in the period in which such determination was made. At December 31, 2011 and January 1, 2011, management +believed that it had provided sufficient reserves for excess or obsolete inventories. +GOODWILL AND OTHER NON-AMORTIZABLE INTANGIBLES +Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually. +The Company has early-adopted the provisions of ASU 2011-08, which permits the Company to qualitatively assess indicators of the Company’s reporting unit’s fair value when it is unlikely that a reporting unit is impaired. After completing +the qualitative assessment, the Company may also use assumptions about expected future operating performance and utilize a discounted cash flow analysis to estimate fair value. If the recorded values of these assets are not recoverable, based on +either the assessment screen or discounted cash flow analysis, management performs the next step, which compares the fair value of the reporting unit to the fair value of the tangible and intangible assets of the reporting units. Goodwill is +considered impaired if the fair value of the tangible and intangible assets exceeds the fair value of the reporting unit. +The Company tests +indefinite-lived intangibles by comparison of the individual carrying values to the fair value. Future cash flows of the individual indefinite-lived intangible assets are used to measure their fair value after consideration by management of certain +assumptions, such as forecasted growth rates and cost of capital, which are derived from internal projections and operating plans. +The +Company did not recognize any impairment charges for goodwill or indefinite-lived intangible assets during the fiscal years ended December 31, 2011 or January 1, 2011 as the annual impairment testing indicated that all reporting unit +goodwill and indefinite-lived intangible asset fair values exceed their respective recorded values. +INCOME TAXES +The Company maintains certain strategic management and operational activities in overseas subsidiaries, and its foreign earnings are taxed at rates that +are generally lower than the U.S. federal statutory income tax rate. A significant amount of the Company’s earnings are generated by its Canadian, European and Asia Pacific subsidiaries and, to a lesser extent, in jurisdictions that are not +subject to income tax and free trade zones where the Company owns manufacturing operations. The Company has not provided for U.S. taxes for earnings generated in foreign jurisdictions because it plans to reinvest these earnings indefinitely outside +the U.S. However, if certain foreign earnings previously treated as permanently reinvested are repatriated, the additional U.S. tax liability could have a material adverse effect on the Company’s after-tax results of operations and financial +position. Income tax audits associated with the allocation of this income and other complex issues may require an extended period of time to resolve and may result in income tax adjustments if changes to the income allocation are required between +jurisdictions with different income tax rates. Because income tax adjustments in certain jurisdictions can be significant, the Company records accruals representing management’s best estimate of the resolution of these matters. To the extent +additional information becomes available, such accruals are adjusted to reflect the revised estimated outcome. The Company believes its tax accruals are adequate to cover exposures related to changes in income allocation between tax jurisdictions. +The carrying value of the Company’s deferred tax assets assumes that the Company will be able to generate sufficient taxable income in future years to utilize these deferred tax assets. If these assumptions change, the Company may be required +to record valuation allowances against its gross deferred tax assets in future years, which would cause the Company to record additional income tax expense in its consolidated statements of operations. Management evaluates the potential the Company +will be able to realize its gross deferred tax assets and assesses the need for valuation allowances on a quarterly basis. +On a periodic +basis, the Company estimates what the effective tax rate will be for the full fiscal year and records a quarterly income tax provision in accordance with the projected full year rate. As the fiscal year progresses, +34 +Table of Contents +that estimate is refined based upon actual events and the distribution of earnings in each tax jurisdiction during the year. This continual estimation process periodically results in a change to +the expected effective tax rate for the fiscal year. When this occurs, the Company adjusts the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date provision reflects the revised anticipated annual +rate. +RETIREMENT BENEFITS +The determination of the obligation and expense for retirement benefits is dependent on the selection of certain actuarial assumptions used in calculating +such amounts. These assumptions include, among others, the discount rate, expected long-term rate of return on plan assets and rates of increase in compensation. These assumptions are reviewed with the Company’s actuaries and updated annually +based on relevant external and internal factors and information, including but not limited to, long-term expected asset returns, rates of termination, regulatory requirements and plan changes. +The Company utilizes a bond matching calculation to determine the discount rate used to calculate its year-end pension liability and subsequent year +pension expense. A hypothetical bond portfolio is created based on a presumed purchase of individual bonds to settle the plan’s expected future benefit payments. The discount rate is the resulting yield of the hypothetical bond portfolio. The +bonds selected are rated AA- or higher by at least two recognized ratings agency and are non-callable, currently purchasable and non-prepayable. The discount rate at year end 2011 was 5.42%. Pension expense is also impacted by the expected long-term +rate of return on plan assets, which the Company determined to be 8.0% in 2011. This determination is based on both actual historical rates of return experienced by the pension assets and the long-term rate of return of a composite portfolio of +equity and fixed income securities that reflects the approximate diversification of the pension assets. +STOCK-BASED COMPENSATION +The Company accounts for stock-based compensation in accordance with the fair value recognition provisions of FASB ASC Topic 718, +Compensation – Stock Compensation . The Company utilizes the Black-Scholes model, which requires the input of subjective assumptions. These assumptions include estimating (a) the length of time employees will retain their vested +stock options before exercising them (“expected term”), (b) the volatility of the Company’s common stock price over the expected term and (c) the number of options that will be forfeited. Changes in these assumptions can +materially affect the estimate of fair value of stock-based compensation and, consequently, the related expense amounts recognized in the consolidated statements of operations. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +The Company faces market risk +to the extent that changes in foreign currency exchange rates affect the Company’s foreign assets, liabilities and inventory purchase commitments and to the extent that its long-term debt requirements are affected by changes in interest rates. +The Company manages these risks by attempting to denominate contractual and other foreign arrangements in U.S. dollars. The Company does not believe that there has been a material change during 2011 in the nature of the Company’s primary market +risk exposures, including the categories of market risk to which the Company is exposed and the particular markets that present the primary risk of loss to the Company. As of the date of this Annual Report on Form 10-K, the Company does not know of +or expect there to be any material change in the near-term in the general nature of its primary market risk exposure. +Under the provisions of +FASB ASC Topic 815, Derivatives and Hedging , the Company is required to recognize all derivatives on the balance sheet at fair value. Derivatives that are not qualifying hedges must be adjusted to fair value through earnings. If a derivative +is a qualifying hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in +accumulated other comprehensive income until the hedged item is recognized in earnings. +The Company conducts wholesale operations outside of +the United States in the United Kingdom, continental Europe and Canada where the functional currencies are primarily the British pound, euro and Canadian dollar, +35 +Table of Contents +respectively. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with U.S. dollar inventory purchases made by non-U.S. wholesale operations in +the normal course of business. At December 31, 2011 and January 1, 2011, the Company had outstanding forward currency exchange contracts to purchase $106.3 million and $111.8 million, respectively, of U.S. dollars with maturities ranging +up to 336 and 364 days, respectively. +The Company also has production facilities in the Dominican Republic and sourcing locations in Asia, +where financial statements reflect the U.S. dollar as the functional currency. However, operating costs are paid in the local currency. Royalty revenue generated by the Company from third-party foreign licensees is calculated in the licensees’ +local currencies, but paid in U.S. dollars. Accordingly, the Company’s reported results are subject to foreign currency exposure for this stream of revenue and expenses. +Assets and liabilities outside the United States are primarily located in the United Kingdom, Canada and the Netherlands. The Company’s investments in foreign subsidiaries with a functional currency +other than the U.S. dollar are generally considered long-term. Accordingly, the Company currently does not hedge these net investments. At December 31, 2011, a stronger U.S. dollar compared to foreign currencies decreased the value of +these investments in net assets by $11.3 million. At January 1, 2011, a stronger U.S. dollar compared to foreign currencies decreased the value of these investments in net assets by $2.9 million. These changes resulted in cumulative foreign +currency translation adjustments at December 31, 2011 and January 1, 2011 of $0.3 million and $11.5 million, respectively, that are deferred and recorded as a component of accumulated other comprehensive income in stockholders’ +equity. +Because the Company markets, sells and licenses its products throughout the world, it could be affected by weak economic conditions +in foreign markets that could reduce demand for its products. +The Company is exposed to changes in interest rates primarily as a result of +its revolving credit agreement. As of December 31, 2011 the Company had $11.0 million outstanding on its revolving credit facility and had no outstanding balances on its revolving credit facility as of January 1, 2011. +The Company does not enter into contracts for speculative or trading purposes, nor is it a party to any leveraged derivative instruments. +OFF-BALANCE SHEET ARRANGEMENTS +The +Company has no off-balance sheet arrangements as of December 31, 2011. +CONTRACTUAL OBLIGATIONS +The Company has the following payments under contractual obligations due by period: +Total +Less than +1 year +1-3 years +3-5 years +More than +5 years +(Thousands of Dollars) +Operating leases +$ +133,506 +18,574 +32,941 +29,065 +52,926 +Debt obligations +11,515 +11,515 +– +– +– +Purchase obligations (1) +198,016 +198,016 +– +– +– +Restructuring related obligations +330 +330 +– +– +– +Deferred compensation +566 +148 +208 +37 +173 +Pension (2) +26,657 +26,657 +– +– +– +SERP +32,749 +2,091 +5,792 +7,094 +17,772 +Dividends declared +5,699 +5,699 +– +– +– +Minimum royalties +4,350 +750 +2,100 +1,500 +– +Minimum advertising +18,662 +2,360 +5,369 +5,696 +5,237 +Total (3) +$ +432,050 +$ +266,140 +$ +46,410 +$ +43,392 +$ +76,108 +36 +Table of Contents +(1) +Purchase obligations primarily relate to inventory and capital expenditure commitments. +(2) +Pension obligations reflect expected pension funding as there are currently no required funding obligations under government regulation. Funding amounts are calculated +on an annual basis and no required or planned funding beyond one year has been determined. +(3) +The Company adopted FASB ASC Topic 740, Income Taxes, on December 31, 2006. The total amount of unrecognized tax benefits on the Consolidated Balance Sheet +at December 31, 2011 is $13.1 million. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes. As a +result, this amount is not included in the table above. +At December 31, 2011, the Company had $139.0 million of additional +borrowing capacity available under a revolving credit agreement with a termination date of June 7, 2014 and $1.6 million of additional borrowing capacity under three standby letters of credit. +Item 7A. Quantitative and Qualitative Disclosures About Market +Risk +The response to this Item is set forth under the caption “Quantitative and Qualitative Disclosures About Market Risk” +in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and is incorporated herein by reference. +Item 8. Financial Statements and Supplementary Data +The response to this Item is set forth in Appendix A of this Annual Report on Form 10-K and is incorporated herein by reference. +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +None. +Item 9A. Controls and Procedures +Evaluation of Disclosure Controls and Procedures +An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of +the design and operation of the Company’s disclosure controls and procedures. Based on and as of the time of such evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that the +Company’s disclosure controls and procedures were effective as of the end of the period covered by this report. +Management’s +Report on Internal Control Over Financial Reporting +Management is responsible for establishing and maintaining adequate internal control +over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, we conducted an +evaluation of the effectiveness of internal control over financial reporting as of December 31, 2011, based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission (“COSO”). Based on that evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2011. +The effectiveness of the Company’s internal control over financial reporting as of December 31, 2011 has been audited by Ernst & Young LLP, an independent registered public accounting +firm, as stated in its report, which is included in Appendix A and is incorporated into this Item 9A by reference. +37 +Table of Contents +Changes in Internal Control Over Financial Reporting +There was no change in the Company’s internal control over financial reporting that occurred during the sixteen-week period ended December 31, +2011 that has materially affected, or that is reasonably likely to materially affect, the Company’s internal control over financial reporting. +Item 9B. Other Information +None. +PART III +Item 10. Directors, Executive Officers and Corporate Governance +The Company’s Audit Committee is comprised of four Board members, all of whom are independent under independence standards adopted +by the Board and applicable SEC regulations and New York Stock Exchange standards (including independence standards related specifically to Audit Committee membership). The Audit Committee members each have financial and business experience with +companies of substantial size and complexity and have an understanding of financial statements, internal controls and audit committee functions. The Company’s Board of Directors has determined that Jeffrey M. Boromisa and William K. Gerber are +audit committee financial experts, as defined by the SEC. Additional information regarding the Audit Committee is provided in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on +April 19, 2012, under the caption “Corporate Governance” under the subheading “Board of Directors and Committees.” +The Company has adopted an Accounting and Finance Code of Ethics that applies to the Company’s principal executive officer, principal financial +officer and principal accounting officer, and has adopted a Code of Conduct & Compliance that applies to the Company’s directors and employees. The Accounting and Finance Code of Ethics and the Code of Conduct & Compliance are +available on the Company’s website at www.wolverineworldwide.com/investor-relations/corporate-governance . Any waiver from the Accounting and Finance Code of Ethics or the Code of Conduct & Compliance with respect to the +Company’s executive officers and directors will be disclosed on the Company’s website. Any amendment to the Accounting and Finance Code of Ethics and the Code of Conduct & Compliance will be disclosed on the Company’s +website. +The information regarding directors of the Company contained under the caption “Directors” in the Definitive Proxy +Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 19, 2012, is incorporated herein by reference. +The information regarding directors and executive officers of the Company under the caption “Additional Information” under the subheading “Section 16(a) Beneficial Ownership Reporting +Compliance” in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 19, 2012, is incorporated herein by reference. +Item 11. Executive Compensation +The information contained under the captions “Non-Employee Director Compensation in Fiscal Year 2011,” “Compensation Discussion and Analysis,” “Compensation Committee +Report,” “2011 Summary Compensation Table,” “Grants of Plan-Based Awards in Fiscal 2011,” “Outstanding Equity Awards at 2011 Fiscal Year-End,” “Option Exercises and Stock Vested in Fiscal 2011,” +“Pension Plans and 2011 Pension Benefits” and “Potential Payments upon Termination or Change in Control” in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on +April 19, 2012, is incorporated herein by reference. The information contained under the caption “Corporate Governance” under the subheadings “Risk +38 +Table of Contents +Considerations in Compensation Programs” and “Board of Directors and Committees” in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders +to be held on April 19, 2012, is also incorporated herein by reference. +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +The information contained under the caption “Securities Ownership of Officers and Directors and Certain Beneficial Owners” contained in the +Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 19, 2012, is incorporated herein by reference. +Equity Compensation Plan Information +The following table provides information about the +Company’s equity compensation plans as of December 31, 2011: +Plan +Category 1 +Number of Securities to be +Issued Upon Exercise of +Outstanding Options, +Warrants and Rights +(a) +Weighted Average +Exercise Price +of +Outstanding +Options, Warrants +and Rights +(b) +Number of Securities +Remaining Available for +Future Issuance under +Equity Compensation +Plans +(Excluding +Securities Reflected in +Column (a)) +(c) +Equity compensation +plans approved by +security holders +3,694,984 +2,3 +$ +23.40 +3,786,121 +4 +Equity compensation +plans not approved by +security holders +- +N/A +- +Total +3,694,984 +$ +23.40 +3,786,121 +1 +Each plan for which aggregated information is provided contains customary anti-dilution provisions that are applicable in the event of a stock split, +stock dividend or certain other changes in the Company’s capitalization. +2 +Includes: (i) 3,343,546 stock options awarded to employees under the 1993 Stock Incentive Plan, the 1995 Stock Incentive Plan, the 1997 Stock +Incentive Plan, the Amended and Restated Stock Incentive Plan of 1999, the Amended and Restated Stock Incentive Plan of 2001, the Amended and Restated Stock Incentive Plan of 2003, the Amended and Restated Stock Incentive Plan of 2005 and the Stock +Incentive Plan of 2010; and (ii) and 351,448 stock options awarded to non-employee directors under the Stock Incentive Plan of 2010, the Amended and Restated Stock Incentive Plan of 2005 and the Amended and Restated Directors’ Stock Option +Plan last approved by stockholders in 2002. Column (a) does not include stock units credited to outside directors’ fee accounts or retirement accounts under the Outside Directors’ Deferred Compensation Plan. Stock units do not have an +exercise price. Each stock unit credited to a director’s fee account and retirement account under the Outside Directors’ Deferred Compensation Plan will be converted into one share of common stock upon distribution. Column (a) also +does not include shares of restricted or unrestricted common stock previously issued under the Company’s equity compensation plans. +3 +Of this amount, 828,072 options were not exercisable as of December 31, 2011, due to vesting restrictions. +4 +Comprised of: (i) 414,570 shares available for issuance under the Outside Directors’ Deferred Compensation Plan upon the retirement of the +current directors or upon a change in control; and (ii) 3,371,551 shares issuable under the Stock Incentive Plan of 2010. +The Outside Directors’ Deferred Compensation Plan is a supplemental, unfunded, nonqualified deferred compensation plan for non-employee directors. Beginning in 2006, the Company began paying an +annual equity retainer to non-management directors in the form of a contribution under the Outside Directors’ Deferred Compensation Plan. Non-management directors may also voluntarily elect to receive, in lieu of some or all directors’ +fees, a number of stock units equal to the amount of the deferred directors’ fees divided by the fair market value of the Company’s common stock on the date +39 +Table of Contents +of payment of the next cash dividend on the Company’s common stock. These stock units are increased by a dividend equivalent based on dividends paid by the Company and the amount of stock +units credited to the participating director’s fee account and retirement account. Upon distribution, the participating directors receive a number of shares of the Company’s common stock equal to the number of stock units to be distributed +at that time. Distribution is triggered by termination of service as a director or by a change in control of the Company and can occur in a lump sum, in installments or on another deferred basis. Of the 414,570 shares issuable under the Outside +Directors’ Deferred Compensation Plan, 227,278 shares have been issued to a trust to satisfy the Company’s obligations when distribution is triggered and are included in shares the Company reports as issued and outstanding. +The Stock Incentive Plan of 2010 is an equity-based incentive plan for officers, key employees, and directors. The Stock Incentive Plan +of 2010 authorizes awards of stock options, restricted common stock, common stock, restricted stock units, and/or stock appreciation rights. The Stock Incentive Plan of 2010 provides that each share of restricted or unrestricted common stock and +each restricted stock unit is counted as two shares against the total number of shares authorized for issuance under the plan. The number of securities listed as remaining available in column (c) of the table assumes the grant of all stock +options, which count as only one share against the total number of shares authorized for issuance under the plan. Actual shares available under the plan will be less to the extent that the Company awards restricted common stock, unrestricted common +stock or restricted stock units under the plan. The numbers provided in this footnote and in column (c) will increase to the extent that options relating to the number of shares listed in column (a) of the table or other outstanding awards +(e.g., shares of restricted or unrestricted stock, restricted stock units or stock appreciation rights) previously issued under the plan are canceled, surrendered, modified, exchanged for substitutes or expire or terminate prior to exercise or +vesting because the number of shares underlying any such awards will again become available for issuance under the plan under which the award was granted. +Of the total number of shares available under column (C), the number of shares with respect to the following plans may be issued other than upon the exercise of an option, warrant or right outstanding as +of December 31, 2011: +• +Outside Directors’ Deferred Compensation Plan: 414,570 +• +Stock Incentive Plan of 2010: 1,685,776 +Item 13. Certain Relationships and Related Transactions, and Director Independence +The information contained under the caption “Related Party Matters” under the subheadings “Certain Relationships and Related +Transactions” and “Related Person Transactions Policy” contained in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 19, 2012, is incorporated herein by +reference. The information contained under the caption “Corporate Governance” under the subheading “Director Independence” contained in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of +Stockholders to be held on April 19, 2012, is incorporated herein by reference. +Item 14. Principal Accountant Fees and Services +The information contained under the caption “Independent Auditor” in the Definitive Proxy Statement of the Company with respect to the Annual +Meeting of Stockholders to be held on April 19, 2012, is incorporated herein by reference. +40 +Table of Contents +PART IV +Item 15. Exhibits and Financial Statement Schedules +Item 15(a)(1). Financial Statements Attached as Appendix A +The following consolidated financial statements of Wolverine World Wide, Inc. and its subsidiaries are filed as a part of this report: +• +Consolidated Balance Sheets as of December 31, 2011 and January 1, 2011. +• +Consolidated Statements of Stockholders’ Equity and Comprehensive Income for the Fiscal Years Ended December 31, 2011, January 1, +2011 and January 2, 2010. +• +Consolidated Statements of Operations for the Fiscal Years Ended December 31, 2011, January 1, 2011 and January 2, 2010. +• +Consolidated Statements of Cash Flows for the Fiscal Years Ended December 31, 2011, January 1, 2011 and January 2, 2010. +• +Notes to the Consolidated Financial Statements. +• +Reports of Independent Registered Public Accounting Firm. +Item 15(a)(2). Financial Statement Schedules Attached as Appendix B +The following consolidated financial statement schedule of Wolverine World Wide, Inc. and its subsidiaries is filed as a part of this report: +• +Schedule II—Valuation and Qualifying Accounts. +All other schedules (I, III, IV, and V) for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and, therefore, +have been omitted. +Item 15(a)(3). Exhibits +The following exhibits are filed as part of this report: +Exhibit +Number +Document +3.1 +Restated Certificate of Incorporation. Previously filed as Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the period ended December 30, 2006. Here incorporated by +reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on December 15, 2010. Here incorporated by +reference. +4.1 +The Registrant has other long-term debt instruments outstanding in addition to those described in Exhibit 4.2. The authorized amount of none of these classes of debt exceeds 10% of +the Company’s total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +4.2 +Credit Agreement, dated as of June 7, 2010, among Wolverine World Wide, Inc., certain foreign subsidiaries of Wolverine World Wide, Inc., JPMorgan Chase Bank, N.A., as +Administrative Agent, and the lenders party thereto. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on June 8, 2010. Here incorporated by reference. +10.1 +1993 Stock Incentive Plan, as amended and restated.* Previously filed as Exhibit 10.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +41 +Table of Contents +Exhibit +Number +Document +10.2 +Amended and Restated 1995 Stock Incentive Plan.* Previously filed as Exhibit 10.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.3 +Amended and Restated 1997 Stock Incentive Plan.* Previously filed as Exhibit 10.3 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.4 +Amended and Restated Stock Incentive Plan of 1999.* Previously filed as Exhibit 10.4 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.5 +Amended and Restated Stock Incentive Plan of 2001.* Previously filed as Exhibit 10.5 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.6 +Amended and Restated Stock Incentive Plan of 2003.* Previously filed as Exhibit 10.6 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.7 +Amended and Restated Stock Incentive Plan of 2005.* Previously filed as Exhibit 10.7 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.8 +Amended and Restated Directors’ Stock Option Plan.* Previously filed as Exhibit 10.8 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10.9 +Amended and Restated Outside Directors’ Deferred Compensation Plan.* Previously filed as Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the fiscal year ended +December 29, 2007. Here incorporated by reference. +10.10 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Exhibit 10.10 to the Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +10.11 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Exhibit 10.11 to the Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +10.12 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 29, 2007. Here +incorporated by reference. +10.13 +Executive Severance Agreement.* Previously filed as Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated by reference. A +participant schedule of current executive officers who are parties to this agreement is attached as Exhibit 10.13. +10.14 +Executive Severance Agreement.* A participant schedule of current executive officers who are parties to this agreement is included in Exhibit 10.14 +10.15 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and with Messrs. Grady, Grimes, Jeppesen, Krueger and Zwiers and Ms. +Linton. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +42 +Table of Contents +Exhibit +Number +Document +10.16 +Amended and Restated Benefit Trust Agreement dated April 25, 2007.* Previously filed as Exhibit 10.5 to the Company’s Current Report on Form 8-K filed on April 25, 2007. Here +incorporated by reference. +10.17 +Employees’ Pension Plan (Restated as amended through January 1, 2011).* +10.18 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 15, 2005. Here incorporated by +reference. +10.19 +Form of Non-Qualified Stock Option Agreement for Blake W. Krueger and Timothy J. O’Donovan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 15, 2005. Here incorporated by reference. +10.20 +Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.19 applies.* Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 15, 2005. Here incorporated by reference. +10.21 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company’s Current Report on Form 8-K filed on February 15, 2005. Here incorporated by +reference. +10.22 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 17, 2006. Here incorporated by +reference. +10.23 +Form of Non-Qualified Stock Option Agreement for Blake W. Krueger and Timothy J. O’Donovan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 17, 2006. Here incorporated by reference. +10.24 +Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.23 applies.* Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 17, 2006. Here incorporated by reference. +10.25 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company’s Current Report on Form 8-K filed on February 17, 2006. Here incorporated by +reference. +10.26 +Form of Stock Option Agreement for non-employee directors.* Previously filed as Exhibit 10.23 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 1, +2005. Here incorporated by reference. +10.27 +2009 Form of Non-Qualified Stock Option Agreement for Donald T. Grimes, Blake W. Krueger, Pamela L. Linton and James D. Zwiers.* Previously filed as Exhibit 10.26 to the +Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.28 +2009 Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.27 applies.* Previously filed as Exhibit 10.27 to the Company’s +Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.29 +Form of Performance Share Award Agreement (2009 – 2011 performance period).* Previously filed as Exhibit 10.28 to the Company’s Annual Report on Form 10-K for the fiscal +year ended January 3, 2009. Here incorporated by reference. +10.30 +Form of Performance Share Award Agreement (2010 – 2012 performance period).* Previously filed as Exhibit 10.29 to the Company’s Annual Report on Form 10-K for the fiscal +year ended January 2, 2010. Here incorporated by reference. +43 +Table of Contents +Exhibit +Number +Document +10.31 +Form of Performance Share Award Agreement (2011 – 2013 performance period).* Previously filed as Exhibit 10.30 to the Company’s Annual Report on Form 10-K for the fiscal +year ended January 1, 2011. Here incorporated by reference. +10.32 +Form of Performance Share Award Agreement (2012 – 2014 performance period).* +10.33 +Separation Agreement between Wolverine World Wide, Inc. and Blake W. Krueger, dated as of March 13, 2008, as amended.* Previously filed as Exhibit 10.1 to the Company’s +Quarterly Report on Form 10-Q for the period ended March 22, 2008. Here incorporated by reference. +10.34 +First Amendment to Separation Agreement between Wolverine World Wide, Inc. and Blake W. Krueger, dated as of December 11, 2008.* Previously filed as Exhibit 10.30 to the +Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.35 +409A Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated by +reference. A participant schedule of current executive officers who participate in this plan is attached as Exhibit 10.35. +10.36 +Form of 409A Supplemental Retirement Plan Participation Agreement with Blake W. Krueger.* Previously filed as Exhibit 10.32 to the Company’s Annual Report on Form 10-K for the +fiscal year ended January 3, 2009. Here incorporated by reference. +10.37 +Outside Directors’ Deferred Compensation Plan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated +by reference. +10.38 +Stock Incentive Plan of 2010.* Previously filed as Exhibit 10.1 to the Company’s Registration Statement on Form S-8 filed on March 4, 2010. Here incorporated by +reference. +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31.1 +Certification of Chairman, Chief Executive Officer and President under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Senior Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +101 +Interactive Data File.** +* +Management contract or compensatory plan or arrangement. +** +IN ACCORDANCE WITH THE TEMPORARY HARDSHIP EXEMPTION PROVIDED BY RULE 201 OF REGULATION S-T, THE DATE BY WHICH THE INTERACTIVE DATA FILE IS REQUIRED TO +BE SUBMITTED HAS BEEN EXTENDED BY SIX BUSINESS DAYS. +44 +Table of Contents +The Company will furnish a copy of any exhibit listed above to any stockholder without charge upon written +request to Mr. Kenneth A. Grady, General Counsel and Secretary, 9341 Courtland Drive N.E., Rockford, Michigan 49351. +45 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed +on its behalf by the undersigned, thereunto duly authorized. +WOLVERINE WORLD WIDE, INC. +Dated: February 29, 2012 +By: +/s/ Blake W. Krueger +Blake W. Krueger +Chairman, +Chief Executive Officer and President +(Principal Executive Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following +persons on behalf of the Registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ Blake W. Krueger +Blake W. Krueger +Chairman, Chief Executive Officer and President (Principal Executive Officer) +February 29, 2012 +/s/ Donald T. Grimes +Donald T. Grimes +Senior Vice President, Chief Financial Officer and Treasurer +(Principal Financial and Accounting Officer) +February 29, 2012 +*/s/ Jeffrey M. Boromisa +Jeffrey M. Boromisa +Director +February 29, 2012 +*/s/ William K. Gerber +William K. Gerber +Director +February 29, 2012 +*/s/ Alberto L. Grimoldi +Alberto L. Grimoldi +Director +February 29, 2012 +*/s/ Joseph R. Gromek +Joseph R. Gromek +Director +February 29, 2012 +*/s/ David T. Kollat +David T. Kollat +Director +February 29, 2012 +/s/ Blake W. Krueger +Blake W. Krueger +Director +February 29, 2012 +*/s/ Brenda J. Lauderback +Brenda J. Lauderback +Director +February 29, 2012 +*/s/ Nicholas T. Long +Nicholas T. Long +Director +February 29, 2012 +*/s/ David P. Mehney +David P. Mehney +Director +February 29, 2012 +*/s/ Timothy J. O’Donovan +Timothy J. O’Donovan +Director +February 29, 2012 +46 +Table of Contents +Signature +Title +Date +*/s/ Shirley D. Peterson +Shirley D. Peterson +Director +February 29, 2012 +*/s/ Michael A. Volkema +Michael A. Volkema +Director +February 29, 2012 +*By /s/ Blake W. Krueger +Blake W. Krueger +Attorney-in-Fact +Chairman, Chief Executive Officer and President +February 29, 2012 +47 +Table of Contents +APPENDIX A +Financial Statements +Table of Contents +CONSOLIDATED BALANCE SHEETS +As of Fiscal Year End +2011 +2010 +(Thousands of Dollars, Except Share and Per Share Data) +ASSETS +Current assets: +Cash and cash equivalents +$ +140,012 +$ +150,400 +Accounts receivable, less allowances (2011 – $12,688; 2010 – $11,413) +219,963 +196,457 +Inventories +Finished products +211,183 +188,647 +Raw materials and work-in-process +23,574 +20,008 +234,757 +208,655 +Deferred income taxes +9,801 +13,225 +Prepaid expenses and other current assets +29,963 +11,397 +Total current assets +634,496 +580,134 +Property, plant and equipment: +Land +826 +826 +Buildings and improvements +73,926 +71,724 +Machinery and equipment +135,118 +129,707 +Software +83,809 +79,307 +293,679 +281,564 +Accumulated depreciation +(215,190 +) +(207,167 +) +78,489 +74,397 +Other assets: +Goodwill +38,894 +39,014 +Other non-amortizable intangibles +17,375 +16,464 +Cash surrender value of life insurance +38,203 +36,042 +Deferred income taxes +42,349 +37,602 +Other +1,846 +2,922 +138,667 +132,044 +Total assets +$ +851,652 +$ +786,575 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable +$ +57,099 +$ +64,080 +Accrued salaries and wages +22,635 +26,848 +Income taxes +2,822 +2,746 +Taxes, other than income taxes +8,093 +6,586 +Restructuring reserve +330 +1,314 +Other accrued liabilities +44,033 +37,046 +Accrued pension liabilities +2,151 +2,018 +Current maturities of long-term debt +515 +517 +Borrowings under revolving credit agreement +11,000 +– +Total current liabilities +148,678 +141,155 +Long-term debt, less current maturities +– +517 +Deferred compensation +4,113 +4,410 +Accrued pension liabilities +103,825 +83,685 +Other liabilities +16,386 +12,911 +Stockholders’ equity: +Common stock, $1 par value: authorized 160,000,000 shares; shares +issued, including treasury shares: 2011 – +65,019,406; 2010 – 63,976,387 +65,019 +63,976 +Additional paid-in capital +138,585 +108,286 +Retained earnings +889,765 +789,684 +Accumulated other comprehensive income (loss) +(71,029 +) +(41,123 +) +Cost of shares in treasury: 2011 – 16,848,374 shares; 2010 – 14,976,835 +shares +(443,690 +) +(376,926 +) +Total stockholders’ equity +578,650 +543,897 +Total liabilities and stockholders’ equity +$ +851,652 +$ +786,575 +See accompanying notes to consolidated financial statements. +A-1 +Table of Contents +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME +Fiscal Year +2011 +2010 +2009 +(Thousands of Dollars, Except Share and Per Share Data) +COMMON STOCK OUTSTANDING +Balance at beginning of the year +$ +63,976 +$ +62,764 +$ +61,656 +Common stock issued under stock incentive plans, net of forfeitures (2011 – +1,043,019 shares; 2010 – 1,212,463 shares; 2009 – 1,108,112 shares) +1,043 +1,212 +1,108 +Balance at end of the year +65,019 +63,976 +62,764 +ADDITIONAL PAID-IN CAPITAL +Balance at beginning of the year +108,286 +81,021 +64,696 +Stock-based compensation expense +14,074 +11,543 +8,649 +Amounts associated with common stock issued under stock incentive plans: +Proceeds over par value +4,919 +6,289 +2,050 +Income tax benefits +4,071 +4,094 +1,427 +Issuance of performance-based shares (2011 – 206,148 shares; +2010 – 215,027 shares; 2009 – 286,006 +shares) +7,550 +5,197 +4,507 +Issuance of treasury shares (2011 –24,354 shares; 2010 – 25,829 shares; 2009 – 32,455 shares) +(315 +) +142 +(111 +) +Net change in employee notes receivable +– +– +(197 +) +Balance at end of the year +138,585 +108,286 +81,021 +RETAINED EARNINGS +Balance at beginning of the year +789,684 +706,439 +666,027 +Net earnings +123,287 +104,470 +61,912 +Cash dividends declared (2011 – $0.48 per share; 2010 – $0.44 per share; 2009 – $0.44 per share) +(23,206 +) +(21,225 +) +(21,500 +) +Balance at end of the year +889,765 +789,684 +706,439 +ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) +Balance at beginning of the year +(41,123 +) +(42,806 +) +(42,834 +) +Foreign currency translation adjustments +(11,290 +) +(2,929 +) +15,349 +Change in fair value of foreign exchange contracts, net of taxes +(2011 – $(2,346); 2010 – $(750); 2009 – +$3,482) +5,110 +1,731 +(7,469 +) +Pension adjustments, net of taxes (2011 – $12,776; 2010 – $(1,551); 2009 – $4,228 +(23,726 +) +2,881 +(7,852 +) +Balance at end of the year +(71,029 +) +(41,123 +) +(42,806 +) +COST OF SHARES IN TREASURY +Balance at beginning of the year +(376,926 +) +(325,385 +) +(319,623 +) +Common stock acquired for treasury (2011 – 1,895,893 shares; 2010 – 1,832,193 shares; 2009 – 454,205 +shares) +(67,388 +) +(52,190 +) +(6,566 +) +Issuance of treasury shares (2011 – 24,354 shares; 2010 – 25,829 shares; 2009 – 32,455 +shares) +624 +649 +804 +Balance at end of the year +(443,690 +) +(376,926 +) +(325,385 +) +Total stockholders’ equity at end of the year +$ +578,650 +$ +543,897 +$ +482,033 +COMPREHENSIVE INCOME +Net earnings +$ +123,287 +$ +104,470 +$ +61,912 +Foreign currency translation adjustments +(11,290 +) +(2,929 +) +15,349 +Change in fair value of foreign exchange contracts, net of taxes +5,110 +1,731 +(7,469 +) +Pension adjustments, net of taxes +(23,726 +) +2,881 +(7,852 +) +Total comprehensive income +$ +93,381 +$ +106,153 +$ +61,940 +See accompanying notes to consolidated financial statements. +A-2 +Table of Contents +CONSOLIDATED STATEMENTS OF OPERATIONS +Fiscal Year +2011 +2010 +2009 +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +1,409,068 +$ +1,248,517 +$ +1,101,056 +Cost of goods sold +852,316 +754,537 +663,461 +Restructuring and other transition costs +– +1,406 +5,873 +Gross profit +556,752 +492,574 +431,722 +Selling, general and administrative expenses +386,534 +347,499 +316,378 +Restructuring and other transition costs +– +2,828 +29,723 +Operating profit +170,218 +142,247 +85,621 +Other expenses (income): +Interest expense +1,395 +571 +494 +Interest income +(370 +) +(184 +) +(383 +) +Other expense (income)—net +283 +(1,366 +) +(182 +) +1,308 +(979 +) +(71 +) +Earnings before income taxes +168,910 +143,226 +85,692 +Income taxes +45,623 +38,756 +23,780 +Net earnings +$ +123,287 +$ +104,470 +$ +61,912 +Net earnings per share (see Note 1): +Basic +$ +2.54 +$ +2.15 +$ +1.26 +Diluted +$ +2.48 +$ +2.11 +$ +1.24 +See accompanying notes to consolidated financial +statements. +A-3 +Table of Contents +CONSOLIDATED STATEMENTS OF CASH FLOWS +Fiscal Year +2011 +2010 +2009 +(Thousands of Dollars) +OPERATING ACTIVITIES +Net earnings +$ +123,287 +$ +104,470 +$ +61,912 +Adjustments necessary to reconcile net earnings to net cash provided by operating activities: +Depreciation +14,870 +14,509 +15,932 +Amortization +1,037 +1,692 +1,689 +Deferred income taxes +7,676 +(4,298 +) +(7,845 +) +Stock-based compensation expense +14,074 +11,543 +8,943 +Excess tax benefits from stock-based compensation +(3,255 +) +(1,362 +) +(462 +) +Pension contribution +(31,800 +) +(10,400 +) +(2,600 +) +Pension expense +17,502 +16,286 +15,891 +Restructuring and other transition costs +– +4,234 +35,596 +Cash payments related to restructuring and other transition costs +(984 +) +(7,516 +) +(20,653 +) +Other +11,271 +3,524 +(7,929 +) +Changes in operating assets and liabilities: +Accounts receivable +(24,802 +) +(32,466 +) +9,817 +Inventories +(28,120 +) +(51,173 +) +44,500 +Other operating assets +(18,559 +) +1,080 +3,103 +Accounts payable +(7,054 +) +21,672 +(7,326 +) +Income taxes +76 +(11,888 +) +12,817 +Other operating liabilities +3,595 +7,959 +5,224 +Net cash provided by operating activities +78,814 +67,866 +168,609 +INVESTING ACTIVITIES +Business acquisitions +– +– +(7,954 +) +Additions to property, plant and equipment +(19,397 +) +(16,370 +) +(11,670 +) +Proceeds from sales of property, plant and equipment +50 +1,756 +– +Other +(3,236 +) +(2,424 +) +(2,679 +) +Net cash used in investing activities +(22,583 +) +(17,038 +) +(22,303 +) +FINANCING ACTIVITIES +Net borrowings (repayments) under revolver +11,000 +– +(59,500 +) +Payments of long-term debt +(530 +) +(538 +) +– +Payments of capital lease obligations +– +– +(5 +) +Cash dividends paid +(22,737 +) +(21,414 +) +(21,502 +) +Purchase of common stock for treasury +(67,388 +) +(52,190 +) +(6,566 +) +Proceeds from shares issued under stock incentive plans +14,083 +13,631 +7,867 +Excess tax benefits from stock-based compensation +3,255 +1,362 +462 +Net cash used in financing activities +(62,317 +) +(59,149 +) +(79,244 +) +Effect of foreign exchange rate changes +(4,302 +) +(1,718 +) +3,875 +Increase (decrease) in cash and cash equivalents +(10,388 +) +(10,039 +) +70,937 +Cash and cash equivalents at beginning of the year +150,400 +160,439 +89,502 +Cash and cash equivalents at end of the year +$ +140,012 +$ +150,400 +$ +160,439 +OTHER CASH FLOW INFORMATION +Interest paid +$ +840 +$ +192 +$ +486 +Net income taxes paid +$ +29,967 +$ +30,604 +$ +7,297 +See accompanying notes to consolidated financial statements. +A-4 +Table of Contents +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +All amounts are in thousands of dollars except share and per share data and elsewhere as noted. +1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Nature of Operations +Wolverine World Wide, Inc. is a leading designer, manufacturer and marketer of a broad range of quality casual footwear and apparel; performance outdoor footwear and apparel; industrial work shoes, boots +and apparel; and uniform shoes and boots. The Company’s portfolio of owned and licensed brands includes: +Bates ® , Cat ® Footwear, Chaco ® , +Cushe ® , Harley-Davidson ® Footwear, Hush +Puppies ® , HyTest ® , Merrell ® , +Patagonia ® Footwear, Sebago ® , Soft Style ® and +Wolverine ® . Licensing and distribution arrangements with third parties extend the global reach of the +Company’s brand portfolio. The Company also operates a consumer-direct division to market both its own brands and branded footwear and apparel from other manufacturers and a leathers division that markets Wolverine Performance +Leathers ™. +Principles of Consolidation +The consolidated financial statements include the accounts of Wolverine World Wide, Inc. and its wholly-owned subsidiaries (collectively, the “Company”). All intercompany accounts and +transactions have been eliminated in consolidation. +Fiscal Year +The Company’s fiscal year is the 52- or 53-week period that ends on the Saturday nearest to December 31. Fiscal years presented in this report include the 52-week period ended December 31, +2011, the 52-week period ended January 1, 2011 and the 52-week period ended January 2, 2010. +Use of Estimates +The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts +reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. +Revenue Recognition +Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped, legal title has passed to the customer and collectability is reasonably +assured. Revenue generated through licensees and distributors involving products bearing the Company’s trademarks is recognized as earned according to stated contractual terms upon either the purchase or shipment of branded products by +licensees and distributors. +The Company records provisions for estimated sales returns and allowances at the time of sale based on historical +rates of returns and allowances and specific identification of outstanding returns not yet received from customers. However, estimates of actual returns and allowances in any future period are inherently uncertain and actual returns and allowances +may differ from these estimates. If actual or expected future returns and allowances were significantly greater or lower than established reserves, a reduction or increase to net revenues would be recorded in the period this determination was made. +Cost of Goods Sold +Cost of goods sold includes the actual product costs, including inbound freight charges, purchasing, sourcing, inspection and receiving costs. Warehousing costs are included in selling, general and +administrative expenses. +Shipping and Handling Costs +Shipping and handling costs that are charged to and reimbursed by the customer are recognized as revenue, while the related expenses incurred by the Company are recorded as cost of goods sold. +A-5 +Table of Contents +Cash Equivalents +Cash equivalents include highly liquid investments with an original maturity of three months or less. Cash equivalents are stated at cost, which approximates market. +Allowance for Uncollectible Accounts +The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from its customers’ inability to make +required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. Adjustments to these estimates may be required if the financial +condition of the Company’s customers were to change. +Inventories +The Company values its inventory at the lower of cost or market. Cost is determined by the last-in, first-out (“LIFO”) method for all domestic raw materials and work-in-process inventories and +certain domestic finished goods inventories. Cost is determined using the first-in, first-out (“FIFO”) method for all raw materials, work-in-process and finished goods inventories in foreign countries; certain domestic finished goods +inventories; and for all finished goods inventories of the Company’s consumer-direct business, due to the unique nature of those operations. The Company has applied these inventory cost valuation methods consistently from year to year. +Property, Plant and Equipment +Property, plant and equipment are stated on the basis of cost and include expenditures for computer hardware and software, store furniture and fixtures, office furniture and machinery and equipment. +Normal repairs and maintenance are expensed as incurred. +Depreciation of property, plant and equipment is computed using the straight-line +method. The depreciable lives range from fourteen to twenty years for buildings and improvements and from three to ten years for machinery, equipment and software. Leasehold improvements are depreciated at the lesser of the estimated useful life or +lease term, including reasonably-assured lease renewals as determined at lease inception. +Goodwill and Other Intangibles +Goodwill represents the excess of the purchase price over the fair value of net tangible and identifiable intangible assets of acquired businesses. Other intangibles consist primarily of trademarks and +patents. Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually. The Company has early-adopted the provisions of ASU 2011-08, which permits the Company to qualitatively +assess indicators of the Company’s reporting unit’s fair value when it is unlikely that a reporting unit is impaired. After completing the qualitative assessment, the Company may also use assumptions about expected future operating +performance and utilize a discounted cash flow analysis to estimate fair value. If the recorded values of these assets are not recoverable, based on either the assessment screen or discounted cash flow analysis, management performs the next step, +which compares the fair value of the reporting unit to the fair value of the tangible and intangible assets of the reporting units. Goodwill is considered impaired if the fair value of the tangible and intangible assets exceeds the fair value of the +reporting unit. +The Company tests indefinite-lived intangibles by comparison of the individual carrying values to the fair value. Future cash +flows of the individual indefinite-lived intangible assets are used to measure their fair value after consideration by management of certain assumptions, such as forecasted growth rates and cost of capital, which are derived from internal +projections and operating plans. +The Company did not recognize any impairment charges for goodwill or indefinite-lived intangible assets +during the fiscal years ended December 31, 2011 or January 1, 2011 as our annual impairment testing indicated that all reporting unit goodwill and indefinite-lived intangible asset fair values exceed their respective recorded values. +A-6 +Table of Contents +Other amortizable intangible assets (principally patents) are amortized using the straight-line method over +their estimated useful lives (periods ranging from two to seven years). Other amortizable intangible assets are included in other assets on the consolidated balance sheets and have gross carrying amounts of $8,573 and $8,614 for fiscal 2011 and +fiscal 2010, respectively, and accumulated amortization of $7,448 and $6,472 for fiscal 2011 and fiscal 2010, respectively. +Estimated +aggregate amortization expense for such intangibles for each of the five fiscal years subsequent to 2011 is as follows: +2012 +2013 +2014 +2015 +2016 +Amortization expense +$ +481 +$ +246 +$ +149 +$ +104 +$ +28 +The changes in the carrying amount of goodwill and other non-amortizable intangibles for the years ended December 31, 2011 and +January 1, 2011 are as follows: +Goodwill +Trademarks +Total +Balance at January 2, 2010 +$ +39,972 +$ +16,226 +$ +56,198 +Intangibles acquired +— +360 +360 +Foreign currency translation effects +(958 +) +(122 +) +(1,080 +) +Balance at January 1, 2011 +$ +39,014 +$ +16,464 +$ +55,478 +Intangibles acquired +— +1,074 +1,074 +Intangibles disposed +— +(11 +) +(11 +) +Foreign currency translation effects +(120 +) +(152 +) +(272 +) +Balance at December 31, 2011 +$ +38,894 +$ +17,375 +$ +56,269 +Impairment of Long-Lived Assets +The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or an asset +group may not be recoverable. Each impairment test is based on a comparison of the carrying amount of the asset or asset group to the future undiscounted net cash flows expected to be generated by the asset or asset group. If such assets are +considered to be impaired, the impairment amount to be recognized is the amount by which the carrying value of the assets exceeds their fair value. +Retirement Benefits +The determination of the obligation and expense for retirement benefits is dependent on the selection of certain actuarial assumptions used in calculating such amounts. These assumptions include, among +others, the discount rate, expected long-term rate of return on plan assets and rates of increase in compensation. These assumptions are reviewed with the Company’s actuaries and updated annually based on relevant external and internal factors +and information, including, but not limited to, long-term expected asset returns, rates of termination, regulatory requirements and plan changes. See Note 6 to the consolidated financial statements for additional information. +Stock-Based Compensation +The Company accounts for stock-based compensation in accordance with the fair value recognition provisions of FASB ASC Topic 718, Compensation – +Stock Compensation (“ASC 718”). The Company recognized compensation expense of $14,074, $11,543, and $8,943 and related income tax benefits of $4,540, $3,552, and $2,321 for grants under its stock-based compensation plans in the +statements of operations for the years ended December 31, 2011, January 1, 2011, and January 2, 2010, respectively. +Stock-based compensation expense recognized in the consolidated condensed statements of operations for the years ended December 31, +2011, January 1, 2011, and January 2, 2010, is based on awards ultimately expected to vest and, as such, has been reduced for estimated forfeitures. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if +necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience. +A-7 +Table of Contents +The Company estimated the fair value of employee stock options on the date of grant using the Black-Scholes +model. The estimated weighted-average fair value for each option granted was $10.46, $6.97, and $4.40 per share for fiscal years 2011, 2010, and 2009, respectively, with the following weighted-average assumptions: +2011 +2010 +2009 +Expected market price volatility (1) +38.6% +37.9% +34.8% +Risk-free interest rate (2) +1.8% +1.9% +1.6% +Dividend yield (3) +1.6% +1.9% +1.8% +Expected term (4) +4 years +4 years +4 years +(1) +Based on historical volatility of the Company’s common stock. The expected volatility is based on the daily percentage change in the price of the stock over the +four years prior to the grant. +(2) +Represents the U.S. Treasury yield curve in effect for the expected term of the option at the time of grant. +(3) +Represents the Company’s cash dividend yield for the expected term. +(4) +Represents the period of time that options granted are expected to be outstanding. As part of the determination of the expected term, the Company concluded that all +employee groups exhibit similar exercise and post-vesting termination behavior. +The Company issued 1,294,246 shares of common +stock in connection with the exercise of stock options and new restricted stock grants during the fiscal year ended December 31, 2011. The Company cancelled 92,201 shares of common stock issued under restricted stock awards as a result of +forfeitures during fiscal year 2011. +Income Taxes +The provision for income taxes is based on the geographic dispersion of the earnings reported in the consolidated financial statements. A deferred income tax asset or liability is determined by applying +currently-enacted tax laws and rates to the cumulative temporary differences between the carrying values of assets and liabilities for financial statement and income tax purposes. +The Company records an increase in liabilities for income tax accruals associated with tax benefits claimed on tax returns but not recognized for financial statement purposes (unrecognized tax benefits). +The Company recognizes interest and penalties related to unrecognized tax benefits through interest expense and income tax expense, respectively. +Earnings Per Share +The Company calculates earnings per share in accordance with FASB ASC Topic 260, Earnings Per Share (“ASC 260”). ASC 260 addresses whether instruments granted in share-based payment +transactions are participating securities prior to vesting, and therefore need to be included in the earnings allocation in computing earnings per share under the two-class method. Under the guidance in ASC 260, the Company’s unvested +share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents, whether paid or unpaid, are participating securities and must be included in the computation of earnings per share pursuant to the two-class method. +The following table sets forth the computation of basic and diluted earnings per share: +2011 +2010 +2009 +Numerator: +Net earnings +$ +123,287 +$ +104,470 +$ +61,912 +Adjustment for earnings allocated to nonvested restricted common stock +(2,627 +) +(1,608 +) +(1,036 +) +Net earnings used to calculate basic earnings per share +120,660 +102,862 +60,876 +Adjustment for earnings reallocated to nonvested restricted common stock +112 +38 +8 +Net earnings used to calculate diluted earnings per share +$ +120,772 +$ +102,900 +$ +60,884 +A-8 +Table of Contents +2011 +2010 +2009 +Denominator: +Weighted average shares outstanding +$ +48,910,599 +$ +49,051,739 +$ +49,192,662 +Adjustment for nonvested restricted common stock +(1,432,541 +) +(1,206,460 +) +(921,715 +) +Shares used to calculate basic earnings per share +47,478,058 +47,845,279 +48,270,947 +Effect of dilutive stock options +1,250,612 +1,011,731 +708,485 +Shares used to calculate diluted earnings per share +48,728,670 +48,857,010 +48,979,432 +Net earnings per share: +Basic +$ +2.54 +$ +2.15 +$ +1.26 +Diluted +$ +2.48 +$ +2.11 +$ +1.24 +Options to purchase 338,877 shares of common stock in fiscal year 2011, 865,072 shares in fiscal year 2010, and 2,353,412 shares in +fiscal year 2009 have not been included in the denominator for the computation of diluted earnings per share because the related exercise prices were greater than the average market price for the year, and they were, therefore, anti-dilutive. +Foreign Currency +For most of the Company’s international subsidiaries, the local currency is the functional currency. Assets and liabilities of these subsidiaries are +translated into U.S. dollars at the year-end exchange rate. Operating statement amounts are translated at average exchange rates for each period. The cumulative translation adjustments resulting from changes in exchange rates are included in the +consolidated balance sheets as a component of accumulated other comprehensive income (loss) in stockholders’ equity. Transaction gains and losses are included in the consolidated statements of operations and were not material for fiscal years +2011, 2010 and 2009. +Financial Instruments and Risk Management +The Company follows FASB ASC Topic 820, Fair Value Measurements and Disclosures (“ASC 820”), which provides a consistent definition of +fair value, focuses on exit price, prioritizes the use of market-based inputs over entity-specific inputs for measuring fair value and establishes a three-tier hierarchy for fair value measurements. This topic requires fair value measurements to be +classified and disclosed in one of the following three categories: +Level 1: +Fair value is measured using quoted prices (unadjusted) in active markets for identical assets and liabilities. +Level 2: +Fair value is measured using either direct or indirect inputs, other than quoted prices included within Level 1, which are observable for similar assets or +liabilities. +Level 3: +Fair value is measured using valuation techniques in which one or more significant inputs are unobservable. +The Company’s financial instruments consist of cash and cash equivalents, +accounts and notes receivable, accounts payable, foreign currency forward exchange contracts, borrowings under the Company’s revolving credit agreement and long-term debt. The carrying amount of the Company’s financial instruments is +historical cost, which approximates their fair value, except for the foreign currency exchange contracts, which are carried at fair value. The Company does not hold or issue financial instruments for trading purposes. +As of December 31, 2011 and January 1, 2011, assets of $4,015 and liabilities of $1,095, respectively, have been recognized for the fair value +of the Company’s foreign currency forward exchange contracts. In accordance with ASC 820, these assets and liabilities fall within Level 2 of the fair value hierarchy. The prices for the financial instruments are determined using prices for +recently-traded financial instruments with similar underlying terms as well as directly or indirectly observable inputs. The Company did not have any additional assets or liabilities that were measured at fair value on a recurring basis at +December 31, 2011 and January 1, 2011. +A-9 +Table of Contents +The Company follows FASB ASC Topic 815, Derivatives and Hedging , which is intended to improve +transparency in financial reporting and requires that all derivative instruments be recorded on the consolidated balance sheets at fair value by establishing criteria for designation and effectiveness of hedging relationships. The Company utilizes +foreign currency forward exchange contracts to manage the volatility associated with U.S. dollar inventory purchases made by non-U.S. wholesale operations in the normal course of business. At December 31, 2011 and January 1, 2011, foreign +exchange contracts with a notional value of $106,265 and $111,802, respectively, were outstanding to purchase U.S. dollars with maturities ranging up to 336 days and 364 days, respectively. These contracts have been designated as cash flow hedges. +The fair value of the foreign currency forward exchange contracts represents the estimated receipts or payments necessary to terminate the +contracts. Hedge effectiveness is evaluated by the hypothetical derivative method. Any hedge ineffectiveness is reported within the cost of goods sold caption of the consolidated condensed statements of operations. Hedge ineffectiveness was not +material to the Company’s consolidated condensed financial statements for fiscal years 2011, 2010, or 2009. If, in the future, the foreign exchange contracts are determined to be ineffective hedges or terminated before their contractual +termination dates, the Company would be required to reclassify into earnings all or a portion of the unrealized amounts related to the cash flow hedges that are currently included in accumulated other comprehensive income (loss) within +stockholders’ equity. +For the fiscal years ended December 31, 2011, January 1, 2011, and January 2, 2010, the +Company recognized net losses of $1,302, $318 and $547, respectively, in accumulated other comprehensive income (loss) related to the effective portion of its foreign exchange contracts. For the fiscal years ended December 31, +2011, January 1, 2011, and January 2, 2010, the Company reclassified a gain of $2,949, a gain of $1,274, and a loss of $2,996, respectively, from accumulated other comprehensive income (loss) into cost of goods sold related to the +effective portion of its foreign exchange contracts designated and qualifying as cash flow hedges. +Comprehensive Income (Loss) +Comprehensive income (loss) represents net earnings and any revenue, expenses, gains and losses that, under accounting principles generally accepted in the United States, are excluded from net earnings +and recognized directly as a component of stockholders’ equity. The ending accumulated other comprehensive income (loss) is as follows: +2011 +2010 +Foreign currency translation adjustments +$ +258 +$ +11,548 +Change in fair value of foreign exchange contracts, net of taxes (2011 – $(1,518); 2010 – $828) +3,295 +(1,815 +) +Pension adjustments, net of taxes (2011 – $39,684; 2010 – $26,908) +(74,582 +) +(50,856 +) +Accumulated other comprehensive income (loss) +$ +(71,029 +) +$ +(41,123 +) +Reclassifications +Certain prior period amounts on the consolidated financial statements have been reclassified to conform to current period presentation. These reclassifications did not affect net earnings. +2. INVENTORIES +Inventories of $63,210 at December 31, 2011 and $66,370 at January 1, 2011 have been valued using the LIFO method. If the +FIFO method had been used, inventories would have been $15,301 and $11,071 higher than reported at December 31, 2011 and January 1, 2011, respectively. +A-10 +Table of Contents +3. DEBT +Long-term debt consists of the following obligations: +2011 +2010 +Notes payable +$ +515 +$ +1,034 +Current maturities +(515 +) +(517 +) +Total long-term debt +$ +— +$ +517 +In 2009, the Company entered into a $1,615 note payable in connection with the Cushe ® acquisition. The note is payable over three years at a fixed interest rate of 4.5%. +The Company’s credit agreement with a bank syndicate provides the Company with access to capital under a revolving credit facility, including a +swing-line facility and letter of credit facility, in an initial aggregate amount of up to $150.0 million and is set to expire June 17, 2014. This amount is subject to increase up to a maximum aggregate amount of $225.0 million under certain +circumstances. The revolving credit facility is used to support working capital requirements and other business needs. There was $11,000 outstanding at December 31, 2011 and there were no amounts outstanding at January 1, 2011 under the +Company’s revolving credit facility. The Company considers balances drawn on the revolving credit facility, if any, to be short-term in nature. The Company was in compliance with all debt covenant requirements at December 31, 2011 and +January 1, 2011 under the Company’s revolving credit facility. Interest is paid at a variable rate based on one of the following options elected by the Company: prime, LIBOR, or money market rate plus applicable spread. The annual interest +rate for fiscal year 2011 related to the outstanding revolver balance was 2.60%. Cash flow from operations, along with proceeds from the revolving credit facility, if any, are expected to be sufficient to meet working capital needs for the +foreseeable future. Any excess cash flows from operating activities are expected to be used to purchase property, plant and equipment, reduce debt, fund internal and external growth initiatives, pay dividends or repurchase the Company’s common +stock. +4. LEASES +The Company leases machinery, equipment, and certain warehouse, office and retail store space under operating lease agreements that +expire at various dates through 2023. Certain leases contain renewal provisions and generally require the Company to pay utilities, insurance, taxes and other operating expenses. +At December 31, 2011, minimum rental payments due under all non-cancelable leases were as follows: +2012 +2013 +2014 +2015 +2016 +Thereafter +Minimum rental payments +$ +18,574 +$ +17,330 +$ +15,611 +$ +14,437 +$ +14,628 +$ +52,926 +Rental expense under all operating leases, consisting primarily of minimum rentals, totaled $20,117 in fiscal year 2011, +$18,919 in fiscal year 2010 and $19,187 in fiscal year 2009. +5. CAPITAL STOCK +The Company has 2,000,000 authorized shares of $1 par value preferred stock, of which none was issued or outstanding as of +December 31, 2011 or January 1, 2011. The Company has designated 150,000 shares of preferred stock as Series A junior participating preferred stock and 500,000 shares of preferred stock as Series B junior participating preferred stock for +possible future issuance. +As of December 31, 2011, the Company had stock options outstanding under various stock incentive plans. As of +December 31, 2011, the Company had approximately 3,371,551 stock incentive units (stock options, stock appreciation rights, restricted stock, restricted stock units and common stock) available for issuance. Each option or stock appreciation +right granted counts as one stock incentive unit and all other awards granted, including restricted stock, count as two stock incentive units. Options granted under each plan have an exercise price equal +A-11 +Table of Contents +to the fair market value of the underlying stock on the grant date, expire no later than ten years from the grant date, and generally vest over three years. Restricted stock issued under these +plans is subject to certain restrictions, including a prohibition against any sale, transfer, or other disposition by the officer or employee during the vesting period (except for certain transfers for estate planning purposes for certain officers), +and a requirement to forfeit all or a certain portion of the award upon certain terminations of employment or upon failure to achieve performance criteria in certain instances. These restrictions typically lapse over a three- to five-year period +from the date of the award. The Company has elected to recognize expense for these stock-based incentive plans ratably over the vesting term on a straight-line basis. Certain option and restricted share awards provide for accelerated vesting under +various scenarios, including retirement and upon a change in control of the Company. With regard to acceleration of vesting upon retirement, employees of eligible retirement age are vested in accordance with plan provisions and applicable stock +option and restricted stock agreements. The Company issues shares to plan participants upon exercise or vesting of stock-based incentive awards from either authorized, but unissued, shares or treasury shares. +A summary of the transactions under the stock option plans is as follows: +Shares +Under +Option +Weighted- +Average +Exercise +Price +Average +Remaining +Contractual +Term +(Years) +Aggregate +Intrinsic +Value +Outstanding at January 3, 2009 +4,572,384 +$ +19.95 +5.6 +$ +16,155 +Granted +863,017 +17.55 +Exercised +(582,318 +) +13.56 +Cancelled +(233,737 +) +20.91 +Outstanding at January 2, 2010 +4,619,346 +$ +20.17 +5.8 +$ +34,212 +Granted +537,807 +25.55 +Exercised +(848,106 +) +16.83 +Cancelled +(60,137 +) +23.84 +Outstanding at January 1, 2011 +4,248,910 +$ +21.47 +5.7 +$ +44,254 +Granted +398,749 +36.75 +Exercised +(887,671 +) +19.90 +Cancelled +(65,004 +) +26.79 +Outstanding at December 31, 2011 +3,694,984 +$ +23.40 +5.5 +$ +45,663 +Estimated forfeitures +(3,238 +) +Vested or expected to vest at December 31, 2011 +3,691,746 +$ +23.39 +5.5 +$ +45,654 +Nonvested at December 31, 2011 and expected to vest +(824,834 +) +Exercisable at December 31, 2011 +2,866,912 +$ +22.06 +4.7 +$ +39,045 +The total pretax intrinsic value of options exercised during the years ended December 31, 2011, January 1, 2011 and +January 2, 2010 was $14,931, $10,407 and $5,745, respectively. As of December 31, 2011, there was $2,414 of unrecognized compensation expense related to stock option awards that is expected to be recognized over a weighted-average period +of 1.0 years. As of January 1, 2011 and January 2, 2010, there was $2,393 and $2,329, respectively, of unrecognized compensation expense related to stock option awards that was expected to be recognized over a weighted-average period of +1.1 and 1.2 years, respectively. +The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on +the Company’s closing stock price of $35.64 as of December 31, 2011, which would have been received by the option holders had all option holders exercised in-the-money options as of that date. The total number of in-the-money options +exercisable as of December 31, 2011 was 2,831,883 and the weighted-average exercise price was $21.85. As of January 1, 2011, 3,134,585 outstanding options were exercisable and the weighted-average exercise price was $21.24. +A-12 +Table of Contents +Beginning in 2009, the Board of Directors has awarded an annual grant of performance share awards to the +officers of the Company. The number of performance-based shares that will be earned (and eligible to vest) during the performance period will depend on the Company’s level of success in achieving two specifically identified performance targets. +Any portion of the performance shares that are not earned by the end of the three-year measurement period will be forfeited. The final determination of the number of shares to be issued in respect to an award is determined by the Compensation +Committee of the Company’s Board of Directors. +A summary of the nonvested restricted shares issued under stock award plans is as +follows: +Restricted +Awards +Weighted- +Average +Grant Date +Fair Value +Performance +Awards +Weighted- +Average +Grant Date +Fair Value +Nonvested at January 3, 2009 +472,492 +$ +24.11 +— +— +Granted +350,653 +17.34 +286,006 +17.21 +Vested +(145,797 +) +20.31 +— +— +Forfeited +(36,878 +) +22.45 +(22,101 +) +17.11 +Nonvested at January 2, 2010 +640,470 +$ +21.34 +263,905 +$ +17.22 +Granted +262,342 +25.51 +215,027 +24.30 +Vested +(117,438 +) +22.71 +— +— +Forfeited +(21,828 +) +21.93 +(4,407 +) +17.11 +Nonvested at January 1, 2011 +763,546 +$ +22.55 +474,525 +$ +20.43 +Granted +200,427 +36.57 +206,148 +36.63 +Vested +(165,186 +) +24.27 +— +— +Forfeited +(52,858 +) +24.72 +(39,343 +) +24.76 +Nonvested at December 31, 2011 +745,929 +$ +25.78 +641,330 +$ +25.37 +As of December 31, 2011, there was $6,466 of unrecognized compensation expense related to nonvested share-based compensation +arrangements granted under restricted stock award plans. That cost is expected to be recognized over a weighted-average period of 2.0 years. The total fair value of shares vested during the year ended December 31, 2011 was $6,203. As of +January 1, 2011, there was $6,194 of unrecognized compensation cost related to nonvested share-based compensation arrangements granted under restricted stock award plans. That cost is expected to be recognized over a weighted-average period of +1.6 years. The total fair value of shares vested during the year ended January 1, 2011 was $3,012. As of January 2, 2010, there was $4,792 of unrecognized compensation cost related to nonvested share-based compensation arrangements granted +under restricted stock award plans. That cost is expected to be recognized over a weighted-average period of 2.0 years. The total fair value of shares vested during the year ended January 2, 2010 was $2,761. +As of December 31, 2011, there was $4,718 of unrecognized compensation expense related to nonvested share-based compensation arrangements granted +under performance-based award plans. That cost is expected to be recognized over a weighted-average period of 2.0 years. The total fair value of shares vested during the year ended December 31, 2011 was $4,699. As of January 1, 2011, there +was $4,950 of unrecognized compensation cost related to nonvested share-based compensation arrangements granted under performance-based restricted stock award plans. That cost is expected to be recognized over a weighted-average period of 2.0 years. +The total fair value of shares vested during the year ended January 1, 2011 was $3,203. As of January 2, 2010, there was $2,992 of unrecognized compensation cost related to nonvested share-based compensation arrangements granted under +performance-based restricted stock award plans. That cost is expected to be recognized over a weighted-average period of 2.0 years. The total fair value of shares vested during the year ended January 2, 2010 was $1,496. +A-13 +Table of Contents +6. RETIREMENT PLANS +The Company has two non-contributory, defined benefit pension plans covering a majority of its domestic employees. The Company’s +principal defined benefit pension plan provides benefits based on the employee’s years of service and final average earnings (as defined in the plan), while the other plan provides benefits at a fixed rate per year of service. +The Company has a Supplemental Executive Retirement Plan (the “SERP”) for certain current and former employees that entitles a participating +employee to receive payments from the Company following retirement based on the employee’s years of service and final average earnings (as defined in the SERP). Under the SERP, the employees can elect early retirement with a corresponding +reduction in benefits. The Company also has individual deferred compensation agreements with certain former employees that entitle these employees to receive payments from the Company for a period of fifteen to eighteen years following retirement. +The Company maintains life insurance policies with a cash surrender value of $38,203 at December 31, 2011 and $36,042 at January 1, 2011 that are intended to fund deferred compensation benefits under the SERP and deferred compensation +agreements. +The Company has a defined contribution 401(k) plan covering substantially all domestic employees that provides for Company +contributions based on earnings. The Company recognized expense for its defined contribution plan of $2,500 in fiscal year 2011, $2,061 in fiscal year 2010 and $1,919 in fiscal year 2009. +The Company has certain defined contribution plans at foreign subsidiaries. Contributions to these plans were $918 in fiscal year 2011, $858 in fiscal year 2010 and $954 in fiscal year 2009. The Company +also has a benefit plan at a foreign location that provides for retirement benefits based on years of service. The obligation recorded under this plan was $3,139 at December 31, 2011 and $3,068 at January 1, 2011 and is recognized as a +deferred compensation liability on the accompanying balance sheet. +The following summarizes the status of and changes in the Company’s +assets and related obligations for its pension plans (which include the Company’s defined benefit pension plans and the SERP) for the fiscal years: +2011 +2010 +Change in projected benefit obligations: +Projected benefit obligations at beginning of the year +$ +230,114 +$ +211,670 +Service cost pertaining to benefits earned during the year +6,499 +5,729 +Interest cost on projected benefit obligations +13,326 +12,719 +Actuarial losses +30,320 +10,955 +Benefits paid to plan participants +(11,160 +) +(10,959 +) +Projected benefit obligations at end of the year +$ +269,099 +$ +230,114 +Change in fair value of pension assets: +Fair value of pension assets at beginning of the year +$ +144,411 +$ +125,492 +Actual return on plan assets +(3,857 +) +17,549 +Company contributions - pension +31,800 +10,400 +Company contributions - SERP +1,929 +1,929 +Benefits paid to plan participants +(11,160 +) +(10,959 +) +Fair value of pension assets at end of the year +$ +163,123 +$ +144,411 +Funded status +$ +(105,976 +) +$ +(85,703 +) +Amounts recognized in the consolidated balance sheets: +Current liabilities +$ +(2,151 +) +$ +(2,018 +) +Non current liabilities +(103,825 +) +(83,685 +) +Net amount recognized +$ +(105,976 +) +$ +(85,703 +) +A-14 +Table of Contents +2011 +2010 +Amounts recognized in accumulated other comprehensive income (loss): +Unrecognized net actuarial loss (net of tax: 2011 – $(74,272); 2010 – $(50,452)) +$ +(113,789 +) +$ +(76,258 +) +Unrecognized prior service cost (net of tax: 2011 – $(310); 2010 – $(404)) +(477 +) +(622 +) +Net amount recognized +$ +(114,266 +) +$ +(76,880 +) +Funded status of pension plans and SERP (supplemental): +Funded status of qualified defined benefit plans and SERP +$ +(105,976 +) +$ +(85,703 +) +Nonqualified trust assets (cash surrender value of life insurance) recorded in other assets and intended to satisfy the projected +benefit obligation of unfunded SERP +38,203 +34,549 +Net funded status of pension plans and SERP (supplemental) +$ +(67,773 +) +$ +(51,154 +) +The accumulated benefit obligations for all defined benefit pension plans and the SERP were $254,198 at December 31, 2011 and +$218,949 at January 1, 2011. +The following is a summary of net pension and SERP expense recognized by the Company: +2011 +2010 +2009 +Service cost pertaining to benefits earned during the year +$ +(6,499 +) +$ +(5,729 +) +$ +(4,543 +) +Interest cost on projected benefit obligations +(13,326 +) +(12,719 +) +(12,233 +) +Expected return on pension assets +14,400 +12,467 +10,911 +Net amortization loss +(12,077 +) +(10,305 +) +(9,275 +) +Curtailment (gain) +— +— +(612 +) +Special termination benefit charge +— +— +(139 +) +Net pension expense +$ +(17,502 +) +$ +(16,286 +) +$ +(15,891 +) +The prior service cost and actuarial loss included in accumulated other comprehensive income (loss) and expected to be recognized in +net periodic pension expense during 2012 is $127 and $20,826, respectively. Expense for qualified defined benefit pension plans was $12,579 in fiscal year 2011, $11,903 in fiscal year 2010 and $12,871 in fiscal year 2009. +2011 +2010 +Weighted-average assumptions used to determine benefit obligations at fiscal year-end: +Discount rate +5.42% +5.94% +Rate of compensation increase - pension +4.85% +3.25% +Rate of compensation increase - SERP +7.00% +3.25% +Weighted average assumptions used to determine net periodic benefit cost for the years ended: +Discount rate +5.94% +6.17% +Expected long-term rate of return on plan assets +8.00% +8.50% +Rate of compensation increase - pension +4.85% +3.25% +Rate of compensation increase - SERP +7.00% +3.25% +Unrecognized net actuarial losses exceeding certain corridors are amortized over a five-year period, unless the minimum amortization +method based on average remaining service periods produces a higher amortization. The Company utilizes a bond matching calculation to determine the discount rate. A hypothetical bond portfolio is created based on a presumed purchase of high-quality +corporate bonds with maturities that match the plan’s expected future cash outflows. The discount rate is the resulting yield of the hypothetical bond portfolio. The discount rate is used in the calculation of the year end pension liability and +service cost for the subsequent year. +A-15 +Table of Contents +The long-term rate of return is based on overall market expectations for a balanced portfolio with an asset +mix similar to the Company’s, utilizing historic returns for broad market and fixed income indices. +2011 +2010 +$ +% +$ +% +Weighted average asset allocations at fiscal yearend by asset category are as follows: +Equity securities +119,444 +73.2% +102,144 +70.7% +Fixed income investments +43,581 +26.7% +37,038 +25.7% +Cash and money market investments +98 +0.1% +5,229 +3.6% +Fair value of plan assets +163,123 +100.0% +144,411 +100.0% +The Company’s investment policy for plan assets uses a blended approach of U.S. and foreign equities combined with U.S. fixed +income investments. Policy guidelines indicate that total equities should not exceed 80% and fixed income securities should not exceed 28%. Within the equity and fixed income classifications, the investments are diversified. +In accordance with ASC 820, the 2011 assets fall within Level 2 of the fair value hierarchy. Fair value is measured using either direct or indirect +inputs, other than quoted prices included within Level 1, which are observable for similar assets or liabilities. In accordance with ASC 820, the 2010 assets fall within Level 1 of the fair value hierarchy. Fair value is determined using quoted +prices (unadjusted) in active markets for identical assets. The change results from all of the plan assets being transferred to a new trustee in fiscal year 2011. +The Company expects to contribute approximately $27.0 million to its qualified defined benefit pension plans and approximately $2.1 million to the SERP in 2012. +Expected benefit payments for the five years subsequent to 2011 and the sum of the five years following those are as follows: +2012 +2013 +2014 +2015 +2016 +2017- 2021 +Expected benefit payments +$ +12,288 +$ +12,843 +$ +14,469 +$ +15,049 +$ +15,736 +$ +86,392 +7. INCOME TAXES +The geographic components of earnings before income taxes are as follows: +2011 +2010 +2009 +United States +$ +105,470 +$ +86,817 +$ +51,167 +Foreign +63,440 +56,409 +34,525 +$ +168,910 +$ +143,226 +$ +85,692 +The provisions for income taxes consist of the following: +2011 +2010 +2009 +Current expense: +Federal +$ +22,860 +$ +28,620 +$ +7,506 +State +99 +1,866 +1,596 +Foreign +15,134 +13,759 +20,930 +Deferred expense (credit): +Federal +5,848 +(4,896 +) +(6,380 +) +State +458 +(351 +) +(475 +) +Foreign +1,224 +(242 +) +603 +$ +45,623 +$ +38,756 +$ +23,780 +A-16 +Table of Contents +A reconciliation of the Company’s total income tax expense and the amount computed by applying the +statutory federal income tax rate of 35% to earnings before income taxes is as follows: +2011 +2010 +2009 +Income taxes at U.S. statutory rate +$ +59,119 +$ +50,129 +$ +29,992 +State income taxes, net of federal income tax +1,008 +557 +324 +Nontaxable earnings of foreign affiliates +(4,611 +) +(4,586 +) +(2,981 +) +Research and development credits +(600 +) +(600 +) +(700 +) +Foreign earnings taxed at rates different from the U.S. statutory rate +(13,415 +) +(9,226 +) +(8,444 +) +Adjustments for uncertain tax positions +3,506 +2,142 +4,908 +Other +616 +340 +681 +$ +45,623 +$ +38,756 +$ +23,780 +Significant components of the Company’s deferred income tax assets and liabilities as of the end of fiscal years 2011 and 2010 are +as follows: +2011 +2010 +Deferred income tax assets: +Accounts receivable and inventory valuation allowances +$ +5,341 +$ +5,415 +Deferred compensation accruals +3,146 +2,073 +Accrued pension expense +36,560 +29,644 +Stock-based compensation +11,182 +9,963 +Net operating loss and foreign tax credit carryforward +2,755 +1,397 +Other amounts not deductible until paid +7,285 +10,448 +Total gross deferred income tax assets +66,269 +58,940 +Less valuation allowance +(2,463 +) +(1,397 +) +Net deferred income tax assets +63,806 +57,543 +Deferred income tax liabilities: +Tax depreciation in excess of book depreciation +(6,045 +) +(4,347 +) +Other +(5,611 +) +(2,369 +) +Total deferred income tax liabilities +(11,656 +) +(6,716 +) +Net deferred income tax assets +$ +52,150 +$ +50,827 +The valuation allowance for deferred tax assets as of December 31, 2011 and January 1, 2011, was $2,463, and $1,397, +respectively. The net change in the total valuation allowance for each of the years ended December 31, 2011, and January 1, 2011, was $1,066 and $371, respectively. The valuation allowance was related to foreign net operating loss +carryforwards and foreign tax credit carryforwards that, in the judgment of management, are not more likely than not to be realized. The ultimate realization of the carryforwards depends on the generation of future taxable income in the foreign tax +jurisdictions. +At December 31, 2011, the Company had foreign net operating loss carryforwards of $6,913, which have expiration periods +ranging from nine years to an unlimited term during which they are available to offset future foreign taxable income. The Company also had foreign tax credit carryforwards of $511, which are available for an unlimited carryforward period to offset +future foreign taxable income. +A-17 +Table of Contents +The following table summarizes the activity related to the Company’s unrecognized tax benefits: +2011 +2010 +Beginning balance +$ +10,741 +$ +8,396 +Increases related to current year tax positions +5,293 +2,645 +Decreases related to prior years positions +(1,139) +- +Decrease due to lapse of statute +(1,070) +(300) +Ending balance +$ +13,825 +$ +10,741 +The portion of the unrecognized tax benefits that, if recognized currently, would reduce the annual effective tax rate was $13,137, as +of December 31, 2011, $9,731 as of January 1, 2011 and $7,588 as of January 2, 2010. The Company recognizes interest and penalties related to unrecognized tax benefits through interest expense and income tax expense, respectively. +Interest accrued related to unrecognized tax benefits was $789 as of December 31, 2011 and $818 as of January 1, 2011. +The Company +is subject to periodic audits by domestic and foreign tax authorities. Currently, the Company is undergoing routine periodic audits in both domestic and foreign tax jurisdictions. It is reasonably possible that the amounts of unrecognized tax +benefits could change in the next 12 months as a result of the audits; however, any payment of tax is not expected to be significant to the consolidated financial statements. +For the majority of tax jurisdictions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2007. +No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the remaining +undistributed earnings of foreign subsidiaries of $260,195 at December 31, 2011, as the Company expects such earnings will remain reinvested overseas indefinitely. At January 1, 2011, undistributed foreign earnings were $199,767. +8. LITIGATION AND CONTINGENCIES +The Company is involved in various environmental claims and other legal actions arising in the normal course of business. The +environmental claims include sites where the U.S. Environmental Protection Agency has notified the Company that it is a potentially responsible party with respect to environmental remediation. These remediation claims are subject to ongoing +environmental impact studies, assessment of remediation alternatives, allocation of costs between responsible parties and concurrence by regulatory authorities and have not yet advanced to a stage where the Company’s liability is fixed. +However, after taking into consideration legal counsel’s evaluation of all actions and claims against the Company, it is management’s opinion that the outcome of these matters will not have a material adverse effect on the Company’s +consolidated financial position, results of operations or cash flows. +The Company is involved in routine litigation incidental to its +business and is a party to legal actions and claims, including, but not limited to, those related to employment and intellectual property. Some of the legal proceedings include claims for compensatory as well as punitive damages. While the final +outcome of these matters cannot be predicted with certainty, considering, among other things, the meritorious legal defenses available and liabilities that have been recorded along with applicable insurance, it is management’s opinion that the +outcome of these items will not have a material adverse effect on the Company’s financial position, results of operations or cash flows. +The Company has future minimum royalty and advertising obligations due under the terms of certain licenses held by the Company. These minimum future +obligations are as follows: +2012 +2013 +2014 +2015 +Beyond +Minimum royalties +750 +900 +1,200 +1,500 +— +Minimum advertising +2,360 +2,645 +2,724 +2,806 +8,127 +A-18 +Table of Contents +Minimum royalties are based on both fixed obligations and assumptions regarding the consumer price index. +Royalty obligations in excess of minimum requirements are based upon future sales levels. In accordance with these agreements, the Company incurred royalty expense of $3,270, $3,028, and $2,861 for 2011, 2010, and 2009, respectively. +The terms of certain license agreements also require the Company to make advertising expenditures based on the level of sales. In accordance with these +agreements, the Company incurred advertising expense of $3,273, $2,998, and $2,682 for fiscal years 2011, 2010, and 2009, respectively. +The +Company had no amounts outstanding under commercial letters of credit at December 31, 2011 and had $95 outstanding at January 1, 2011. +9. BUSINESS SEGMENTS +The Company has one reportable segment that is engaged in designing, manufacturing, sourcing, marketing, licensing and distributing +branded footwear, apparel and accessories. Revenue from this segment is derived from the sale of branded footwear, apparel and accessories to third-party customers and royalty income from the licensing of the Company’s trademarks and brand +names to third-party licensees and distributors. The operating groups aggregated into the branded footwear, apparel and licensing reportable segment all source, market and distribute products in a similar manner. +The other business units in the following tables consist of the Company’s consumer-direct, leather marketing and pigskin procurement operations. +Substantially all of the assets of the pigskin procurement operations were sold to a third-party buyer on December 29, 2010. These other operations do not collectively form a reportable segment at December 31, 2011 because their respective +operations are dissimilar and they do not meet the applicable quantitative requirements. At December 31, 2011, the Company owned and operated 101 brick-and-mortar retail stores in the United States, Canada and the United Kingdom and operated 42 +consumer-direct websites. The other business units distribute products through retail and wholesale channels. +The Company measures segment +profits as earnings before income taxes. The accounting policies used to determine profitability and total assets of the branded footwear, apparel and licensing segment and other business units are the same as disclosed in Note 1. +Business segment information is as follows: +2011 +Branded +Footwear, +Apparel +and Licensing +Other +Businesses +Corporate +Consolidated +Revenue +$ +1,274,069 +$ +134,999 +$ +— +$ +1,409,068 +Intersegment revenue +53,500 +2,178 +— +55,678 +Interest expense – net +— +— +1,025 +1,025 +Depreciation expense +6,260 +3,407 +5,203 +14,870 +Earnings (loss) before income taxes +203,959 +11,436 +(46,485 +) +168,910 +Total assets +663,388 +71,236 +117,028 +851,652 +Additions to property, plant and equipment +7,517 +7,282 +4,598 +19,397 +A-19 +Table of Contents +2010 +Branded +Footwear, +Apparel, +and Licensing +Other +Businesses +Corporate +Consolidated +Revenue +$ +1,117,644 +$ +130,873 +$ +– +$ +1,248,517 +Intersegment revenue +44,721 +2,789 +– +47,510 +Interest expense – net +– +– +387 +387 +Depreciation expense +6,067 +3,373 +5,069 +14,509 +Earnings (loss) before income taxes +174,563 +12,987 +(44,324 +) +143,226 +Total assets +599,354 +41,980 +145,241 +786,575 +Additions to property, plant and equipment +8,282 +4,329 +3,759 +16,370 +2009 +Branded +Footwear, +Apparel, +and Licensing +Other +Businesses +Corporate +Consolidated +Revenue +$ +991,168 +$ +109,888 +$ +– +$ +1,101,056 +Intersegment revenue +55,983 +3,019 +– +59,002 +Interest expense – net +– +– +111 +111 +Depreciation expense +6,501 +3,035 +6,396 +15,932 +Earnings (loss) before income taxes +116,568 +(8,092 +) +(22,784 +) +85,692 +Total assets +499,091 +34,036 +174,806 +707,933 +Additions to property, plant and equipment +3,240 +3,712 +4,718 +11,670 +Geographic information, based on shipping destination, related to revenue from external customers included in the consolidated +statements of operations is as follows: +2011 +2010 +2009 +United States +$ +841,988 +$ +768,594 +$ +690,269 +Foreign: +Europe +336,949 +218,542 +198,487 +Canada +113,970 +103,374 +89,409 +Other +116,161 +158,007 +122,891 +Total from foreign territories +567,080 +479,923 +410,787 +$ +1,409,068 +$ +1,248,517 +$ +1,101,056 +The Company’s long-lived assets (primarily property, plant and equipment) are as follows: +2011 +2010 +United States +$ +71,418 +$ +69,545 +Foreign countries +8,917 +7,774 +$ +80,335 +$ +77,319 +The Company does not believe that it is dependent upon any single customer because no customer accounts for more than 10% of +consolidated revenue. +The Company sources approximately 95% (based on pairs) of its footwear products from third party suppliers located +primarily in the Asia Pacific region. The remainder is produced in Company-owned manufacturing facilities in the United States and the Dominican Republic. All apparel and accessories are sourced from third +A-20 +Table of Contents +party suppliers. While changes in suppliers could cause delays in manufacturing and a possible loss of sales, management believes that other suppliers could provide similar products on comparable +terms. +Revenue derived from the branded footwear, apparel and licensing segment accounted for approximately 90% of revenue in fiscal years +2011, 2010 and 2009. No other business unit accounts for more than 10% of consolidated revenue. +10. RESTRUCTURING AND OTHER TRANSITION COSTS +On January 7, 2009, the Board of Directors of the Company approved a strategic restructuring plan designed to create significant +operating efficiencies, improve the Company’s supply chain and create a stronger global platform. On October 7, 2009, the Company announced an expansion of its restructuring plan to include the consolidation of two domestic manufacturing +facilities into one and to finalize realignment in certain of the Company’s product creation organizations. The strategic restructuring plan and all actions under the plan, except for certain cash payments, were completed as of June 19, +2010. Accordingly, the Company did not incur any restructuring or other transition costs for the year ended December 31, 2011. For the years ended January 1, 2011 and January 2, 2010 the Company incurred restructuring and other +transition costs of $4,234 ($3,087 on an after-tax basis) and $35,596 ($25,700 on an after-tax basis), or $0.06 and $0.53 per diluted share, respectively. +Restructuring +The Company did not incur restructuring charges for the year ended +December 31, 2011. For the years ended January 1, 2011 and January 2, 2010, the Company incurred restructuring charges of $2,239 ($1,632 on an after-tax basis) and $29,083 ($20,998 on an after-tax basis), respectively. +The following is a summary of the activity with respect to a reserve established by the Company in connection with the restructuring plan, by category of +costs: +Severance and +employee related +Facility exit costs +and other +Total +Balance at January 2, 2010 +$ +3,866 +$ +2,060 +$ +5,926 +Charges incurred +571 +1,668 +2,239 +Amounts paid or utilized +(4,150 +) +(2,701 +) +(6,851 +) +Balance at January 1, 2011 +$ +287 +$ +1,027 +$ +1,314 +Amounts paid or utilized +(287 +) +(697 +) +(984 +) +Balance at December 31, 2011 +$ +— +$ +330 +$ +330 +Other Transition Costs +Incremental costs incurred related to the restructuring plan that do not qualify as restructuring costs under the provisions of FASB ASC Topic 420, +Exit or Disposal Cost Obligations , have been included in the Company’s consolidated condensed statements of operations on the line items titled “Restructuring and other transition costs”. These primarily include costs related +to closure of facilities, new employee training and transition to outsourced services. All costs included in this caption were solely related to the transition and implementation of the restructuring plan and do not include ongoing business +operating costs. There were no other transition costs incurred during the year ended December 31, 2011. Other transition costs for the years ended January 1, 2011, and January 2, 2010, were, $1,995 ($1,454 on an after-tax basis) and +$6,513 ($4,702 on an after-tax basis), respectively. +11. BUSINESS ACQUISITIONS +The Company accounted for the following acquisitions under the provisions of FASB ASC Topic 805, Business Combinations . +On January 8, 2009, the Company announced the acquisition of the Cushe ® footwear brand. The purchase price consisted of $1,550 cash, a $1,550 note payable over three years and contingent +consideration of $878. The +A-21 +Table of Contents +Company acquired assets valued at $285, consisting primarily of property, plant and equipment, inventory, and assumed operating liabilities valued at $303, resulting in goodwill and intangibles +of $3,986 at January 2, 2010. Amounts relating to the acquisition are subject to changes in foreign currency exchange rates. +On January 22, 2009, the Company acquired the Chaco ® +footwear brand and certain assets valued at $3,912, consisting primarily of accounts receivable and inventory, for cash of $6,910 and assumed operating liabilities valued at $4,662. The purchase resulted in goodwill and intangibles recorded of +$7,660. +Using the purchase method of accounting, the purchase price in each of these acquisitions is allocated to the assets acquired and +liabilities assumed based on their estimated fair values as of the effective date of the acquisition. The excess purchase price over the assets and liabilities is recorded as goodwill. The purchase price allocation for each acquisition was finalized +during the third quarter of 2009 and a final determination of all purchase accounting adjustments was made upon finalization of asset valuations and acquisition costs. Pro forma results of operations have not been presented because the effects of +these acquisitions, individually and in the aggregate, were not material to the Company’s consolidated results of operations. Both of the brands have been consolidated into the Company’s results of operations since their respective +acquisition dates. +12. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) +The Company reports its quarterly results of operations on the basis of 12-week periods for each of the first three fiscal quarters and +a 16- or 17-week period for the fiscal fourth quarter. The fourth quarters of fiscal year 2011 and fiscal year 2010 consist of 16 weeks. The aggregate quarterly earnings per share amounts disclosed in the table below may not equal the annual per +share amounts due to rounding and the fact that results for each quarter are calculated independently of the annual period. +The +Company’s unaudited quarterly results of operations are as follows: +2011 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Revenue +$ +330,872 +$ +310,139 +$ +361,590 +$ +406,466 +Gross profit +137,797 +122,117 +146,683 +150,153 +Net earnings +35,863 +23,963 +40,435 +23,026 +Net earnings per share: +Basic +$ +0.74 +$ +0.49 +$ +0.84 +$ +0.48 +Diluted +0.72 +0.48 +0.82 +0.47 +2010 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Revenue +$ +284,897 +$ +258,199 +$ +320,396 +$ +385,025 +Gross profit +117,589 +103,681 +128,571 +142,733 +Net earnings +27,459 +17,222 +34,143 +25,646 +Net earnings per share: +Basic +$ +0.55 +$ +0.35 +$ +0.71 +$ +0.54 +Diluted +0.54 +0.35 +0.70 +0.52 +A-22 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Shareholders of Wolverine World Wide, Inc. +We have audited the accompanying consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of December 31, 2011 and January 1, 2011, and the related consolidated statements +of stockholders’ equity and comprehensive income, operations, and cash flows for each of the three fiscal years in the period ended December 31, 2011. Our audits also included the financial statement schedule listed in the Index at +Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that +we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial +statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for +our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial +position of Wolverine World Wide, Inc. and subsidiaries at December 31, 2011 and January 1, 2011, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended +December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly +in all material respects the information set forth therein. +We also have audited, in accordance with the standards of the Public Company +Accounting Oversight Board (United States), Wolverine World Wide, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of +Sponsoring Organizations of the Treadway Commission and our report dated February 29, 2012 expressed an unqualified opinion thereon. +/s/ +Ernst & Young LLP +Grand Rapids, Michigan +February 29, 2012 +A-23 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Shareholders of Wolverine World Wide, Inc. +We have audited Wolverine World Wide, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued +by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Wolverine World Wide, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of +the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control +over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting +Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included +obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing +such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial +reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that +(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as +necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors +of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of +any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, Wolverine World Wide, Inc. maintained, in all material respects, effective internal control over financial reporting as of +December 31, 2011, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting +Oversight Board (United States), the consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of December 31, 2011 and January 1, 2011, and the related consolidated statements of stockholders’ equity and +comprehensive income, operations, and cash flows for each of the three fiscal years in the period ended December 31, 2011, and our report dated February 29, 2012 expressed an unqualified opinion thereon. +/s/ Ernst & Young LLP +Grand Rapids, +Michigan +February 29, 2012 +A-24 +Table of Contents +Schedule +Valuation and Qualifying Accounts +APPENDIX B +Schedule II - Valuation and Qualifying Accounts +Wolverine World Wide, +Inc. and Subsidiaries +Column A +Column B +Column C +Column D +Column E +Additions +Description +Balance at +Beginning of +Period +(1) +Charged to +Costs and +Expenses +(2) +Charged to +Other +Accounts +(Describe) +Deductions +(Describe) +Balance at End +of +Period +Fiscal year ended December 31, 2011 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +5,754,000 +$ +5,953,000 +$ +6,927,000 +(A) +$ +4,780,000 +Allowance for sales returns +4,474,000 +48,484,000 +47,761,000 +(B) +5,197,000 +Allowance for cash discounts +1,185,000 +10,084,000 +8,558,000 +(C) +2,711,000 +Inventory valuation allowances +8,619,000 +8,753,000 +7,042,000 +(D) +10,330,000 +$ +20,032,000 +$ +73,274,000 +$ +70,287,000 +$ +23,018,000 +Fiscal year ended January 1, 2011 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +8,137,000 +$ +3,846,000 +$ +6,229,000 +(A) +5,754,000 +Allowance for sales returns +4,649,000 +38,093,000 +38,268,000 +(B) +4,474,000 +Allowance for cash discounts +1,160,000 +10,568,000 +10,543,000 +(C) +1,185,000 +Inventory valuation allowances +6,350,000 +8,276,000 +6,007,000 +(D) +8,619,000 +$ +20,296,000 +$ +52,296,000 +$ +52,560,000 +20,032,000 +Fiscal year ended January 2, 2010 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +8,383,000 +$ +1,733,000 +$ +1,979,000 +(A) +$ +8,137,000 +Allowance for sales returns +5,311,000 +35,702,000 +36,364,000 +(B) +4,649,000 +Allowance for cash discounts +1,467,000 +11,717,000 +12,024,000 +(C) +1,160,000 +Inventory valuation allowances +8,912,000 +6,419,000 +8,981,000 +(D) +6,350,000 +$ +24,073,000 +$ +48,255,000 +$ +52,032,000 +$ +20,296,000 +(A) +Accounts charged off, net of recoveries. +(B) +Actual customer returns. +(C) +Discounts given to customers. +(D) +Adjustment upon disposal of related inventories. +Table of Contents +EXHIBIT INDEX +Exhibit +Number +Document +3.1 +Restated Certificate of Incorporation. Previously filed as Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the period ended December 30, 2006. Here incorporated by +reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on December 15, 2010. Here incorporated by +reference. +4.1 +The Registrant has other long-term debt instruments outstanding in addition to those described in Exhibit 4.2. The authorized amount of none of these classes of debt exceeds 10% of +the Company’s total consolidated assets. The Company agrees to furnish copies of any agreement defining the rights of holders of any such long-term indebtedness to the Securities and Exchange Commission upon request. +4.2 +Credit Agreement, dated as of June 7, 2010, among Wolverine World Wide, Inc., certain foreign subsidiaries of Wolverine World Wide, Inc., JPMorgan Chase Bank, N.A., as +Administrative Agent, and the lenders party thereto. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on June 8, 2010. Here incorporated by reference. +10.1 +1993 Stock Incentive Plan, as amended and restated.* Previously filed as Exhibit 10.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10.2 +Amended and Restated 1995 Stock Incentive Plan.* Previously filed as Exhibit 10.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.3 +Amended and Restated 1997 Stock Incentive Plan.* Previously filed as Exhibit 10.3 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.4 +Amended and Restated Stock Incentive Plan of 1999.* Previously filed as Exhibit 10.4 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.5 +Amended and Restated Stock Incentive Plan of 2001.* Previously filed as Exhibit 10.5 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.6 +Amended and Restated Stock Incentive Plan of 2003.* Previously filed as Exhibit 10.6 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.7 +Amended and Restated Stock Incentive Plan of 2005.* Previously filed as Exhibit 10.7 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.8 +Amended and Restated Directors’ Stock Option Plan.* Previously filed as Exhibit 10.8 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10.9 +Amended and Restated Outside Directors’ Deferred Compensation Plan.* Previously filed as Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the fiscal year ended +December 29, 2007. Here incorporated by reference. +Table of Contents +Exhibit +Number +Document +10.10 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Exhibit 10.10 to the Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +10.11 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Exhibit 10.11 to the Company’s Annual Report on Form 10-K for the fiscal year +ended January 3, 2009. Here incorporated by reference. +10.12 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 29, 2007. Here +incorporated by reference. +10.13 +Executive Severance Agreement.* Previously filed as Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated by reference. A +participant schedule of current executive officers who are parties to this agreement is attached as Exhibit 10.13. +10.14 +Executive Severance Agreement.* A participant schedule of current executive officers who are parties to this agreement is included in Exhibit 10.14 +10.15 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and with Messrs. Grady, Grimes, Jeppesen, Krueger and Zwiers and Ms. +Linton. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.16 +Amended and Restated Benefit Trust Agreement dated April 25, 2007.* Previously filed as Exhibit 10.5 to the Company’s Current Report on Form 8-K filed on April 25, 2007. Here +incorporated by reference. +10.17 +Employees’ Pension Plan (Restated as amended through January 1, 2011).* +10.18 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 15, 2005. Here incorporated by +reference. +10.19 +Form of Non-Qualified Stock Option Agreement for Blake W. Krueger and Timothy J. O’Donovan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 15, 2005. Here incorporated by reference. +10.20 +Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.19 applies.* Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 15, 2005. Here incorporated by reference. +10.21 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company’s Current Report on Form 8-K filed on February 15, 2005. Here incorporated by +reference. +10.22 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 17, 2006. Here incorporated by +reference. +10.23 +Form of Non-Qualified Stock Option Agreement for Blake W. Krueger and Timothy J. O’Donovan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 17, 2006. Here incorporated by reference. +10.24 +Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.23 applies.* Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 17, 2006. Here incorporated by reference. +10.25 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company’s Current Report on Form 8-K filed on February 17, 2006. Here incorporated by +reference. +Table of Contents +Exhibit +Number +Document +10.26 +Form of Stock Option Agreement for non-employee directors.* Previously filed as Exhibit 10.23 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 1, +2005. Here incorporated by reference. +10.27 +2009 Form of Non-Qualified Stock Option Agreement for Donald T. Grimes, Blake W. Krueger, Pamela L. Linton and James D. Zwiers.* Previously filed as Exhibit 10.26 to the +Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.28 +2009 Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.27 applies.* Previously filed as Exhibit 10.27 to the Company’s +Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.29 +Form of Performance Share Award Agreement (2009 – 2011 performance period).* Previously filed as Exhibit 10.28 to the Company’s Annual Report on Form 10-K for the fiscal +year ended January 3, 2009. Here incorporated by reference. +10.30 +Form of Performance Share Award Agreement (2010 – 2012 performance period).* Previously filed as Exhibit 10.29 to the Company’s Annual Report on Form 10-K for the fiscal +year ended January 2, 2010. Here incorporated by reference. +10.31 +Form of Performance Share Award Agreement (2011 – 2013 performance period).* Previously filed as Exhibit 10.30 to the Company’s Annual Report on Form 10-K for the fiscal +year ended January 1, 2011. Here incorporated by reference. +10.32 +Form of Performance Share Award Agreement (2012 – 2014 performance period).* +10.33 +Separation Agreement between Wolverine World Wide, Inc. and Blake W. Krueger, dated as of March 13, 2008, as amended.* Previously filed as Exhibit 10.1 to the Company’s +Quarterly Report on Form 10-Q for the period ended March 22, 2008. Here incorporated by reference. +10.34 +First Amendment to Separation Agreement between Wolverine World Wide, Inc. and Blake W. Krueger, dated as of December 11, 2008.* Previously filed as Exhibit 10.30 to the +Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.35 +409A Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated by +reference. A participant schedule of current executive officers who participate in this plan is attached as Exhibit 10.35. +10.36 +Form of 409A Supplemental Retirement Plan Participation Agreement with Blake W. Krueger.* Previously filed as Exhibit 10.32 to the Company’s Annual Report on Form 10-K for the +fiscal year ended January 3, 2009. Here incorporated by reference. +10.37 +Outside Directors’ Deferred Compensation Plan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated +by reference. +10.38 +Stock Incentive Plan of 2010.* Previously filed as Exhibit 10.1 to the Company’s Registration Statement on Form S-8 filed on March 4, 2010. Here incorporated by +reference. +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +Table of Contents +Exhibit +Number +Document +31.1 +Certification of Chairman, Chief Executive Officer and President under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Senior Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +101 +Interactive Data File.** +* +Management contract or compensatory plan or arrangement. +** +IN ACCORDANCE WITH THE TEMPORARY HARDSHIP EXEMPTION PROVIDED BY RULE 201 OF REGULATION S-T, THE DATE BY WHICH THE INTERACTIVE DATA FILE IS REQUIRED TO BE SUBMITTED HAS +BEEN EXTENDED BY SIX BUSINESS DAYS. +The Company will furnish a copy of any exhibit listed above to any stockholder without +charge upon written request to Mr. Kenneth A. Grady, General Counsel and Secretary, 9341 Courtland Drive N.E., Rockford, Michigan 49351. \ No newline at end of file diff --git a/raw/filings/0000110471/2011/0001193125-12-089426/filing_metadata.csv b/raw/filings/0000110471/2011/0001193125-12-089426/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..6b71fa957a049c9cc0d75bdf0c5d2d4812dbbe3c --- /dev/null +++ b/raw/filings/0000110471/2011/0001193125-12-089426/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000110471,WWW,WOLVERINE WORLD WIDE INC /DE/,10-K,2012-02-29,2011-12-31,2012-02-29T21:57:42.000Z,0001193125-12-089426,d268216d10k.htm,FORM 10-K,2424575,0,0,https://www.sec.gov/Archives/edgar/data/110471/000119312512089426/d268216d10k.htm,https://www.sec.gov/Archives/edgar/data/110471/000119312512089426/,2011,2011,1 diff --git a/raw/filings/0000110471/2011/0001193125-12-089426/item1.txt b/raw/filings/0000110471/2011/0001193125-12-089426/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..1e969987ae25febcd0f67da0bb41c5bb024a9fc8 --- /dev/null +++ b/raw/filings/0000110471/2011/0001193125-12-089426/item1.txt @@ -0,0 +1,256 @@ +Item 1. Business +General +Wolverine World Wide, Inc. (the “Company”) is a leading designer, +manufacturer and marketer of a broad range of quality casual footwear and apparel, performance outdoor footwear and apparel, industrial work shoes, boots and apparel, and uniform shoes and boots. The Company, a Delaware corporation, is the successor +of a Michigan corporation of the same name, originally organized in 1906, which, in turn, was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +Approximately 52 million pairs/units of the Company’s branded footwear and apparel were sold in the fiscal year ended +December 31, 2011 (“fiscal year 2011”) in more than 190 countries and territories around the world. The Company’s products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort +and performance. The products are marketed under widely recognized brand names, including Bates ® , +Cat ® Footwear, Chaco ® , Cushe ® , +Harley-Davidson ® Footwear, Hush Puppies ® , HyTest ® , +Merrell ® , Patagonia ® Footwear, Sebago ® , +Soft Style ® and Wolverine ® . The Company believes that its primary competitive advantages are its well-recognized brand names, its patented proprietary designs and comfort technologies, its wide +range of distribution channels and its diversified manufacturing and sourcing base. Cat ® is a registered +trademark of Caterpillar, Inc., Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. and +Patagonia ® is a registered trademark of Patagonia, Inc. +The Company’s brands are sold at various price points targeting a wide range of consumers of casual, work and outdoor footwear +and apparel. The Company also licenses some of its brands for use on products other than footwear or apparel. The Company has one reportable segment that is engaged in designing, manufacturing, sourcing, marketing, licensing and distributing branded +footwear, apparel and accessories. In January 2011, the Company realigned the operating groups included in the branded footwear, apparel and licensing reportable segment. As a result, the Company now identifies three operating groups within its +reportable segment: (i) the Outdoor Group , consisting of Merrell ® , Patagonia ® and Chaco ® footwear, and Merrell ® +brand apparel and accessories, (ii) the Heritage Group , consisting of Wolverine ® boots and +shoes and Wolverine ® brand apparel, and Cat ® footwear, Bates ® , +Harley-Davidson ® footwear and HyTest ® footwear, and (iii) the Lifestyle Group , consisting of Hush Puppies ® footwear and apparel, +Sebago ® footwear and apparel, and Cushe ® and Soft Style ® +footwear. +The Company’s Global Operations Group is responsible for manufacturing, sourcing, distribution and customer +support. The Company directly sells its products in the United States, Canada and certain countries in Europe to a wide range of retail customers, including department stores, national chains, catalogs, specialty retailers, mass merchants and +Internet retailers, and to governments and municipalities. Many of the retailers carrying Wolverine products operate multiple storefront locations. The Company’s products are marketed worldwide in more than 190 countries and territories through +Company-owned wholesale and retail operations, licensees and distributors. +For financial information regarding the Company, see the +consolidated financial statements and the accompanying notes, which are attached as Appendix A to this Annual Report on Form 10-K. As described above, the Company has one reportable segment, branded footwear, apparel and licensing. The +Company’s other operating groups consist of its consumer-direct operations and leathers operations, which are described below. Financial information regarding the Company’s reportable segment and other operating groups and financial +information by geographic area is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Annual Report on Form 10-K. +4 +Table of Contents +Branded Footwear, Apparel and Licensing +The Company sources and markets a broad range of footwear styles, including shoes, boots and sandals under many recognizable brand +names, including Bates ® , Cat ® , Chaco ® , Cushe ® , Harley-Davidson ® , Hush Puppies ® , +HyTest ® , Merrell ® , Patagonia ® , +Sebago ® , Soft Style ® and Wolverine ® . The +Company combines quality materials and skilled workmanship to produce footwear according to its specifications at both Company-owned and third-party manufacturing facilities. The Company also markets Merrell ® , Sebago ® , and Wolverine ® brand +apparel and accessories and licenses some of its brands for use on non-footwear products, including Hush +Puppies ® apparel, eyewear, watches, socks, handbags and plush toys and Wolverine ® brand eyewear and gloves. +The Company’s branded footwear, apparel and licensing operating groups for fiscal year 2011 are described below. +1. +The Outdoor Group The Outdoor Group consists of Merrell ® footwear, Merrell ® +apparel and accessories, Patagonia ® footwear and Chaco ® footwear. +Merrell ® Footwear: +Merrell ® footwear is designed to inspire and encourage everyone to increase participation in the +outdoors. Known for quality, durability and comfort, the Merrell ® footwear line uses a variety of +proprietary designs and technologies to create footwear with unique styling, performance and comfort features for the trail or the town. Merrell ® footwear products offer a wide range of styles from technical hiking, multi-sport footwear and the minimalist +Merrell ® Barefoot Collection to versatile, lifestyle product for more casual outdoor adventures for men, women +and kids. Merrell ® footwear products are sold primarily through outdoor specialty retailers, sporting +goods chains, department stores, on-line retailers and catalogs. Merrell ® footwear is marketed in +approximately 150 countries and territories worldwide. +Merrell ® Apparel and Accessories: The Merrell ® apparel line extends the +Merrell ® commitment to an active outdoor lifestyle with a versatile line of apparel built for the summit +or the street. The apparel line features stylized lifestyle silhouettes built with the technical, high performance, weather fighting materials that consumers expect from an outdoor brand. In addition to Merrell ® apparel, the Outdoor Group markets Merrell ® accessories, including packs, bags and luggage for men and women. +Patagonia ® Footwear: Pursuant to an agreement with +Lost Arrow Corporation, the Company has the exclusive footwear marketing and distribution rights under +Patagonia ® and other trademarks. The Patagonia ® footwear line focuses primarily on casual and outdoor performance footwear. Patagonia ® is a registered trademark of Patagonia, Inc. +Chaco ® Footwear: The Chaco ® footwear line focuses primarily on performance sandals and closed-toe products for the outdoor enthusiast. +2. +The Heritage Group The Heritage Group markets footwear, apparel and accessories products under the Wolverine ® brand and footwear under the Cat ® , Bates ® , +Harley-Davidson ® and HyTest ® brands. +Wolverine ® Footwear: +The Wolverine ® brand offers high quality boots and shoes that incorporate innovative technologies to +deliver comfort and durability. The Wolverine ® brand, which has been in existence for 129 years, markets +footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® , MultiShox ® , +Wolverine Fusion ® and Wolverine Compressor ® technologies, as well as the development of the Contour Welt ® line, have allowed the +Wolverine ® brand to offer a broad +5 +Table of Contents +line of work footwear with a focus on comfort. The +Wolverine ® work product line, whose target consumers are industrial workers, features work boots and shoes +with protective features such as toe caps, metatarsal guards and electrical hazard protection. The +Wolverine ® rugged casual and outdoor sport product lines incorporate DuraShocks ® , Wolverine iCS TM and other technologies and comfort features into products designed for casual and outdoor sport use. The target +consumers for the rugged casual line products have active lifestyles. The outdoor sport line is designed to meet the needs of hunters, fishermen and other active outdoor sports enthusiasts. +Wolverine ® Apparel and Licensing: The Heritage Group markets a line of work and rugged casual Wolverine ® brand apparel. In addition, the Company licenses its Wolverine ® brand for use on eyewear and gloves. +Cat ® Footwear: Pursuant to a license arrangement with Caterpillar, Inc., the Company has exclusive footwear marketing and distribution rights under +Caterpillar ® , Cat ® , Cat & Design, Walking +Machines ® and other trademarks. The Company believes the association with Cat ® equipment encourages customers to view the footwear as high-quality, rugged and durable. Cat ® brand footwear products include work boots and shoes, sport boots, rugged casual and lifestyle footwear, including +lines of work and casual footwear featuring iTechnology ™ and Hidden Tracks ® comfort features. +Cat ® footwear targets work and industrial users and active lifestyle users. Cat ® footwear is marketed in approximately 145 countries and territories worldwide. Cat ® , Caterpillar ® , Cat & Design and Walking Machines ® are registered trademarks of Caterpillar Inc. +Bates ® Uniform Footwear: +The Bates ® brand is a leader in supplying footwear to military and civilian uniform users. +Bates ® utilizes DuraShocks ® , DuraShocks SR ™ , +CoolTech, Wolverine iCS ™ and other proprietary comfort technologies in the design of its military-style +boots and oxford shoes. Bates ® contracts with the United States Department of Defense and the military +branches of several foreign countries to supply military footwear. Civilian uniform users include individuals in police, security, postal, restaurant and other industrial occupations. Bates ® products are also distributed through specialty retailers and catalogs. +Harley-Davidson ® Footwear: +Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has footwear marketing and distribution rights for Harley-Davidson ® branded footwear. +Harley-Davidson ® branded footwear products include motorcycle, casual, fashion, work and western footwear +for men, women and children. Harley-Davidson ® footwear is sold globally through a network of +independent Harley-Davidson ® dealerships and other retail outlets. Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. +HyTest ® Safety Footwear: The HyTest ® product line consists primarily of high-quality work boots and shoes that incorporate various specialty safety features designed to protect against hazards of the +workplace, including steel toe, composite toe, metatarsal guards, and electrical hazard, static dissipating and conductive footwear. HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company’s occupational and work footwear brands to workers at industrial facilities and also through +direct sales arrangements with large industrial customers. +3. +The Lifestyle Group The Lifestyle Group consists of Hush Puppies ® footwear and apparel, +Sebago ® footwear and apparel, and Cushe ® and Soft Style ® +footwear. +Hush Puppies ® : Since 1958, the Hush +Puppies ® brand has been a leader in casual footwear. The brand offers shoes, sandals and boots for men, +women and children, and is marketed in +6 +Table of Contents +approximately 140 countries and territories. The modern styling is complemented by a variety of comfort features and proprietary technologies that have earned the brand its reputation for +comfort, style and value. In addition, the Hush Puppies ® brand is licensed for use on certain items, +including apparel, eyewear, handbags, socks, watches and plush toys. +Sebago ® : The Sebago ® product line has been marketed since 1946 and consists primarily of performance nautical and American-inspired casual footwear for men and women, such as boat shoes +and hand sewn loafers. Highly recognized Sebago ® line extensions include Sebago Docksides ™ , Drysides ™ and Athletic Marine. The +Sebago ® product line is marketed in approximately 125 countries and territories worldwide. The Sebago ® manufacturing and design tradition of quality components, durability, comfort and “Americana” heritage is +further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. The Company also markets a classic and marine Sebago ® apparel line. +Cushe ® : The +Cushe ® business focuses on relaxed, design-led footwear for active men and women. The Cushe ® Footwear business targets younger adult consumers and better-grade retailers with products ranging from sport casual +footwear to sandals. Cushe ® is marketed under three primary collections: Universal Traveler, Urban Safari +and Coastal Supremacy. +Soft Style ® : The Soft +Style ® product line consists primarily of women’s dress and casual footwear. +Other Businesses +In addition to its +branded footwear, apparel and licensing operations, the Company also (i) operates 89 retail stores in North America and 12 retail stores in the United Kingdom that feature footwear and apparel; and (ii) operates a performance leathers +business through its Wolverine Leathers Division. +1. +Wolverine Retail The Company’s consumer-direct business operates 89 North American and 12 United Kingdom-based retail stores at +December 31, 2011. These stores are operated under the Hush Puppies ® , Hush Puppies and +Family SM , Track’N Trail ® , Sebago ® , Wolverine Company Store, Rockford Footwear Depot ® and Merrell ® names. +The Rockford Footwear Depot ® , Track’N +Trail ® , Hush Puppies ® and Hush Puppies and Family SM +retail formats carry a large selection of Company-branded products, featuring such brands as Wolverine ® , Merrell ® , Hush +Puppies ® , Cat ® , Chaco ® , Cushe ® , Patagonia ® , Sebago ® and +Harley-Davidson ® . The Company also operates +Merrell ® concept stores, Hush Puppies ® concept stores and +Sebago ® concept stores, providing a platform to showcase these brands exclusively. In addition, the +Company operates 42 consumer-direct retail websites, including www.merrell.com, www.wolverine.com, www.cushe.com, www.hushpuppies.com , www.chacos.com, www.catfootwear.com , www.sebago.com and www.batesfootwear.com . +2. +The Wolverine Leathers Division The Wolverine Leathers Division markets pigskin leather for use primarily in the footwear industry. The Company believes +pigskin leather offers superior performance and other advantages over cowhide leather. The Company’s waterproof and stain resistant leathers are featured in some of the Company’s footwear lines and many products offered by the +Company’s international licensees and distributors. +Marketing +The Company’s marketing strategy is to develop brand-specific plans and related promotional materials for U.S. and international markets to foster a +consistent message for each of the Company’s core brands. Each brand +7 +Table of Contents +operating group has dedicated marketing personnel who develop the marketing strategy for brands within that group. Marketing campaigns and strategies vary by brand and are designed to target +accounts and/or end users as the brand operating groups strive to increase awareness of, and affinity for, the Company’s brands. The Company’s advertisements typically emphasize fashion, comfort, quality, durability, functionality and +other performance and lifestyle aspects of the Company’s products. Components of the brand-specific plans vary and may include print, radio and television advertising, search engine optimization, social networking sites, event sponsorships, +in-store point-of-purchase displays, promotional materials, and sales and technical assistance. +The Company’s brand operating groups +provide its licensees and distributors with creative direction, brand images and other materials to convey consistent brand messaging, including (i) direction on the categories of footwear to be promoted, (ii) photography and layouts, +(iii) broadcast advertising, including commercials and film footage, (iv) point-of-purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting services regarding retail store layout and +design. The Company believes its brand names represent a competitive advantage, and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution +The +Company uses a wide variety of domestic distribution channels and strategies to distribute its branded products: +• +The Company uses a dedicated sales force and customer service team, advertising and point-of-purchase support and maintains in-stock inventories to +service department stores, national chains, specialty retailers, catalogs, independent retailers, uniform outlets and its own consumer direct business. +• +Volume direct programs ship products directly to the retail customer without going through a Company distribution center and provide products at +competitive prices with limited marketing support. The Company uses these programs to service major retail, catalog, mass merchant and government customers. +• +A network of independent Shoemobile ® distribution outlets distributes the Company’s work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the United States military and submits bids for contracts to supply specific footwear products. Such contracts +typically contain future purchase options that may or may not be exercised. +In addition to its wholesale activities, the +Company also operates a consumer-direct business as described above. The Company continues to develop new programs, both independently and in conjunction with its retail customers, for the distribution of its products. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the +Company’s revenue in fiscal year 2011. +The Company experiences moderate fluctuations in sales volume during the year as reflected in +quarterly revenue (and taking into consideration the 16 weeks or 17 weeks included in the Company’s fiscal fourth quarter versus the 12 weeks included in each of the first three fiscal quarters). The Company expects current seasonal sales +patterns to continue in future years. The Company also experiences some fluctuation in its levels of working capital, typically including an increase in working capital requirements near the end of the first and third quarters. The Company meets its +working capital requirements through internal free cash flow and, as needed, a revolving credit agreement. +8 +Table of Contents +International Operations and Global Licensing +The Company’s foreign-sourced revenue is generated from a combination of (i) sales of branded footwear and apparel through the Company’s +owned operations in Canada, the United Kingdom and several branch offices in Europe; (ii) sales to third-party distributors for certain markets and businesses; and (iii) royalty income from a network of third-party licensees and +distributors. The Company’s owned operations are located in markets where the Company believes it can gain a strategic advantage by directly controlling the sale of its products into retail accounts. License and distribution arrangements enable +the Company to develop sales in other markets without the capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. +The Company continues to develop its network of licensees and distributors to market its branded products. The Company assists its licensees in designing products that are appropriate to each foreign +market, but consistent with the global brand position. Pursuant to distribution or license agreements, third-party licensees and distributors either purchase goods directly from the Company and authorized third-party manufacturers or manufacture +branded products themselves, consistent with Company standards. Distributors and licensees are responsible for independently marketing and distributing Company branded products in their respective territories, with product and marketing support from +the Company. +Manufacturing and Sourcing +The Company directly controls the majority of the units of footwear and apparel manufactured or sourced under the Company’s brand names. The balance is controlled directly by the Company’s +licensees. A substantial majority of the units sourced and/or manufactured by the Company are purchased or sourced from third parties, with the remainder produced at Company-owned facilities. The Company sources a majority of its footwear from +numerous third-party manufacturers in the Asia Pacific region, South America and India. The Company maintains offices in the Asia Pacific region to facilitate and develop strategies for the sourcing and importation of quality footwear and apparel. +The Company has established guidelines for each of its third-party manufacturers in order to monitor product quality, labor practices and financial viability. The Company has adopted “Engagement Criteria for Partners & Sources,” a +policy that requires that the Company’s domestic and foreign manufacturers, licensees and distributors use ethical business standards; comply with all applicable health and safety laws and regulations; commit to use environmentally safe +practices; treat employees fairly with respect to wages, benefits and working conditions; and not use child or prison labor. Footwear produced by the Company is manufactured at Company-operated facilities located in Michigan and the Dominican +Republic. +The Company’s owned manufacturing operations allow the Company to (i) reduce its production lead time, to more quickly +respond to market demand and reduce inventory risk, (ii) lower freight, shipping and duty costs for sales to certain markets, and (iii) more closely monitor product quality. The Company’s third-party sourcing strategy allows the +Company to (i) benefit from lower manufacturing costs and state-of-the-art manufacturing facilities, (ii) source high quality raw materials from around the world, and (iii) avoid capital expenditures necessary for additional owned +factories. The Company believes that its overall global manufacturing strategy provides the flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company’s principal required raw material is quality leather, which it purchases from a select group of domestic and foreign suppliers. The +global availability of common upper materials and specialty leathers eliminates any reliance by the Company on a sole supplier. +The Company +currently purchases all of the raw pigskins used for its Wolverine Leathers Division from one domestic source, which has been a reliable and consistent supplier to the Company for over 40 years. Alternative sources of raw pigskin are available, but +with less advantageous pricing, quality and compatibility with the Company’s processing method. The Company purchases all of its other raw materials and component parts from a variety of sources and does not believe that any of these sources +are a dominant supplier. +9 +Table of Contents +The Company is subject to the normal risks of doing business abroad due to its international operations, +including the risk of expropriation, acts of war or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas, tariffs and duties, loss of most favored nation trading status and currency and exchange rate +fluctuations. With respect to international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers, but that a +sustained disruption of such sources of supply could have an adverse impact on the Company’s results of operations and financial position. +Trademarks, Licenses and Patents +The Company holds a significant portfolio of registered and common law trademarks that identify its branded products. The Company’s owned trademarks include Hush Puppies ® , Wolverine ® , Bates ® , Cushe ® , Chaco ® , Soft Style ® , +Wolverine Fusion ® , DuraShocks ® , MultiShox ® , +Wolverine Compressor ® , Hidden Tracks ® , iTechnology TM , Bounce ® , Comfort Curve ® , HyTest ® , Merrell ® , M Circle +Design (registered design trademark), Continuum ® , Sebago ® , Q Form ® and Track ‘N +Trail ® . The Company’s Wolverine Leathers Division markets its pigskin leathers under the trademarks +Wolverine Warrior Leather ® , Weather Tight ® and All Season Weather Leathers ™. The Company has footwear marketing and distribution rights under the Cat ® , Harley-Davidson ® and Patagonia ® +trademarks pursuant to license arrangements with the respective trademark owners. The Cat ® , Harley-Davidson ® , and Patagonia ® licenses extend for three or more years and are subject to early termination for breach. +The Company believes that consumers identify its products by the Company’s trademarks and that its trademarks are valuable assets. The Company is not aware of any infringing uses or any prior claims +of ownership of its trademarks that could materially affect its current business. The Company has a policy of registering its primary trademarks and vigorously defending its trademarks against infringement or other threats whenever practicable. The +Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company vigorously protects its proprietary rights under applicable laws. +Order Backlog +At December 31, 2011 the Company had an order backlog of approximately +$483 million compared to an order backlog of approximately $470 million at January 1, 2011, determined on a consistent basis. A majority of the backlog relates to orders for products expected to be shipped in 2012. Orders in the backlog are +subject to cancellation by customers and to changes in planned customer demand or at-once orders. The backlog at any particular time is affected by a number of factors, including seasonality, retail conditions, expected customer demand, product +availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be predictive of eventual actual shipments. +Competition +The Company markets its +footwear and apparel lines in a highly competitive and fragmented environment. The Company competes with numerous domestic and international marketers and importers, some of which are larger and have greater resources than the Company. The Company +has at least forty major competitors for its brands of footwear and apparel. Product performance and quality, including technological improvements, product identity, competitive pricing and ability to control costs, and the ability to adapt to style +changes are all important elements of competition in the footwear and apparel markets served by the Company. The footwear and apparel industries in general are subject to changes in consumer preferences. The Company strives to maintain its +competitive position through promotions designed to increase brand awareness, manufacturing and sourcing efficiencies, and the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell +its products at competitive prices and to meet shifts in consumer preferences. +10 +Table of Contents +Because of the lack of reliable published statistics, the Company is unable to state with certainty its +competitive position in the overall footwear and apparel industries. Market shares in the non-athletic footwear and apparel industry are highly fragmented, and no one company has a dominant market position. +Research and Development +In addition to normal and recurring product development, design and styling activities, the Company engages in research and development activities related to the development of new production techniques +and to the improvement of the function, performance, reliability and quality of its branded footwear and other products. For example, the Company’s continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University +has helped validate and refine specific biomechanical design concepts, such as Bounce ® , DuraShocks ® and Hidden Tracks ® comfort technologies, which have been incorporated into the Company’s footwear. While the Company expects to continue to be a leading developer of footwear +innovations, research and development costs do not represent a material portion of operating expenses. +Environmental Matters +Compliance with domestic and foreign federal, state and local requirements regulating the discharge of materials into the environment, or +otherwise relating to the protection of the environment have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company. The Company uses and generates certain substances +and wastes that are regulated or may be deemed hazardous to the environment under certain federal, state and local regulations. The Company works with domestic and foreign federal, state and local agencies from time to time to resolve cleanup issues +at various waste sites and other regulatory issues. +Employees +As of December 31, 2011, the Company had approximately 4,435 domestic and foreign production, office and sales employees. Approximately 54 employees were covered by a single union contract that +expires on March 31, 2013. The Company presently considers its employee relations to be good. +Available Information +Information about the Company, including the Company’s Code of Conduct & Compliance, Corporate Governance Guidelines, Director Independence +Standards, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, and Governance Committee Charter, is available at its website at www.wolverineworldwide.com/investor-relations/corporate-governance . +Printed copies of the documents listed above are available, without charge, by writing to the Company at 9341 Courtland Drive, N.E., Rockford, Michigan 49351, Attention: General Counsel. +The Company also makes available on or through its website, free of charge, the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to +those reports (along with certain other Company filings with the Securities and Exchange Commission (“SEC”)), as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These materials +are also accessible on the SEC’s website at www.sec.gov . \ No newline at end of file diff --git a/raw/filings/0000110471/2011/0001193125-12-089426/item13.txt b/raw/filings/0000110471/2011/0001193125-12-089426/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..253948c4972a363d3936b478eaaabb86ee97dd49 --- /dev/null +++ b/raw/filings/0000110471/2011/0001193125-12-089426/item13.txt @@ -0,0 +1,5 @@ +Item 13. Certain Relationships and Related Transactions, and Director Independence +The information contained under the caption “Related Party Matters” under the subheadings “Certain Relationships and Related +Transactions” and “Related Person Transactions Policy” contained in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 19, 2012, is incorporated herein by +reference. The information contained under the caption “Corporate Governance” under the subheading “Director Independence” contained in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of +Stockholders to be held on April 19, 2012, is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000110471/2011/0001193125-12-089426/item9a.txt b/raw/filings/0000110471/2011/0001193125-12-089426/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..69f9d0f20612b2edaaf6afaef36e90cb6525b4c8 --- /dev/null +++ b/raw/filings/0000110471/2011/0001193125-12-089426/item9a.txt @@ -0,0 +1,18 @@ +Item 9A. Controls and Procedures +Evaluation of Disclosure Controls and Procedures +An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of +the design and operation of the Company’s disclosure controls and procedures. Based on and as of the time of such evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that the +Company’s disclosure controls and procedures were effective as of the end of the period covered by this report. +Management’s +Report on Internal Control Over Financial Reporting +Management is responsible for establishing and maintaining adequate internal control +over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, we conducted an +evaluation of the effectiveness of internal control over financial reporting as of December 31, 2011, based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission (“COSO”). Based on that evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2011. +The effectiveness of the Company’s internal control over financial reporting as of December 31, 2011 has been audited by Ernst & Young LLP, an independent registered public accounting +firm, as stated in its report, which is included in Appendix A and is incorporated into this Item 9A by reference. +37 +Table of Contents +Changes in Internal Control Over Financial Reporting +There was no change in the Company’s internal control over financial reporting that occurred during the sixteen-week period ended December 31, +2011 that has materially affected, or that is reasonably likely to materially affect, the Company’s internal control over financial reporting. \ No newline at end of file diff --git a/raw/filings/0000110471/2011/0001193125-12-089426/rp_note.txt b/raw/filings/0000110471/2011/0001193125-12-089426/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000110471/2011/0001193125-12-089426/rpt_disclosure.txt b/raw/filings/0000110471/2011/0001193125-12-089426/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..1ab27e11481d9b32c84442691142a1096910f62b --- /dev/null +++ b/raw/filings/0000110471/2011/0001193125-12-089426/rpt_disclosure.txt @@ -0,0 +1,55 @@ +Certain Relationships and Related Transactions +Wolverine Worldwide has entered into agreements with Grimoldi, S.A., an Argentinean corporation of which Mr. Alberto L. Grimoldi, a +director of Wolverine Worldwide, is chairman and a 35% shareholder. The agreements grant Grimoldi, S.A. the exclusive rights to distribute and sell footwear products in Argentina under the Hush Puppies ® , Caterpillar ® , and Patagonia ® brand names, and footwear and apparel under the Merrell ® brand name. Grimoldi, S.A. or its subsidiary purchases products, samples, footwear components, advertising materials and miscellaneous items from Wolverine Worldwide +or pays Wolverine Worldwide royalties and certain sublicense fees based on sales or purchases of products in Argentina. Grimoldi, S.A. was obligated to pay Wolverine Worldwide purchase prices, royalties, sublicense fees, service fees and interest +relating to purchases made or royalties and fees incurred in fiscal year 2011 totaling $5,462,805. All of the transactions described above occurred pursuant to continuing contractual arrangements between Wolverine Worldwide and Grimoldi, S.A. +Wolverine Worldwide expects similar transactions to occur between Grimoldi, S.A. and Wolverine Worldwide and its subsidiaries during 2012. +In the +ordinary course of its business, Wolverine Worldwide purchases promotional merchandise for use in connection with the sale of its products. In fiscal year 2011, Wolverine Worldwide purchased promotional merchandise from Bullseye Group, LLC totaling +$217,863. One-third of Bullseye Group, LLC is owned by Daniel Mehney, the son of David P. Mehney, a director of Wolverine Worldwide. Wolverine Worldwide anticipates purchasing promotional materials from Bullseye Group, LLC in 2012. +The Governance Committee reviewed and approved or ratified each of these transactions in accordance with Wolverine Worldwide’s related person transactions +policy, as described below. +Related Person Transactions Policy +Wolverine Worldwide’s Board adopted written policies and procedures regarding related person transactions. They require the Governance Committee to review and either approve or disapprove the Company entering +into any Interested Transactions (defined below). If advance approval is not feasible, then the Governance Committee must review and ratify the Interested Transaction at its next meeting. +Interested Transaction +Any transaction, arrangement or relationship or series of similar +transactions, arrangements or relationships (including any indebtedness or guarantee of indebtedness) in which: +(1) the aggregate amount involved is or is expected +to exceed $100,000 since the beginning of Wolverine Worldwide’s last completed fiscal year; +(2) Wolverine Worldwide is a participant; +and +(3) any Related Person (defined +below) has or will have a direct or indirect interest (other than solely as a result of being a director or less than ten percent beneficial owner of another entity). +Related Person +Any: +(a) person who is or was at any point during the +last fiscal year for which Wolverine Worldwide filed a Form 10-K and proxy statement, an executive officer, director or nominee for election as a director; +(b) greater than five percent beneficial owner of +Wolverine Worldwide’s common stock; or +(c) immediate family member * of any of the foregoing. +* +Immediate family member includes a person’s spouse, parents, stepparents, children, stepchildren, siblings, mothers- and fathers-in- law, sons- and daughters-in-law, and +brothers- and sisters-in-law and anyone residing in such person’s home (other than a tenant or employee). +The Governance Committee +considers whether the Interested Transaction is on terms no less favorable than terms generally available to an unaffiliated third-party under the same or similar circumstances, the extent of the Related Person’s interest in the +Page 63 +Table of Contents +Wolverine Worldwide Notice of 2012 Annual Meeting of Stockholders and Proxy Statement +transaction, and other factors that it deems relevant. No director participates in any discussion or approval of an Interested Transaction for which he or she is a Related Person, except to +provide all material information to the Governance Committee. +The following Interested Transactions are pre-approved under the policies and procedures: +(a) +any transaction with another company where a Related Person’s only relationship is as an employee, director or beneficial owner of less than ten percent of that +company’s shares, if the aggregate amount involved does not exceed the greater of $1,000,000, or two percent of that company’s total revenues. +(b) +any charitable contribution by Wolverine Worldwide to a charitable organization where a Related Person is an employee, if the aggregate amount involved does not exceed the lesser +of $100,000, or two percent of the charitable organization’s total annual receipts. +ADDITIONAL +INFORMATION +Stockholders List +A list of stockholders entitled to vote at the meeting will be available for review by Wolverine Worldwide stockholders at the office of R. Paul Guerre, Secretary, +Wolverine World Wide, Inc., 9341 Courtland Drive, N.E., Rockford, Michigan 49351, during ordinary business hours for the 10-day period before the meeting. +Director and Officer Indemnification +The Company indemnifies its directors and NEOs to the fullest extent +permitted by law so that they will be free from undue concern about personal liability in connection with their service to the Company. \ No newline at end of file diff --git a/raw/filings/0000110471/2012/0001193125-13-079739/filing.txt b/raw/filings/0000110471/2012/0001193125-13-079739/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..aa5cba387538efac57547f7ca7b5a9c2c402c5ca --- /dev/null +++ b/raw/filings/0000110471/2012/0001193125-13-079739/filing.txt @@ -0,0 +1,5794 @@ +10-K +1 +d463484d10k.htm +10-K +10-K +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +þ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 29, 2012 +¨ +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: +001-6024 +WOLVERINE WORLD WIDE, INC. +(Exact name of registrant as specified in its charter) +Delaware +38-1185150 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer +Identification No.) +9341 Courtland Drive N.E., +Rockford, Michigan +49351 +(Address of principal executive offices) +(Zip Code) +Registrant’s telephone number, including area code: (616) 866-5500 +Securities registered pursuant to Section 12(b) of the Securities Exchange Act: +Title of each class +Name of each exchange on which registered +Common Stock, $1 Par Value +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities +Act. Yes þ No ¨ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the +Act. Yes ¨ No þ +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 þ 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 þ No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in +definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ +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 +þ +Accelerated filer +¨ +Non-accelerated filer +¨ (do not check if a smaller reporting company) +Smaller reporting company +¨ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the +Act). Yes ¨ No þ +The aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant based on the closing price on +the New York Stock Exchange on June 15, 2012, the last business day of the registrant’s most recently completed second fiscal quarter: $1,794,568,939. Number of shares outstanding of the registrant’s Common Stock, $1 par value as of +February 25, 2013: 50,091,288. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the definitive proxy statement for the registrant’s annual stockholders’ meeting to be held April 18, 2013 are +incorporated by reference into Part III of this report. +Table of Contents +PART I +5 +Item 1. +Business +5 +Item 1A. +Risk Factors +14 +Item 1B. +Unresolved Staff Comments +24 +Item 2. +Properties +24 +Item 3. +Legal Proceedings +25 +Item 4. +Mine Safety Disclosures +25 +Supplemental Item. +Executive Officers of the Registrant +25 +PART II +26 +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +26 +Item 6. +Selected Financial Data +28 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +29 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +45 +Item 8. +Financial Statements and Supplementary Data +45 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +45 +Item 9A. +Controls and Procedures +45 +Item 9B. +Other Information +46 +PART III +46 +Item 10. +Directors, Executive Officers and Corporate Governance +46 +Item 11. +Executive Compensation +47 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +47 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +47 +Item 14. +Principal Accountant Fees and Services +47 +PART IV +48 +Item 15. +Exhibits and Financial Statement Schedules +48 +SIGNATURES +53 +2 +FORWARD-LOOKING STATEMENTS +This document contains “forward-looking statements,” which are statements relating to future, not past, events. In this context, forward-looking statements often address management’s +current beliefs, assumptions, expectations, estimates and projections about future business and financial performance, global political, economic and market conditions, and the Company itself. Such statements often contain words such as +“anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “plans,” “predicts,” “projects,” “should,” +“will,” variations of such words, and similar expressions. Forward-looking statements, by their nature, address matters that are, to varying degrees, uncertain. Uncertainties that could cause the Company’s performance to differ +materially from what is expressed in forward-looking statements include, but are not limited to, the following: +• +changes in national, regional or global economic and market conditions; +• +the impact of financial and credit markets on the Company, its suppliers and customers; +• +changes in interest rates, tax laws, duties, tariffs, quotas or applicable assessments in countries of import and export; +• +the impact of regulation, regulatory and legal proceedings, and legal compliance risks; +• +currency fluctuations; +• +currency restrictions; +• +changes in future pension funding requirements or pension expenses; +• +the risks of doing business in developing countries, and politically or economically volatile areas; +• +the ability to secure and protect owned intellectual property or use licensed intellectual property; +• +changes in consumer preferences, spending patterns, buying patterns, price sensitivity or demand for the Company’s products; +• +the impact of seasonality and unpredictable weather conditions; +• +changes in relationships with, including the loss of, significant customers; +• +the cancellation of orders for future delivery; +• +the failure of the Department of Defense to exercise future purchase options or award new contracts, or the cancellation or modification of existing +contracts by the Department of Defense or other military purchasers; +• +matters relating to the Company’s recent acquisition of the Performance + Lifestyle Group (“PLG”) business of Collective Brands, Inc., +including the Company’s ability to realize the benefits of the PLG acquisition or to do so in a timely manner, the Company’s ability to integrate its business with PLG successfully or in a timely and cost-efficient manner, the degree of +business disruption relating to the PLG acquisition, and the Company’s increased indebtedness following the PLG acquisition; +• +the cost, availability and management of raw materials, inventories, services and labor for owned and contract manufacturers; +• +problems affecting the Company’s distribution system, including service interruptions at shipping and receiving ports; +3 +• +the failure to maintain the security of personally identifiable and other information of the Company’s customers and employees; +• +the inability for any reason to effectively compete in global footwear, apparel and consumer-direct markets; and +• +strategic actions, including new initiatives and ventures, acquisitions and dispositions, and the Company’s success in integrating acquired +businesses and implementing new initiatives and ventures. +These uncertainties could cause a material difference between a +forward-looking statement and an actual outcome. The uncertainties included here are not exhaustive and are described in more detail in Part I, Item 1A, “Risk Factors” of this Annual Report on Form 10-K. Given these risks and +uncertainties, investors should not place undue reliance on forward-looking statements as predictors of actual results. The Company does not undertake an obligation to update, amend or clarify forward-looking statements, whether as a result of new +information, future events or otherwise. +4 +PART I +Item 1. Business +General +Wolverine World Wide, Inc. (the “Company”) is a leading designer, +manufacturer and marketer of a broad range of quality casual footwear and apparel, performance outdoor and athletic footwear and apparel, children’s footwear, industrial work boots and apparel, and uniform shoes and boots. The Company, a +Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which, in turn, was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +On October 9, 2012, the Company acquired the Performance + Lifestyle Group (“PLG”) business of Collective Brands, +Inc. for approximately $1,249.5 million in cash, which amount is subject to the finalization of certain post-closing adjustments. PLG designs and markets casual and athletic footwear, apparel and related accessories for adults and children under +well-known brand names, including Sperry Top-Sider ® , Saucony ® , Stride Rite ® and Keds ® . PLG +includes both wholesale and consumer-direct operations. The PLG acquisition expanded the Company’s portfolio to 16 brands that are marketed in approximately 200 countries and territories around the world. +The Company’s products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort +and performance. The products are marketed under widely recognized brand names, including Bates ® , +Cat ® Footwear, Chaco ® , Cushe ® , +Harley-Davidson ® Footwear, Hush Puppies ® , HyTest ® , Keds ® , Merrell ® , Patagonia ® +Footwear, Sebago ® , Soft Style ® , Saucony ® , Sperry +Top-Sider ® , Stride Rite ® and Wolverine ® . The +Company believes that its primary competitive advantages are its well-recognized brand names, its patented proprietary designs, its diverse product offerings and comfort technologies, its wide range of distribution channels and its diversified +manufacturing and sourcing base. Cat ® is a registered trademark of Caterpillar, Inc., +Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. and Patagonia ® is a registered trademark of Patagonia, Inc. +The Company’s brands are sold at various price points targeting a wide range of consumers of casual, work, outdoor and athletic +footwear and apparel. The Company also licenses some of its brands for use on products other than footwear or apparel. Following the acquisition of PLG, as of December 29, 2012, the Company identifies four operating groups within its branded +wholesale footwear, apparel and licensing reportable segment: (i) the Outdoor Group , consisting of +Merrell ® , Patagonia ® and Chaco ® footwear, +and Merrell ® apparel and accessories, (ii) the Heritage Group , consisting of Wolverine ® footwear and apparel, and Cat ® , Bates ® , +Harley-Davidson ® and HyTest ® footwear, (iii) the Lifestyle Group , consisting of Hush Puppies ® , and Sebago ® +footwear and apparel, and Cushe ® and Soft Style ® footwear and, (iv) the Performance + Lifestyle Group, consisting of Sperry Top-Sider ® , Saucony ® , Stride Rite ® and Keds ® . As a result of the acquisition of PLG, the Company now also reports a second reportable segment for its +consumer-direct operations. The consumer-direct reportable segment represents the Company’s brick-and-mortar retail and eCommerce businesses that include both the Wolverine Retail and PLG Retail operating groups. +The Company’s Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support. The Company +directly sells its products in the United States (U.S.), Canada and certain countries in Europe to a wide range of retail customers, including department stores, national chains, catalogs, specialty retailers, mass merchants and Internet retailers, +and to governments and municipalities. Many of the retailers carrying the Company’s products operate multiple storefront locations. The Company’s products are marketed worldwide in approximately 200 countries and territories through +Company-owned wholesale and retail operations and through licensees and distributors. +5 +For financial information regarding the Company, see the consolidated financial statements and the +accompanying notes, which are attached as Appendix A to this Annual Report on Form 10-K. As described above, the Company has two reportable segments consisting of the branded wholesale footwear, apparel and licensing and consumer-direct reportable +segments. The Company’s other operating segment consists of its Wolverine Leathers Division, which is described below. Financial information regarding the Company’s reportable segments and other operating group and financial information by +geographic area is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Annual Report on Form 10-K. +Branded Wholesale Footwear, Apparel and Licensing +The Company +sources and markets a broad range of footwear styles, including shoes, boots and sandals under many recognizable brand names, including Bates ® , Cat ® , Chaco ® , Cushe ® , +Harley-Davidson ® , Hush Puppies ® , HyTest ® , Keds ® , Merrell ® , Patagonia ® , +Saucony ® , Sebago ® , Soft Style ® , +Sperry Top-Sider ® , Stride Rite ® and Wolverine ® . The +Company combines quality materials and skilled workmanship to produce footwear according to its specifications at both Company-owned and third-party manufacturing facilities. The Company also markets Merrell ® , Saucony ® , Sebago ® , Sperry Top-Sider ® and Wolverine ® brand apparel and accessories and licenses some of its brands for use on non-footwear products, including Hush Puppies ® apparel, eyewear, watches, socks, handbags and plush toys, Wolverine ® brand eyewear and gloves, Keds ® apparel, Saucony ® +apparel , Sperry Top-Sider ® apparel , and Stride Rite ® apparel. +The operating groups for the Company’s branded wholesale footwear, apparel and licensing reportable segment for fiscal 2012 are described below. +1. +The Outdoor Group - The Outdoor Group consists of Merrell ® footwear, Merrell ® +apparel and accessories, Patagonia ® footwear and Chaco ® footwear. +Merrell ® Footwear: +Merrell ® footwear is designed to inspire and encourage participation in the outdoors. Known +for quality, durability and comfort, the Merrell ® footwear line uses a variety of proprietary designs and +technologies to create footwear with distinctive styling, performance and comfort features for use on the trail or in town. Merrell ® footwear products offer a wide range of styles from technical hiking, multi-sport footwear and the minimalist Merrell ® Barefoot Collection, to versatile lifestyle products for more casual outdoor adventures for men, women and kids. +Merrell ® footwear products are sold primarily through outdoor specialty retailers, sporting goods chains, +department stores, online retailers and catalogs. +Merrell ® Apparel and Accessories: The Merrell ® apparel line extends the +Merrell ® commitment to an active outdoor lifestyle with a versatile line of apparel built for the summit +or the street. The apparel line features stylized lifestyle silhouettes built with the technical, high performance, weather fighting materials that consumers expect from an outdoor brand. In addition to Merrell ® apparel, the Outdoor Group markets Merrell ® accessories, including packs, bags and luggage for men and women. +Patagonia ® Footwear: Pursuant to +an agreement with Lost Arrow Corporation, the Company has the exclusive footwear marketing and distribution rights under Patagonia ® and other trademarks. The +Patagonia ® footwear line focuses primarily on casual and outdoor performance footwear. Patagonia ® is a registered trademark of Patagonia, Inc. +Chaco ® Footwear: The +Chaco ® footwear line focuses primarily on performance sandals and closed-toe products for the outdoor +enthusiast. +6 +2. +The Heritage Group - The Heritage Group markets footwear, apparel and accessories products under the Wolverine ® brand and footwear under the Cat ® , Bates ® , +Harley-Davidson ® and HyTest ® brands. +Wolverine ® Footwear: +The Wolverine ® brand offers high-quality boots and shoes that incorporate innovative technologies to +deliver comfort and durability. The Wolverine ® brand, in existence for well over 100 years, markets +footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® , MultiShox ® , +Wolverine Fusion ® and Wolverine Compressor ® technologies, as well as the development of the Contour Welt ® line, have allowed the +Wolverine ® brand to offer a broad line of work footwear with a focus on comfort. The Wolverine ® work product line, whose target consumers are industrial workers, features work boots and shoes with protective +features such as toe caps, metatarsal guards and electrical hazard protection. The Wolverine ® rugged +casual and outdoor sport product lines incorporate DuraShocks ® , Wolverine iCS ® and other technologies and comfort features into products designed for casual and outdoor sport use. The target +consumers for the rugged casual line products have active lifestyles. The outdoor sport line is designed to meet the needs of hunters, fishermen and other active outdoor sports enthusiasts. +Wolverine ® Apparel and Licensing: The Heritage Group markets a line of work and rugged casual Wolverine ® brand apparel. In addition, the Company licenses its Wolverine ® brand for use on eyewear and gloves. +Cat ® Footwear: Pursuant to a license arrangement with Caterpillar, Inc., the Company has exclusive footwear marketing and distribution rights under +Caterpillar ® , Cat ® , Cat & Design, Walking +Machines ® and other trademarks. The Company believes the association with Cat ® equipment encourages customers to view the footwear as high-quality, rugged and durable. Cat ® brand footwear products include work boots and shoes, sport boots, rugged casual and lifestyle footwear, including +lines of work and casual footwear featuring iTechnology ™ and Hidden Tracks ® comfort features. +Cat ® footwear targets work and industrial users and active lifestyle users. Cat ® , Caterpillar ® , Cat & Design and Walking Machines ® are registered trademarks of Caterpillar Inc. +Bates ® Uniform Footwear: +The Bates ® brand is a leader in supplying footwear to military and civilian uniform wearers. +Bates ® utilizes DuraShocks ® , DuraShocks SR ™, Wolverine +iCS ® and other proprietary comfort technologies in the design of its military-style boots and oxford shoes. +Bates ® contracts with the United States Department of Defense and the military branches of several +foreign countries to supply military footwear. Civilian uniform users include individuals in police, security, postal, restaurant and other industrial occupations. Bates ® products are also distributed through specialty retailers and catalogs. +Harley-Davidson ® Footwear: Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has footwear marketing and distribution +rights for Harley-Davidson ® branded footwear. Harley-Davidson ® branded footwear products include motorcycle, casual, fashion, work and western footwear for men, women and +children. Harley-Davidson ® footwear is sold globally through a network of independent +Harley-Davidson ® dealerships and other retail outlets. Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. +HyTest ® Safety Footwear: The HyTest ® product line consists primarily of high-quality work boots and shoes that incorporate various specialty safety features designed to protect against hazards of the +workplace, including steel toe, composite toe, metatarsal guards, and electrical +7 +hazard, static dissipating and conductive footwear. +HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company’s occupational and work footwear brands to +workers at industrial facilities and also through direct sales arrangements with large industrial customers. +3. +The Lifestyle Group - The Lifestyle Group consists of Hush Puppies ® footwear and apparel, +Sebago ® footwear and apparel, Cushe ® and Soft Style ® +footwear. +Hush Puppies ® : Since 1958, the Hush +Puppies ® brand has been a leader in casual footwear. The brand offers shoes, sandals and boots for men, +women and children. The brand’s modern styling is complemented by a variety of comfort features and proprietary technologies that have earned the brand its reputation for comfort, style and value. In addition, the Company licenses the Hush +Puppies ® brand for use on certain items, including apparel, eyewear, handbags, socks, watches and plush +toys. +Sebago ® : The Sebago ® +product line has been marketed since 1946 and consists primarily of performance nautical and American-inspired casual footwear for men and women, such as boat shoes and hand sewn loafers. Highly recognized Sebago ® line extensions include Sebago Docksides ® , Drysides ® and +Triwater™. The Sebago ® manufacturing and design tradition of quality components, durability, +comfort and “Americana” heritage is further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. +Cushe ® : The +Cushe ® business focuses on relaxed, design-led footwear for active men and women. The Cushe ® Footwear business targets younger adult consumers and better-grade retailers with products ranging from sport casual +footwear to sandals. Cushe ® is marketed under three primary collections: Universal Traveler, Urban Safari +and Coastal Supremacy. +Soft Style ® : The Soft +Style ® product line consists primarily of women’s dress and casual footwear. +4. +The Performance + Lifestyle Group - PLG consists of Keds ® footwear , Saucony ® +footwear and apparel, Sperry Top-Sider ® footwear and apparel, and Stride Rite ® footwear. +Keds ® : The Keds ® +brand is an authentic casual lifestyle brand with a foundation in canvas footwear. This iconic American brand was founded in 1916 when Keds ® redefined footwear with the introduction of the Champion ® sneaker. The simple and chic design ignited a style revolution, capturing the hearts of girls everywhere from fashion icons to the girl next door. Today, +Keds ® is a head-to-toe fashion lifestyle brand fueled by a passion for imagination, inspiring a new +generation of girls to stay authentic, optimistic and brave. The brand targets teen girl consumers through an extensive collection of Champion ® originals, as well as a wide assortment of fashion sneakers and slip-ons. The brand’s product architecture consists of both core offerings and seasonal +iterations featuring updated prints, patterns, materials and constructions. +Saucony ® : The Saucony ® brand is a leading global performance running brand with roots dating back to 1898. Saucony ® targets elite, dedicated and casual running consumers through best-in-class design, innovation and performance technology. The brand is focused on meeting the +biomechanical needs of runners while maximizing comfort and protection, bringing to market innovations such as: PowerGrid™ midsole technology; Sauc-Fit ® , ComfortLite Sock Liner™ and HydraMAX™ upper technologies; and iBR+™ and XT-900™ outsole material innovations. Saucony ® offers five categories of footwear product—technical, natural motion, race, trail and lifestyle originals, +as well as a complete line of +8 +performance running apparel. Through the Find Your Strong™ brand platform, Saucony ® is strengthening connections with consumers and elevating the position of the brand globally. The brand’s products are distributed primarily through leading +run specialty and sporting goods retailers. +Sperry Top-Sider ® : Sperry Top-Sider ® is a leading nautical performance and lifestyle brand offering footwear, apparel and accessories to a broad range of consumers globally. The brand has been an +American favorite since 1935 with the advent of the industry’s first boat shoe. Today, Sperry +Top-Sider ® remains the unquestioned leader in the boat shoe category, but has also expanded its business +into casuals, dress casuals, wet weather, boots and vulcanized product categories. The brand has evolved into a well-balanced, multi-category, year-round business for men, women and children. In addition to its lifestyle products, Sperry +Top-Sider ® also offers sport-specific and athlete-tested performance footwear solutions for sailors, +boaters, anglers and multi-water sports enthusiast. The Advance Water Technologies ™ product collection featuring A SV™ (Anti-Shock and Vibration) , Grip X3 Technology ® and SON-R +Technology ® has allowed Sperry Top-Sider ® to reinforce its position as an innovation leader in these categories. The brand is primarily distributed through leading premium and better lifestyle retailers +as well as through its own company-owned specialty retail stores. +Stride Rite ® : With a history dating back to 1919, Stride Rite ® is the industry leader in kid-focused footwear technology and innovation. Trusted by parents everywhere, and +endorsed by the American Podiatric Medical Association, Stride Rite ® is focused on delivering the best +possible footwear for kids under 9 across a range of categories. All Stride Rite ® product is created from an in-depth knowledge and understanding of how +children walk and grow; every new material and component is rigorously tested to ensure safety, proper fit and durability for kids. Stride Rite’s ® RITE STEPs™ program, featuring the brand’s proprietary Sensory Response Technology™, is a full footwear solution that meets kid’s needs from +pre-walkers to pre-schoolers. Stride Rite ® sells its own namesake brand, as well as kid’s footwear +offerings from Saucony ® , Sperry Top-Sider ® , Keds ® and select +other footwear brands, through a network of mall-based specialty retail stores and a consumer-direct website. Stride +Rite ® also distributes footwear through better department stores, footwear independents, sporting goods, +mall specialty, online retailers and national family footwear stores. +Consumer-Direct +The operating groups for the Company’s consumer direct reportable segment for fiscal 2012 are described below. +1. +Wolverine Retail consists of the Company’s legacy consumer-direct business, operating 87 North American and 12 United Kingdom-based retail +stores at December 29, 2012. These stores are operated under the Hush Puppies ® , Hush Puppies and +Family SM , Track’N Trail ® , Sebago ® , Wolverine Company +Store ® , Rockford Footwear Depot ® and Merrell ® names. +The Wolverine Company Store ® , Track’N +Trail ® , Hush Puppies ® and Hush Puppies and Family SM +retail formats carry a large selection of Company-branded products, featuring such brands as Wolverine ® , Merrell ® , Hush +Puppies ® , Cat ® , Chaco ® , Cushe ® , Patagonia ® , Sebago ® and +Harley-Davidson ® . The Company also operates +Merrell ® specialty stores, Hush Puppies ® specialty stores and +Sebago ® specialty stores, providing a platform to showcase these brands exclusively. In addition, +Wolverine retail operates 38 consumer-direct retail websites, including www.merrell.com, www.wolverine.com, www.cushe.com, www.hushpuppies.com , www.chacos.com, www.catfootwear.com , www.sebago.com and +www.batesfootwear.com . +2. +PLG Retail markets its products directly to consumers through a variety of owned formats: Stride Rite ® specialty and outlet children’s stores, Stride Rite ® store-in-stores, Sperry +Top-Sider ® +9 +specialty and outlet stores, Saucony ® outlet stores +and eCommerce websites. At December 29, 2012, PLG retail included 345 stores, owned or licensed primarily in North America and 25 consumer-direct retail websites. Stride Rite ® children’s stores are located primarily in large regional shopping centers, clustered generally in the major metropolitan areas of the U.S. Stride Rite ® outlet stores, in addition to children’s footwear, also carry a broad range of footwear for adults. Most of +the outlet stores are located in shopping centers consisting only of outlet stores. PLG retail also operates Stride +Rite ® shoe departments within select locations of a large U.S. department store chain. Sperry +Top-Sider ® stores tend to be located in affluent areas that embrace the nautical lifestyle that the brand +projects. +Other Businesses +In addition to its branded wholesale footwear, apparel and licensing and consumer-direct reportable segments, the Company also operates a performance leathers business through its Wolverine Leathers +Division. +The Wolverine Leathers Division The Wolverine Leathers Division markets pigskin leather for use +primarily in the footwear industry. The Company believes pigskin leather offers superior performance and other advantages over cowhide leather. The Company’s waterproof and stain resistant leathers are featured in some of the Company’s +footwear lines and many products offered by the Company’s international licensees and distributors. +Marketing +The Company’s marketing strategy is to develop brand-specific plans and related promotional materials for U.S. and international markets to foster a +consistent message for each of the Company’s core brands. Each brand operating group has dedicated marketing personnel who develop the marketing strategy for brands within that group. Marketing campaigns and strategies vary by brand and are +designed to target accounts and/or end users as the branded operating groups strive to increase awareness of, and affinity for, the Company’s brands. The Company’s advertisements typically emphasize fashion, comfort, quality, durability, +functionality and other performance and lifestyle aspects of the Company’s products. Components of the brand-specific plans vary and may include print, radio and television advertising, search engine optimization, social networking sites, event +sponsorships, in-store point-of-purchase displays, promotional materials, and sales and technical assistance. +The Company’s branded +operating groups provide its licensees and distributors with creative direction, brand images and other materials to convey consistent brand messaging, including (i) direction on the categories of footwear to be promoted, (ii) photography +and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point-of-purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting services regarding retail +store layout and design. The Company believes its brand names represent a competitive advantage, and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution +The Company targets a wide variety of domestic distribution channels and strategies to distribute its branded products: +• +The Company uses a dedicated sales force and customer service team, advertising and point-of-purchase support and maintains in-stock inventories to +service department stores, national chains, specialty retailers, catalogs, independent retailers, uniform outlets and its own consumer-direct business. +• +Volume direct programs ship products directly to the retail customer without going through a Company distribution center and provide products at +competitive prices with limited marketing support. The Company uses these programs to service major retail, catalog, mass merchant and government customers. +10 +• +A network of independent Shoemobile ® distribution outlets distributes the Company’s work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the U.S. military and submits bids for contracts to supply specific footwear products. Such contracts typically +contain future purchase options that may or may not be exercised. +In addition to its wholesale activities, the Company also +operates a consumer-direct business as described above. The Company continues to develop new programs, both independently and in conjunction with its retail customers, for the distribution of its products. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the +Company’s revenue in fiscal 2012. +The Company experiences moderate fluctuations in sales volume during the year as reflected in +quarterly revenue (and taking into consideration the 16 weeks or 17 weeks included in the Company’s fiscal fourth quarter versus the 12 weeks included in each of the first three fiscal quarters). The Company expects current seasonal sales +patterns to continue in future years. The Company also experiences some fluctuation in its levels of working capital, typically including an increase in net working capital requirements near the end of the first and third fiscal quarters. The +Company meets its working capital requirements through internal free cash flow and, as needed, a Revolving Credit Facility. +International +Operations and Global Licensing +The Company’s foreign-sourced revenue is generated from a combination of (i) sales of branded +footwear and apparel through the Company’s owned operations in Canada, the United Kingdom and certain countries in continental Europe, (ii) sales to third-party distributors for certain markets and businesses, and (iii) royalty income +from a network of third-party licensees and distributors, and income from joint ventures that market the Company’s branded products in certain countries in South America and Asia. The Company’s international owned operations are located in +markets where the Company believes it can gain a strategic advantage by directly controlling the sale of its products into retail accounts. License and distribution arrangements enable the Company to develop sales in other markets without the +capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. During fiscal 2012, the Company formed joint ventures to market and distribute footwear and apparel in Colombia and India. +The Company believes that these joint ventures will provide it with a more meaningful ownership stake and near-term brand impact in these fast-growing markets than its traditional licensee and distributor arrangements. +The Company continues to develop its network of licensees and distributors to market its branded products. The Company assists its licensees in designing +products that are appropriate to each foreign market, but consistent with the global brand positioning. Pursuant to distribution or license agreements, third-party licensees and distributors either purchase goods directly from the Company and +authorized third-party manufacturers or manufacture branded products themselves, consistent with Company standards. Distributors and licensees are responsible for independently marketing and distributing the Company’s branded products in their +respective territories, with product and marketing support from the Company. +Manufacturing and Sourcing +The Company directly controls the majority of the units of footwear and apparel manufactured or sourced under the Company’s brand names. The +Company’s licensees directly control the balance. A substantial majority of the units sourced or manufactured by the Company are procured from third parties, with the remainder produced at Company-owned facilities. The Company sources a +majority of its footwear from numerous third-party manufacturers in the Asia Pacific region, South America and India. The Company maintains offices in the Asia +11 +Pacific region to facilitate and develop strategies for the sourcing and importation of quality footwear and apparel. The Company has established guidelines for each of its third-party +manufacturers in order to monitor product quality, labor practices and financial viability. The Company has adopted “Engagement Criteria for Partners & Sources,” a policy that requires that the Company’s domestic and foreign +manufacturers, licensees and distributors use ethical business standards; comply with all applicable health and safety laws and regulations; commit to use environmentally safe practices; treat employees fairly with respect to wages, benefits and +working conditions; and not use child or prison labor. Footwear produced by the Company is manufactured at Company-operated facilities located in Michigan and the Dominican Republic. +The Company’s owned manufacturing operations allow the Company to (i) reduce its production lead time, to more quickly respond to market demand and reduce inventory risk, (ii) lower +freight, shipping and duty costs for sales to certain markets, and (iii) more closely monitor product quality. The Company’s third-party sourcing strategy allows the Company to (i) benefit from lower manufacturing costs and +state-of-the-art manufacturing facilities, (ii) source high quality raw materials from around the world, and (iii) avoid capital expenditures necessary for additional owned factories. The Company believes that its overall global +manufacturing strategy provides the flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company’s principal required raw material is quality leather, which it purchases from a select group of domestic and foreign suppliers. The global availability of common upper materials and +specialty leathers eliminates any reliance by the Company on a sole supplier. +The Company currently purchases all of the raw pigskins used +for its Wolverine Leathers Division from one domestic source, which has been a reliable and consistent supplier to the Company for over 40 years. Alternative sources of raw pigskin are available, but with less advantageous pricing, quality and +compatibility with the Company’s processing method. The Company purchases all of its other raw materials and component parts from a variety of sources and does not believe that any of these sources are a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war +or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas, tariffs and duties, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing +activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers, but that a sustained disruption of such sources of supply could have +an adverse impact on the Company’s results of operations and financial position. +Trademarks, Licenses and Patents +The Company holds a significant portfolio of registered and common law trademarks that identify its branded products and +technologies. The Company’s owned trademarks include Hush Puppies ® , Dog Likeness (registered design +trademark), Wolverine ® , Bates ® , Cushe ® , Chaco ® , Soft Style ® , Wolverine Fusion ® , +DuraShocks ® , MultiShox ® , Wolverine +Compressor ® , Wolverine ICS ® , Hidden Tracks ® , +iTechnology TM , Bounce ® , Comfort Curve ® , HyTest ® , +Merrell ® , M Circle Design (registered design trademark), Continuum ® , Sebago ® , Q Form ® , Sperry +Top-Sider ® , Saucony ® , Stride Rite ® and +Keds ® . The Company’s Wolverine Leathers Division markets its pigskin leathers under the +trademarks Wolverine Warrior Leather ® , Weather Tight ® and All Season Weather Leathers ™. The Company has footwear marketing and distribution rights under +the Cat ® , Harley-Davidson ® and Patagonia ® +trademarks pursuant to license arrangements with the respective trademark owners. The Cat ® , +Harley-Davidson ® , and Patagonia ® licenses extend for three or more years and are subject to early termination for breach. +The Company believes that consumers identify its products by the Company’s trademarks and that its trademarks are valuable assets. The Company is not aware of any third-party infringing uses or any +prior claims of +12 +ownership of its trademarks that could materially affect its current business. The Company has a policy of registering its primary trademarks and vigorously defending its trademarks against +infringement or other threats whenever practicable. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company vigorously protects its proprietary rights under applicable laws. +Order Backlog +At the end of fiscal +2012, the Company had an order backlog of approximately $879.4 million compared to an order backlog of approximately $483 million at the end of fiscal 2011. The increase in the fiscal 2012 backlog reflects the fiscal 2012 acquisition of PLG. A +majority of the backlog relates to orders for products expected to be shipped in 2013. Orders in the backlog are subject to cancellation by customers and to changes in planned customer demand or at-once orders. The backlog at any particular time is +affected by a number of factors, including seasonality, retail conditions, expected customer demand, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is +not necessarily meaningful and may not be predictive of eventual actual shipments. +Competition +The Company markets its footwear and apparel lines in a highly competitive and fragmented environment. The Company competes with numerous domestic and +international marketers and importers, some of which are larger and have greater resources than the Company. The Company has a significant number of major competitors for its brands of footwear and apparel. Product performance and quality, including +technological improvements, product identity, competitive pricing and ability to control costs, and the ability to adapt to style changes are all important elements of competition in the footwear and apparel markets served by the Company. The +footwear and apparel industries in general are subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotions designed to increase brand awareness, manufacturing and sourcing efficiencies, and +the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its competitive position in the overall footwear and +apparel industries. Market shares in the non-athletic footwear and apparel industry are highly fragmented, and no one company has a dominant market position. +Research and Development +In addition to normal and recurring product +development, design and styling activities, the Company engages in research and development activities related to the development of new production techniques and to the improvement of the function, performance, reliability and quality of its +branded footwear and other products. For example, the Company’s continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University has helped validate and refine specific biomechanical design concepts, such as +Bounce ® , DuraShocks ® and Hidden Tracks ® +comfort technologies that have been incorporated into the Company’s footwear. With the acquisition of PLG, the Company now incorporates the research and testing capabilities of the +Saucony ® human performance and innovation lab as well as research funded at University labs including the +University of Colorado and the University of Delaware with a particular focus on quantifying the interaction between footwear and apparel and runners’ strides. While the Company expects to continue to be a leading developer of footwear +innovations, research and development costs do not represent a material portion of operating expenses. +Environmental Matters +Compliance with foreign and domestic federal, state and local requirements regulating the discharge of materials into the environment, or +otherwise relating to the protection of the environment, have not had, nor are they +13 +expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company. The Company uses and generates certain substances and wastes that are regulated +or may be deemed hazardous to the environment under certain federal, state and local regulations. The Company works with domestic and foreign federal, state and local agencies from time to time to resolve cleanup issues at various waste sites and +other regulatory issues. +Employees +As of December 29, 2012, the Company had approximately 8,299 domestic and foreign production, office and sales employees. Approximately 58 employees were covered by a single union contract that +expires on March 31, 2013. The Company presently considers its employee relations to be good. +Available Information +Information about the Company, including the Company’s Code of Conduct & Compliance, Corporate Governance Guidelines, Director Independence +Standards, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, and Governance Committee Charter, is available at its website at www.wolverineworldwide.com/investor-relations/corporate-governance . +Printed copies of the documents listed above are available, without charge, by writing to the Company at 9341 Courtland Drive, N.E., Rockford, Michigan 49351, Attention: General Counsel. +The Company also makes available on or through its website, free of charge, the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to +those reports (along with certain other Company filings with the Securities and Exchange Commission (“SEC”)), as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These materials +are also accessible on the SEC’s website at www.sec.gov . +Item 1A. Risk Factors +Risks related to the Company’s business +Changes in general economic conditions and other factors affecting consumer spending could adversely affect the Company’s sales, operating results or financial position. +The Company’s global operations depend on factors affecting consumer disposable income and spending patterns. These factors include general economic +conditions, employment rates, business conditions, interest rates and tax policy in each of the markets and regions in which the Company operates. Customers may defer or cancel purchases of the Company’s products due to uncertainty about global +economic conditions. Consumer confidence may decline due to recessionary economic cycles, high interest rates on consumer or business borrowings, restricted credit availability, inflation, high levels of unemployment or consumer debt, high tax rates +or other economic factors. For example, the challenging economic environment in Europe has adversely impacted the Company’s results of operations in fiscal 2012, and the Company expects the adverse economic environment will continue to affect +its sales and earnings across that region in the near future as the result of austerity measures imposed by certain governments and high levels of unemployment, as well as a general loss of consumer confidence. Declining consumer confidence could +adversely affect demand for the Company’s products. Changes in the amount or severity of bad weather and the growth or decline of global footwear, apparel or consumer-direct markets could negatively affect consumer spending. A decline in demand +for the Company’s products could reduce its revenues or profit margins. +General economic conditions and other factors such as those +listed above may increase the Company’s cost of sales and decrease the Company’s profitability. The Company’s profitability is also dependent on the prices of commodities, such as cotton, rubber and petroleum, used to make and +transport its products, as well as the prices of labor, insurance and health care, all of which may be affected by general economic conditions. +14 +The Company operates in competitive industries and markets. +The Company competes with a large number of marketers of footwear or apparel, and consumer-direct companies. Some of these competitors are larger and +have greater resources than the Company. Important elements of such competition are product performance and quality, including technological improvements, product identity, competitive pricing and the ability to adapt to style changes. Consumer +preferences and, as a result, the popularity of particular designs and categories of footwear and apparel, generally change over time. The Company strives to maintain and improve its competitive position by monitoring and responding to changes in +consumer preferences, increasing brand awareness, gaining sourcing efficiencies, and enhancing the style, comfort and perceived value of its products. The Company’s continued ability to sell its products at competitive prices and to meet shifts +in consumer preferences will affect its future sales. If the Company is unable to respond effectively to competitive pressures and changes in consumer spending, its results of operations and financial position may be adversely affected. +Many of the Company’s competitors have more developed consumer and customer bases, are able to sell their products at lower prices, or have greater +financial, technical or marketing resources than the Company, particularly its competitors in the apparel and consumer-direct businesses. The Company’s competitors may own more recognized brands; implement more effective marketing campaigns; +adopt more aggressive pricing policies; make more attractive offers to potential employees, distribution partners and manufacturers; or respond more quickly to changes in consumer preferences. The Company’s results of operations and financial +position could be adversely affected if its strategic initiatives are not successful. +The Company’s operating results could be +adversely affected if it is unable to maintain its brands’ positive images with consumers or adjust to changing footwear and apparel trends. +The Company’s success depends in part on its brands’ images. If the Company is unable to timely and appropriately respond to changing consumer preferences and evolving footwear and apparel +trends, the names and images of its brands may be impaired. If the Company fails to react appropriately to changes in consumer preferences, consumers may consider its brands’ images to be outdated or associate its brands with styles that are no +longer popular. Such failures could result in substantial unsold inventory and adversely affect the Company’s operating results. +The +Company’s operating results depend on effectively managing inventory levels. +The Company’s ability to manage its inventories +effectively is an important factor in its operations. Inventory shortages can impede the Company’s ability to meet demand, adversely affect the timing of shipments to customers, and, consequently, diminish brand loyalty and decrease sales. +Conversely, excess inventories can result in lower gross margins if the Company lowers prices in order to liquidate excess inventories. In addition, inventory may become obsolete as a result of changes in consumer preferences or otherwise. The +Company’s business, results of operations and financial position could be adversely affected if it is unable to effectively manage its inventory. +Increases or changes in duties, quotas, tariffs and other trade restrictions could adversely impact the Company’s sales and profitability. +All of the Company’s products manufactured overseas and imported into the U.S., the European Union and other countries are subject to customs duties +collected by customs authorities. The customs information submitted by the Company is routinely subject to review by customs authorities. Additional U.S. or foreign customs duties, quotas, tariffs, anti-dumping duties, safeguard measures, cargo +restrictions to prevent terrorism or other trade restrictions may be imposed on the importation of the Company’s products in the future. The imposition of such costs or restrictions in foreign countries where the Company operates, as well as in +countries where its third-party distributors and licensees operate, could result in increases in the cost of the Company’s products generally and could adversely affect its sales and profitability. +15 +Foreign currency exchange rate fluctuations could adversely impact the Company’s business. +Foreign currency fluctuations affect the Company’s reported revenue and profitability. Changes in currency exchange rates may impact +the Company’s financial results positively or negatively in one period and not another, which may make it difficult to compare its operating results from different periods. Currency exchange rate fluctuations may also adversely impact third +parties that manufacture the Company’s products by making their costs of raw materials or other production costs more expensive and more difficult to finance, thereby raising prices for the Company, its distributors and its licensees. The +Company’s hedging strategy may not be effective in reducing all risks, and no hedging strategy can completely insulate the Company from foreign exchange risk. The Company does not hedge foreign currency translation rate changes. For a more +detailed discussion of the risks related to foreign currency fluctuation, see Item 7A, Quantitative and Qualitative Disclosures About Market Risk . +Significant supplier capacity constraints, supplier production disruptions, supplier quality issues or price increases could increase the Company’s operating costs and adversely impact the +Company’s business. +The Company currently sources most of its products from third-party manufacturers in foreign countries, +predominantly China. As is common in the industry, the Company does not have long-term contracts with its third-party suppliers. There can be no assurance that the Company will not experience difficulties with such suppliers, including reductions in +the availability of production capacity, failures to meet production deadlines or increases in manufacturing costs. The Company’s future results will depend partly on its ability to maintain positive working relationships with third-party +suppliers. +Foreign manufacturing is subject to a number of risks, including work stoppages, transportation delays and interruptions, +political instability, foreign currency fluctuations, changing economic conditions, expropriation, nationalization, the imposition of tariffs, import and export controls and other non-tariff barriers and changes in governmental policies. Various +factors could significantly interfere with the Company’s ability to source its products, including adverse developments in trade or political relations with China or other countries where it sources its products, or a shift in China’s +manufacturing capacity away from footwear and apparel to other industries. Any of these events could have an adverse effect on the Company’s business, results of operations and financial position and, in particular, on the Company’s +ability to meet customer demands and produce its products in a cost-effective manner. +The cost of raw materials and services could +adversely affect the Company’s results of operations. +The Company’s ability to competitively price its products depends on the +cost of components, services, labor, equipment and raw materials, including leather and materials used in the production of footwear. The cost of services and materials is subject to change based on availability and market conditions that are +difficult to predict. Various conditions, such as diseases affecting the availability of leather, affect the cost of the footwear marketed by the Company. In addition, fuel prices and numerous other factors, such as the possibility of service +interruptions at shipping and receiving ports, affect the Company’s shipping costs. Increases in cost for services and materials used in production could have a negative impact on the Company’s results of operations and financial position. +The Company purchases raw pigskins for its leathers operations from a single domestic source pursuant to short-term contracts. If this source fails to continue to supply the Company with raw pigskin or supplies the Company with raw pigskin on less +favorable terms, the Company’s cost of raw materials for its leathers operations could increase and, as a result, have a negative impact on the Company’s results of operations and financial position. +Labor disruptions could adversely affect the Company’s business. +The Company’s business depends on its ability to source and distribute products in a timely manner. Labor disputes at or that affect independent factories where the Company’s goods are produced, +shipping ports, tanneries, transportation carriers, retail stores or distribution centers create significant risks for the Company’s +16 +business, particularly if these disputes result in work slowdowns, lockouts, strikes or other disruptions during its peak manufacturing and importing seasons. Any labor dispute may have a +material adverse effect on the Company’s business, potentially resulting in cancelled orders by customers and unanticipated inventory accumulation, and may negatively impact the Company’s results of operations and financial position. +A significant reduction in customer purchases of the Company’s products or failure of customers to pay for the Company’s +products in a timely manner could adversely affect the Company’s business. +The Company’s financial success is directly related +to its customers continuing to purchase its products. The Company does not typically have long-term contracts with its customers. Sales to the Company’s customers are generally on an order-to-order basis and are subject to rights of +cancellation and rescheduling by the customers. Failure to fill customers’ orders in a timely manner could harm the Company’s relationships with its customers. Furthermore, if any of the Company’s major customers experiences a +significant downturn in its business, or fails to remain committed to the Company’s products or brands, that customers may reduce or discontinue purchases from the Company, which could have an adverse effect on the Company’s results of +operations and financial position. +The Company sells its products to customers and extends credit based on an evaluation of each +customer’s financial condition. The financial difficulties of a customer could cause the Company to stop doing business with that customer or reduce its business with that customer. The Company’s inability to collect from its customers or +a cessation or reduction of sales to certain customers because of credit concerns could have an adverse effect on the Company’s business, results of operations and financial position. +The general trend toward consolidation in retail and specialty retail could lead to fewer customers, customers seeking more favorable price, payment or other terms from the Company and a decrease in the +number of stores that carry its products. In addition, changes in the channels of distribution, such as the continued growth of Internet commerce and the trend toward the sale of private label products by major retailers, could have an adverse +effect on the Company’s results of operations and financial position. +The Company has been awarded a number of U.S. +Department of Defense contracts that include future purchase options for Bates ® footwear. The +Department of Defense is not obligated to exercise these future purchase options for Bates ® footwear or to +solicit future footwear awards at levels consistent with historical awards or in a manner in which the Company, as a large business contractor, is eligible to bid. Failure by the Department of Defense to exercise purchase options or the +Company’s failure to secure future U.S. Department of Defense contracts could have an adverse effect on the Company’s results of operations and financial position. +Seasonality and weather conditions affect the Company’s business. +The Company +markets and sells footwear and apparel suited for specific seasons, such as sandals in the summer season and boots in the winter season. If the weather conditions for a particular season vary significantly from those typical for the season, such as +an unusually cold and rainy summer, or an unusually warm and dry winter, consumer demand for seasonally appropriate merchandise could be adversely affected. Lower demand for seasonally appropriate merchandise may result in excess inventory, forcing +the Company to sell these products at significantly discounted prices, which would adversely affect the Company’s results of operations. Conversely, if weather conditions permit the Company to sell seasonal products early in the season, this +may reduce inventory levels needed to meet customers’ needs later in that same season. Consequently, the Company’s results of operations are highly dependent on future weather conditions and its ability to react to changes in weather +conditions. +Changes in the credit markets could adversely affect the Company’s financial success. +Changes in the credit markets could adversely impact the Company’s future results of operations and financial position. If the Company’s +third-party distributors, suppliers and retailers are not able to obtain financing on +17 +favorable terms, or at all, they may delay or cancel orders for the Company’s products, or fail to meet their obligations to the Company in a timely manner, either of which could adversely +impact the Company’s sales, cash flow and operating results. In addition, the lack of available credit or an increase in the cost of credit may significantly impair the Company’s ability to obtain additional credit to finance future +expansion plans, or refinance existing credit, on favorable terms, or at all. +Unfavorable findings resulting from a government audit could +subject the Company to a variety of penalties and sanctions, and could negatively impact its future revenues. +The federal government has +the right to audit the Company’s performance under its government contracts. If a government audit discovers improper or illegal activities, the Company could be subject to civil and criminal penalties and administrative sanctions, including +termination of contracts, forfeiture of profits, suspension of payments, fines, and suspension or debarment from doing business with U.S. federal government agencies. The Company could also suffer serious harm to its reputation if the U.S. +government alleges that the Company acted in an improper or illegal manner, whether or not any such allegations have merit. If, as the result of an audit or for any other reason, the Company is suspended or barred from contracting with the federal +government generally, or any specific agency, if the Company’s reputation or relationship with government agencies is impaired, or if the government otherwise ceases doing business with the Company or significantly decreases the amount of +business it does with the Company, the Company’s revenue and profitability would decrease. The Company is also subject to customs and other audits in various jurisdictions where it operates. Negative audit findings could have an adverse effect +on the Company’s results of operations and financial position. +An increase in the Company’s effective tax rate or negative +determinations by domestic or foreign tax authorities could have a material adverse effect on the Company’s results of operations and financial position. +A significant amount of the Company’s earnings are generated by its Canadian, European and Asia Pacific subsidiaries and, to a lesser extent, in jurisdictions that are not subject to income tax and +free trade zones where it owns manufacturing operations. As a result, the Company’s income tax expense has historically differed from the tax computed at the U.S. federal statutory income tax rate due to discrete items and because the Company +does not provide for U.S. taxes on earnings it considers to be permanently reinvested in foreign operations. The Company’s future effective tax rates could be unfavorably affected by a number of factors including: changes in the tax rates in +jurisdictions in which the Company generates income; changes in, or in the interpretation of, tax rules and regulations in the jurisdictions in which the Company does business; decreases in the amount of earnings in countries with low statutory tax +rates; or if the Company repatriates foreign earnings for which no provision for U.S. taxes has previously been made. An increase in the Company’s effective tax rate could have a material adverse effect on its after-tax results of operations +and financial position. +In addition, the Company’s income tax returns are subject to examination by the Internal Revenue Service and +other domestic and foreign tax authorities. The Company regularly assesses the likelihood of outcomes resulting from these examinations to determine the adequacy of its provision for income taxes, and establishes reserves for potential adjustments +that may result from these examinations. While the Company believes the estimates used to establish these reserves are reasonable, there can be no assurance that the final determination of any of these examinations will not have an adverse effect on +the Company’s results of operations and financial position. +Failure of the Company’s international licensees and distributors to +meet sales goals or to make timely payments on amounts owed to the Company could adversely affect the Company’s financial performance. +In many international markets, independent licensees or distributors sell the Company’s products. Failure by the Company’s licensees or +distributors to meet planned annual sales goals or to make timely payments on amounts owed to the Company could have an adverse effect on the Company’s business, results of operations and financial position, and it may be difficult and costly +to locate an acceptable substitute distributor or licensee. If a +18 +change in licensee or distributor becomes necessary, the Company may experience increased costs, as well as substantial disruption and a resulting loss of sales and brand equity in the market +where such licensee or distributor operates. +The Company’s reputation and competitive position are dependent on its third-party +manufacturers, distributors, licensees and others complying with applicable laws and the Company’s ethical standards. +The Company +requires its independent contract manufacturers, distributors, licensees and others with which it does business to comply with its ethical standards and applicable laws relating to working conditions and other matters. If a party with whom the +Company does business is found to have violated the Company’s ethical standards or applicable laws, the Company could receive negative publicity that could damage its reputation and negatively affect the value of its brands. +In addition, the Company relies on its licensees to help preserve the value of the Company’s brands. Although the Company attempts to protect its +brands through approval rights over design, production processes, quality, packaging, merchandising, distribution, advertising and promotion of its licensed products, the Company cannot completely control the use by its licensees of its licensed +brands. The misuse of a brand by a licensee could adversely affect the value of such brand. +Global political and economic uncertainty +could adversely impact the Company’s business. +Concerns regarding acts of terrorism and regional and international conflicts have +created significant global economic and political uncertainties that may have material and adverse effects on consumer demand, acceptance of U.S. brands in international markets, foreign sourcing of products, shipping and transportation, product +imports and exports, and the sale of products in foreign markets, any of which could adversely affect the Company’s ability to source, manufacture, distribute and sell its products. The Company is subject to risks related to doing business in +developing countries and economically volatile areas. These risks include social, political and economic instability; nationalization of the Company’s, or its distributors’ and licensees’, assets and operations by local government +authorities; slower payment of invoices; and restrictions on the Company’s ability to repatriate foreign currency or receive payment of amounts owed by third-party distributors and licensees. In addition, commercial laws in these areas may not +be well developed or consistently administered, and new laws may be retroactively applied. Any of these risks could have an adverse impact on the Company’s prospects and results of operations in these areas. +Concerns regarding the European debt crisis, market perceptions and euro instability could adversely affect the Company’s business, results of +operations and financing. +Concerns persist regarding the debt burden of certain countries in the Eurozone, in particular Greece, Italy, +Ireland, Portugal and Spain, and their ability to meet future financial obligations, as well as the overall stability of the euro and the suitability of the euro as a single currency given the diverse economic and political circumstances in +individual Eurozone countries. These concerns could lead to the re-introduction of individual currencies in one or more Eurozone countries, or, in more extreme circumstances, the possible dissolution of the euro as a currency. Should the euro be +dissolved, the legal and contractual consequences for holders of euro-denominated obligations would be determined by laws in effect at that time. These potential developments, or market perceptions concerning these and related issues, could +adversely affect the value of the Company’s euro-denominated assets and obligations. In addition, concerns over the effect of this financial crisis on financial institutions in Europe and elsewhere could have an adverse impact on the capital +markets generally and, more specifically, on the ability of the Company’s customers, suppliers and lenders to finance their respective businesses. +19 +If the Company is unsuccessful in establishing and protecting its intellectual property, the value of its +brands could be adversely affected. +The Company invests significant resources to develop and protect its intellectual property, and it +believes that its trademarks and other intellectual property rights are important to its future success. The Company’s ability to remain competitive is dependent upon its continued ability to secure and protect trademarks, patents and other +intellectual property rights in the U.S. and internationally for all of the Company’s lines of business. The Company relies on a combination of trade secret, patent, trademark, copyright and other laws, license agreements and other contractual +provisions and technical measures to protect its intellectual property rights; however, some countries’ laws do not protect intellectual property rights to the same extent as do U.S. laws. +The Company’s business could be significantly harmed if it is not able to protect its intellectual property, or if a court found it to be infringing +on other persons’ intellectual property rights. Any intellectual property lawsuits or threatened lawsuits in which the Company is involved, either as a plaintiff or as a defendant, could cost the Company a significant amount of time and money +and distract management’s attention from operating the Company’s business. In addition, if the Company does not prevail on any intellectual property claims, then it may have to change its manufacturing processes, products or trade names, +any of which could reduce its profitability. In addition, some of the Company’s branded footwear operations are operated pursuant to licensing agreements with third-party trademark owners. These agreements are subject to early termination for +breach. Expiration or early termination of any of these license agreements by the licensor could have a material adverse effect on the Company’s business, results of operations and financial position. +The Company periodically discovers products that are counterfeit reproductions of its products or that it believes otherwise infringe on its intellectual +property rights. The Company has not always been able to stop production and sales of counterfeit products and infringement of its intellectual property rights. The actions the Company takes to establish and protect trademarks, patents and other +intellectual property rights both inside and outside of the U.S. may not be adequate to prevent imitation of its products by others. Continued sales of products that infringe the Company’s intellectual property rights could adversely affect its +sales, devalue its brands and result in the shift of consumer preference away from its products. +The Company’s inability to attract +and retain executive managers and other key employees, or the loss of one or more executive managers or other key employees, could adversely affect the Company’s business. +The Company depends on its executive management and other key employees. In the footwear, apparel and consumer-direct industries, competition for key executive talent is intense, and the Company’s +failure to identify, attract or retain executive managers or other key employees could adversely affect its business. The Company must offer and maintain competitive compensation packages to effectively recruit and retain such individuals. Further, +the loss of one or more executive managers or other key employees, or the Company’s failure to successfully implement succession planning, could adversely affect the Company, its results of operations or financial position. +Inflationary pressures and other pressures may lead to higher employment and pension costs for the Company. +General inflationary pressures, changes in employment laws and regulations, and other factors could increase the Company’s overall employment costs. +The Company’s employment costs include costs relating to health care benefits and benefits under its retirement plans, including U.S.-based defined benefit plans. The annual cost of benefits can vary significantly depending on a number of +factors, including changes in the assumed or actual rate of return on pension plan assets, a change in the discount rate used to determine the annual service cost related to the defined benefit plans, a change in method or timing of meeting pension +funding obligations and the rate of health care cost inflation. Increases in the Company’s overall employment and pension costs could have an adverse effect on the Company’s business, results of operations and financial position. +20 +Disruption of the Company’s information technology systems could adversely affect the Company’s +business. +The Company’s information technology systems are critical to the operations of its business. Any interruption, +unauthorized access, impairment or loss of data integrity or malfunction of these systems could severely impact the Company’s business, including as a result of delays in product fulfillment and reduced efficiency in operations. In addition, +costs and potential problems and interruptions associated with the implementation of new or upgraded systems, or with maintenance or adequate support of existing systems, could disrupt or reduce the efficiency of the Company’s operations. +If the Company encounters problems affecting its distribution system, its ability to deliver its products to the market could be adversely +affected. +The Company relies on owned or independently operated distribution facilities to warehouse and ship products to its customers. +The Company’s distribution system includes computer-controlled and automated equipment, which may be subject to a number of risks related to security or computer viruses, the proper operation of software and hardware, power interruptions or +other system failures. Because substantially all of the Company’s products are distributed from a relatively small number of locations, its operations could also be interrupted by earthquakes, floods, fires or other natural disasters near its +distribution centers. The Company maintains business interruption insurance, but it may not adequately protect the Company from the adverse effects that could be caused by significant disruptions affecting its distribution facilities, such as the +long-term loss of customers or an erosion of brand image. In addition, the Company’s distribution capacity is dependent on the timely performance of services by third parties, including the transportation of products to and from the +Company’s distribution facilities. If the Company encounters problems affecting its distribution system, its ability to meet customer expectations, manage inventory, complete sales and achieve operating efficiencies could be materially +adversely affected. +Failure to maintain the security of personally identifiable and other information of the Company’s customers and +employees could negatively impact its business. +In connection with the Company’s business, it collects and retains significant +volumes of certain types of personally identifiable and other information pertaining to its customers and employees. Theft, loss, fraudulent use or misuse of customer, employee or the Company’s other data as a result of cybercrime or otherwise +could adversely impact the Company’s reputation and could result in significant costs, fines, litigation or regulatory action against the Company. +The Company faces risks associated with its growth strategy and acquiring businesses. +The +Company has expanded its products and markets in part through strategic acquisitions, and it may continue to do so in the future, depending on its ability to identify and successfully pursue suitable acquisition candidates. Acquisitions, including +the recent PLG acquisition, involve numerous risks, including risks inherent in entering new markets in which the Company may not have prior experience; potential loss of significant customers or key personnel of the acquired business; managing +geographically-remote operations; and potential diversion of management’s attention from other aspects of the Company’s business operations. Acquisitions may also cause the Company to incur debt or result in dilutive issuances of its +equity securities, write-offs of goodwill and substantial amortization expenses associated with other intangible assets. The Company may not be able to obtain financing on favorable terms that may be necessary to finance future acquisitions, making +any such acquisitions more expensive. Any such financing may have onerous terms that restrict the Company’s operations. The Company cannot provide assurance that it will be able to successfully integrate the operations of any acquired +businesses into its operations and achieve the expected benefits of any acquisitions. The failure to successfully integrate newly acquired businesses or achieve the expected benefits of strategic acquisitions in the future could have an adverse +effect on the Company’s results of operations and financial position. The Company may not consummate a potential acquisition for a variety of reasons, but it may nonetheless incur material costs in the preliminary stages of such an acquisition +that it cannot recover. +21 +Maintenance and growth of the Company’s business depends upon the availability of adequate capital. +The maintenance and growth of the Company’s business depends on the availability of adequate capital, which in turn depends in large +part on cash flow generated by the Company’s business and the availability of equity and debt financing. The Company cannot provide assurance that its operations will generate positive cash flow or that it will be able to obtain equity or debt +financing on acceptable terms or at all. Further, the Company cannot provide assurance that it will be able to finance any expansion plans. +Expanding the Company’s brands into new markets and expanding its owned consumer-direct operations may be difficult and costly, and unsuccessful +efforts to do so may adversely affect the Company’s brands and business. +As part of the Company’s growth strategy, it seeks to +enhance the positioning of its brands, to extend its brands into complementary product categories, to expand geographically, and to expand its owned consumer-direct operations. There can be no assurance that the Company will be able to successfully +implement any or all of these growth strategies, which could have an adverse effect on its results of operations and financial position. +Part +of the future growth of the Company’s owned consumer-direct operations is significantly dependent on the Company’s ability to operate stores in desirable locations at reasonable lease costs. The Company cannot be sure as to when or whether +such desirable locations will become available at reasonable costs. Further, if the Company is unable to renew or replace its existing store leases or enter into leases for new stores at attractive locations on favorable terms, or if the Company +violates any of the terms of its current leases, its growth and profitability could be harmed. +Changes in government regulation may +increase the Company’s costs of compliance and failure to comply with government regulations or other standards may adversely affect its brands and business. +The Company’s business is affected by changes in government and regulatory policies in the U.S. and in foreign jurisdictions. New requirements relating to product safety and testing and new +environmental requirements, as well as changes in tax laws, duties, tariffs and quotas, could have a negative impact on the Company’s ability to produce and market footwear at competitive prices. Failure to comply with such regulations, as well +as comply with ethical, social, product, labor and environmental standards, could also jeopardize the Company’s reputation and potentially lead to various adverse consumer actions, including boycotts. Any negative publicity about these types of +concerns may reduce demand for the Company’s merchandise. Damage to the Company’s reputation or loss of consumer confidence for any of these or other reasons could adversely affect the Company’s results of operations, as well as +require additional resources to rebuild its reputation. +The Company’s operations are subject to environmental and workplace safety +laws and regulations, and costs or claims related to these requirements could adversely affect the Company’s business. +The +Company’s operations are subject to various federal, state and local laws and regulations relating to the protection of the environment, including those governing the discharge of pollutants into the air, soil and water, the management and +disposal of solid and hazardous materials and wastes, employee exposure to hazards in the workplace, and the investigation and remediation of contamination resulting from releases of hazardous materials. Failure to comply with legal requirements +could result in, among other things, revocation of required licenses, administrative enforcement actions, fines and civil and criminal liability. The Company may incur investigation, remediation or other costs related to releases of hazardous +materials or other environmental conditions at its currently or formerly owned or operated properties, regardless of whether such environmental conditions were created by the Company or a third party, such as a prior owner or tenant. The Company has +incurred, and continues to incur, costs to address soil and groundwater contamination at some locations. If such issues become more expensive to address, or if new issues arise, they could increase the Company’s expenses, generate negative +publicity, or otherwise adversely affect the Company. +22 +The disruption, expense and potential liability associated with existing and future litigation against +the Company could adversely affect its reputation, financial position or results of operations. +The Company is a defendant from time to +time in lawsuits and regulatory actions relating to its business. Due to the inherent uncertainties of litigation and regulatory proceedings, the Company cannot accurately predict the ultimate outcome of any such proceedings. An unfavorable outcome +could have an adverse impact on the Company’s business, financial position and results of operations. In addition, regardless of the outcome of any litigation or regulatory proceedings, such proceedings are expensive and may require that the +Company devote substantial resources and executive time to the defense of such proceedings. +Provisions of Delaware law and the +Company’s certificate of incorporation and bylaws could prevent or delay a change in control or change in management that could be beneficial to the Company’s stockholders. +Provisions of the Company’s certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay or prevent a merger, acquisition or other change in control of the +Company. These provisions are intended to protect stockholders’ interests by providing the Company’s Board of Directors a means to attempt to deny coercive takeover attempts or to negotiate with a potential acquirer in order to obtain more +favorable terms. Such provisions include a Board of Directors that is classified so that only one-third of directors stand for election each year. These provisions could also discourage proxy contests and make it more difficult for stockholders to +elect directors and take other corporate actions. +There are risks, including stock market volatility, inherent in owning the +Company’s common stock. +The market price and volume of the Company’s common stock have been, and may continue to be, subject to +significant fluctuations. These fluctuations may arise from general stock market conditions, the impact of risk factors described in this Item 1A on the Company’s financial position and results of operations, a change in sentiment in the +market regarding the Company’s business prospects or other factors, many of which may be outside the Company’s immediate control. Changes in the amounts and frequency of share repurchases or dividends could adversely affect the value of +the Company’s common stock. +Risks related to the recent acquisition of PLG +The Company’s failure to successfully integrate PLG or realize the benefits of the transaction in a timely and cost-efficient manner could +adversely affect the Company’s business. +The success of the PLG acquisition will depend, in part, on the Company’s ability to +fully realize the anticipated benefits and synergies from combining its business and PLG. To realize these anticipated benefits and synergies, the Company must successfully integrate its business with PLG. Any failure to timely realize these +anticipated benefits and synergies could have a material adverse effect on the Company’s results of operations and financial position. The integration process could result in the following: loss of key employees, suppliers, distributors, other +business partners or significant customers; decreases in revenues; information technology systems integration disruptions; increases in taxes or operating or other costs; and/or the disruption of the Company’s business, any of which could limit +the Company’s ability to achieve the anticipated benefits and synergies of the acquisition and could have an adverse effect on the Company’s operating results. Integration efforts also require substantial commitments of management’s +attention and other resources, which could otherwise have been allocated to different uses that may have been beneficial to the Company. +The Company’s indebtedness increased following the completion of the PLG acquisition, which could adversely affect the Company. +The Company’s current indebtedness, which is significantly greater than the Company’s indebtedness prior to the PLG acquisition, could +adversely affect the Company by decreasing its business flexibility and increasing its borrowing costs. In connection with the acquisition, the Company entered into a credit agreement for a new $1.1 +23 +billion senior secured credit facility and issued $375 million aggregate principal amount of 6.125% eight year senior notes in a private offering. The new senior secured credit agreement and the +indenture governing the senior notes contain customary restrictive covenants imposing operating and financial restrictions on the Company, including restrictions that may limit the Company’s ability to engage in acts that may be in its +long-term best interests. These covenants restrict the ability of the Company and certain of its subsidiaries to, among other things: incur or guarantee indebtedness; incur liens; pay dividends or repurchase stock; enter into transactions with +affiliates; consummate asset sales, acquisitions or mergers; prepay certain other indebtedness; or make investments. In addition, the restrictive covenants in the senior secured credit agreement require the Company to maintain specified financial +ratios and satisfy other financial condition tests. +These restrictive covenants may limit the Company’s ability to finance future +operations or capital needs or to engage in other business activities. The Company’s ability to comply with any financial covenants could be materially affected by events beyond its control, and there can be no assurance that the Company will +satisfy any such requirements. If the Company fails to comply with these covenants, it may need to seek waivers or amendments of such covenants, seek alternative or additional sources of financing or reduce its expenditures. The Company may be +unable to obtain such waivers, amendments or alternative or additional financing on favorable terms or at all. +The Company will incur +significant transaction and integration costs as a result of the PLG acquisition. +The Company has incurred significant transaction costs +specifically attributable to the PLG acquisition, including investment banking, legal and accounting fees and expenses, and other related charges. In addition, the Company has incurred, and expects to continue to incur, significant costs in +connection with fully integrating PLG into the Company’s business. Costs incurred in connection with the PLG integration may be higher than expected. These costs could adversely affect the Company’s financial position or results of +operations. +The Company has made certain assumptions relating to the PLG acquisition in its forecasts that may prove to be materially +inaccurate. +The Company has made certain assumptions relating to future revenue growth, cost savings, synergies and associated costs of +the PLG acquisition. These assumptions may be inaccurate based on the information available to the Company, the failure to realize the expected benefits of the PLG acquisition, higher than expected transaction and integration costs and/or unknown +liabilities, as well as general economic and business conditions that may adversely affect the combined company. +Item 1B. Unresolved Staff Comments +None. +Item 2. Properties +The Company operates its domestic administration, sales and marketing operations primarily from an owned facility of approximately 225,000 square feet in +Rockford, Michigan, as well as a leased facility of approximately 147,000 square feet in Lexington, Massachusetts. The Company’s manufacturing operations are conducted primarily at a combination of leased and owned facilities in Michigan and +the Dominican Republic. The Company operates its U.S. distribution operations primarily through an owned distribution center in Rockford, Michigan, of approximately 305,000 square feet, a leased distribution center in Cedar Springs, Michigan, of +approximately 356,000 square feet, a leased distribution center in Howard City, Michigan, of approximately 460,000 square feet, an owned distribution facility of approximately 520,000 square feet in Louisville, Kentucky, and a leased distribution +facility of approximately 200,000 square feet in Brookville, Ohio. +The Company also leases and owns various other offices and distribution +centers to meet its operational requirements. In addition, the Company operates retail stores through leases with various third-party landlords. +24 +The Company conducts international operations in Canada, the United Kingdom, China, Hong Kong and continental Europe through leased distribution centers, offices and/or showrooms. The Company +believes that its current facilities are suitable and adequate to meet its current needs. +Item 3. Legal Proceedings +The Company is involved in litigation and various legal matters arising in the normal course of business, including certain environmental compliance +activities. The Company has considered facts related to legal and regulatory matters and advice of counsel handling these matters, and does not believe the ultimate resolution of such proceedings will have a material adverse effect on the +Company’s financial position, results of operations, or cash flows. +Item 4. Mine Safety Disclosures +Not applicable. +Supplemental Item. Executive Officers of the Registrant +The following table lists the names and ages of the executive officers of the Company and the positions held with the Company as of February 27, +2013. The information provided below the table lists the business experience of each such Executive Officer for at least the past five years. All Executive Officers serve at the pleasure of the Board of Directors of the Company, or, if not appointed +by the Board of Directors, they serve at the pleasure of management. +Name +Age +Positions held with the Company +Donald T. Grimes +50 +Senior Vice President, Chief Financial Officer and Treasurer +R. Paul Guerre +48 +Vice President, General Counsel and Secretary +Michael Jeppesen +53 +President, Global Operations Group +Douglas M. Jones +47 +Corporate Controller +Blake W. Krueger +59 +Chairman of the Board, Chief Executive Officer and President +Pamela L. Linton +63 +Senior Vice President, Global Human Resources +Michael D. Stornant +46 +Vice President, Corporate Finance +James D. Zwiers +45 +Senior Vice President and President, Performance Group +Donald T. Grimes has served the Company as Senior Vice President, Chief Financial Officer and Treasurer since May 2008. +From 2007 to 2008, he was the Executive Vice President and Chief Financial Officer for Keystone Automotive Operations, Inc., a distributor of automotive accessories and equipment. Prior to Keystone, Mr. Grimes held a series of senior corporate +and divisional finance roles at Brown-Forman Corporation, a manufacturer and marketer of premium wines and spirits. During his employment at Brown-Forman, Mr. Grimes was Vice President, Director of Beverage Finance from 2006 to 2007; Vice +President, Director of Corporate Planning and Analysis from 2003 to 2006; and Senior Vice President, Chief Financial Officer of Brown-Forman Spirits America from 1999 to 2003. +R. Paul Guerre has served the Company as Vice President, General Counsel and Secretary since March 2012. From July 2003 to February 2012, Mr. Guerre was a partner with the law firm of +Barnes & Thornberg LLP. Mr. Guerre was an attorney with the law firm of Warner Norcross & Judd LLP from 1991 to July 2003. +Michael Jeppesen has served the Company as President, Global Operations Group since January 2012. From 2005 to 2011, he was Senior Vice President, Design and Sourcing, for Collective Brands, Inc., a +wholesaler and retailer of footwear and related accessories. +Douglas M. Jones has served the Company as Corporate Controller since September +2011. From 2009 to 2011, he was the Company’s Director, Internal Audit. From 2006 to 2009, he was Director – Controls and Plant Financial Reporting for Indalex Inc., a manufacturer of extruded aluminum. +25 +Blake W. Krueger has served the Company as Chairman since January 2010 and as Chief Executive Officer and +President since April 2007. From October 2005 to April 2007, he served as Chief Operating Officer and President. From August 2004 to October 2005, he served as Executive Vice President and Secretary of the Company and President of the Heritage +Brands Group. From November 2003 to August 2004, he served the Company as Executive Vice President, Secretary, and President of Caterpillar Footwear. From April 1996 to November 2003, he served the Company as Executive Vice President, General +Counsel and Secretary. From 1993 to April 1996, he served as General Counsel and Secretary. From 1985 to 1996, he was a partner with the law firm of Warner Norcross & Judd LLP. +Pamela L. Linton has served the Company as Senior Vice President, Global Human Resources since December 2007. From 2005 to 2007, she was an independent consultant. From 2001 to 2005, she was Senior Vice +President, Global Human Resources of American Greetings Corporation, a greeting card and gift wrap company. +Michael D. Stornant has served +the Company as Vice President, Corporate Finance, since January 2013. From 2011 until January 2013, he served as Vice President and General Manager of Bates. From 2009 until 2011, he served as Vice President of Corporate Planning and Analysis. From +2008 until 2009, he served as Corporate Controller. From 2007 until 2008 he served as Senior Vice President of Owned Operations for the Global Operations Group. From 2003 until 2006 he served the Company as Director of Internal Audit. From 1996 +until 2003 he held various finance-related positions at the Company. +James D. Zwiers has served the Company as Senior Vice President and +President, Performance Group since January 2013. From March 2009 until January 2013, he served as Senior Vice President and President, Outdoor Group. From January 2008 until March 2009, he served as Senior Vice President of the Company. From October +2006 to December 2007, he served as President of the Company’s Hush Puppies U.S. Division. From October 2005 to October 2006, he served as the Company’s General Counsel and Secretary. From December 2003 to October 2005, he served as +General Counsel and Assistant Secretary. From January 1998 to December 2003, he served the Company as Associate General Counsel and Assistant Secretary. From 1995 to 1998, he was an attorney with the law firm of Warner Norcross & Judd LLP. +PART II +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +The Company’s common stock is traded on the New York Stock Exchange under the symbol “WWW.” The following table shows the high and low +stock prices on the New York Stock Exchange and dividends declared by fiscal quarter for 2012 and 2011. The number of stockholders of record on February 25, 2013, was 1,594. +2012 +2011 +Stock Price +High +Low +High +Low +First quarter +$ +40.76 +$ +33.30 +$ +37.52 +$ +30.31 +Second quarter +$ +44.13 +$ +34.00 +$ +40.48 +$ +35.35 +Third quarter +$ +47.99 +$ +36.97 +$ +43.36 +$ +30.77 +Fourth quarter +$ +45.63 +$ +39.47 +$ +39.48 +$ +32.77 +Cash Dividends Declared Per Share +2012 +2011 +First quarter +$ +0.12 +$ +0.12 +Second quarter +$ +0.12 +$ +0.12 +Third quarter +$ +0.12 +$ +0.12 +Fourth quarter +$ +0.12 +$ +0.12 +A quarterly dividend of $0.12 per share was declared during the first quarter of fiscal 2013. The Company currently +expects that comparable cash dividends will be paid in future quarters in 2013. +26 +The Company’s senior secured credit agreement and senior notes indenture impose certain restrictions on +the Company’s ability to pay cash dividends. The Company may not pay a dividend if the Company is in default under the credit agreement or the indenture, or if payment of the dividend would cause a default under the credit agreement or the +indenture, including the Company’s covenant to meet prescribed leverage ratios. +See Item 12 for information with respect to the +Company’s equity compensation plans. +Stock Performance Graph +The following graph compares the five year cumulative total stockholder return on the Company’s common stock to the Standard & Poor’s +Small Cap 600 Index and the Standard & Poor’s 600 Footwear Index, assuming an investment of $100 at the beginning of the period indicated. The Company is part of both the Standard & Poor’s Small Cap 600 Index and the +Standard & Poor’s Footwear Index. This Stock Performance Graph shall not be deemed to be incorporated by reference into the Company’s SEC filings and shall not constitute soliciting material or otherwise be considered filed under +the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended. +Five Year Cumulative Total +Return Summary +27 +The following table provides information regarding the Company’s purchases of its own common stock +during the fourth quarter of fiscal 2012: +Issuer Purchases of Equity Securities +Period +Total +Number of +Shares +Purchased +Average +Price +Paid per +Share +Total +Number +of Shares +Purchased +as Part of +Publicly +Announced +Plans or +Programs +Maximum +Dollar Amount +that +May +Yet +Be +Purchased +Under the +Plans +or +Programs +Period 1 (September 9, 2012 to October 6, 2012) +Common Stock Repurchase Program (1) +– +$ +– +– +$ +86,416,818 +Employee Transactions (2) +– +– +Period 2 (October 7, 2012 to November 3, 2012) +Common Stock Repurchase Program (1) +– +$ +– +– +$ +86,416,818 +Employee Transactions (2) +321 +43.67 +Period 3 (November 4 2012 to December 1, 2012) +Common Stock Repurchase Program (1) +– +$ +– +– +$ +86,416,818 +Employee Transactions (2) +232,440 +43.67 +Period 4 (December 2, 2012 to December 29, 2012) +Common Stock Repurchase Program (1) +– +$ +– +– +$ +86,416,818 +Employee Transactions (2) +155,875 +41.14 +Total for Fourth Quarter ended December 29, 2012 +Common Stock Repurchase Program (1) +– +$ +– +– +$ +86,416,818 +Employee Transactions (2) +388,636 +42.65 +(1) +The Company’s Board of Directors approved a common stock repurchase program on February 11, 2010. This program authorized the repurchase of up to +$200 million of common stock over a four-year period, commencing on the effective date of the program. There were no shares repurchased during the Company’s fourth fiscal quarter of fiscal 2012 other than repurchases pursuant to the +“Employee Transactions” set forth above. +(2) +Employee transactions include: (1) shares delivered or attested in satisfaction of the exercise price and/or tax withholding obligations by holders of employee +stock options who exercised options, and (2) restricted shares withheld to offset statutory minimum tax withholding that occurs upon vesting of restricted shares. The Company’s employee stock compensation plans provide that the shares +delivered or attested to, or withheld, shall be valued at the closing price of the Company’s common stock on the date the relevant transaction occurs. +Item 6. +Selected Financial Data +Five-Year Operating and Financial Summary (1) +2012 +2011 +2010 +2009 +2008 +(Thousands of Dollars, Except Per Share Data) +Summary of Operations +Revenue +$ +1,640,838 +$ +1,409,068 +$ +1,248,517 +$ +1,101,056 +$ +1,220,568 +Net earnings attributable to +80,686 +123,287 +104,470 +61,912 +95,821 +Wolverine World Wide, Inc. +Per share of common stock: +Basic net earnings (2)(3) +$ +1.67 +$ +2.54 +$ +2.15 +$ +1.26 +$ +1.94 +Diluted net earnings (2)(3) +1.63 +2.48 +2.11 +1.24 +1.90 +Cash dividends declared +0.48 +0.48 +0.44 +0.44 +0.44 +Financial Position at Year-End +Total assets +2,614,434 +851,652 +786,575 +712,076 +664,780 +Long-term debt +$ +1,219,250 +$ +– +$ +517 +$ +1,077 +$ +– +28 +Notes to Five-Year Operating and Financial Summary +(1) +This summary should be read in conjunction with the consolidated financial statements and the related notes, which are attached as Appendix A to this Annual Report on +Form 10-K. +(2) +Basic earnings per share are based on the weighted average number of shares of common stock outstanding during the year after adjustment for nonvested restricted common +stock. Diluted earnings per share assume the exercise of dilutive stock options and the vesting of all outstanding restricted stock. +(3) +Basic and diluted net earnings per share have been retroactively adjusted to reflect the adoption of FASB ASC Topic 260, Earnings Per Share on January 4, +2009 , for participating securities which represent unvested restricted common stock which contain non-forfeitable rights to dividends or dividend equivalents. +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +OVERVIEW +BUSINESS OVERVIEW +The Company is a leading global designer, manufacturer and marketer of branded footwear, apparel and accessories. The Company’s +stated mission is to “ Excite Consumers Around the World with Innovative Footwear and Apparel that Bring Style to Purpose .” The Company seeks to fulfill this mission by offering innovative products and compelling brand propositions; +delivering supply chain excellence; complementing its footwear brands with strong apparel and accessories offerings; and expanding its global consumer-direct footprint. +The Company’s portfolio consists of 16 brands that were marketed in approximately 200 countries and territories at December 29, 2012. This diverse brand portfolio and broad geographic reach +position the Company for continued strong organic growth. The Company’s brands are distributed into the marketplace via owned operations in the U.S., Canada, the United Kingdom and certain countries in continental Europe. In other regions (Asia +Pacific, Latin America, Middle East, Africa and Europe), the Company relies on a network of third-party distributors, licensees and joint ventures. At December 29, 2012, the Company operated 444 brick-and-mortar retail stores in the U.S., +Canada and the United Kingdom and operated 63 consumer-direct websites. +2012 FINANCIAL OVERVIEW +• +Revenue in fiscal 2012 increased 16.4% to $1.641 billion, including a contribution of $219.4 million from the PLG business included in the stub period +since the date of acquisition. +• +Gross margin in fiscal 2012 was 38.3% compared to 39.5% in the prior year. The lower gross margin was driven by higher full-year closeout sales, a +shift in product mix towards some of the Company’s lower margin businesses and non-recurring transaction and integration costs, which were only partially offset by higher selling prices. +• +Operating expenses as a percentage of revenue increased to 31.4% in fiscal 2012 compared to 27.4% in fiscal 2011 due to transaction and integration +costs associated with the acquisition of PLG, higher pension expense and higher selling costs, partially offset by lower full-year incentive compensation expense. +• +Diluted earnings per share in fiscal 2012 were $1.63 per share compared to $2.48 per share in fiscal 2011. +• +The Company generated strong cash flow from operating activities of $91.6 million in fiscal 2012 and ended the year with $171.4 million of cash and +cash equivalents. +29 +• +The Company declared cash dividends of $0.48 per share in both fiscal 2012 and 2011. +• +The Company repurchased approximately 65,000 shares of common stock in fiscal 2012 for approximately $2.4 million and repurchased approximately +1,840,000 shares in fiscal 2011 for approximately $65.3 million, both of which lowered the average shares outstanding. +2012 DEVELOPMENTS +On October 9, 2012, the Company acquired the Performance + Lifestyle Group (“PLG”) business of Collective Brands, +Inc. The cash consideration paid by the Company for PLG, subject to the finalization of certain post-closing adjustments, was approximately $1,249.5 million. PLG designs and markets casual and athletic footwear, apparel, and related accessories for +adults and children under well-known brand names, including Sperry Top-Sider ® , Saucony ® , Stride Rite ® and Keds ® . The +Company financed the acquisition in part by entering into a new $1.1 billion senior secured credit facility and by issuing $375.0 million aggregate principal amount of 6.125% senior notes due in 2020. +OUTLOOK FOR 2013 +Fiscal 2013 revenue +is expected to increase to approximately $2.7 to $2.8 billion based on continued positive momentum across the brand portfolio including the expected growth of the recently acquired PLG brands. The Company expects modest gross margin growth on the +strength of lower closeout sales compared to the prior year; strategic selling price increases; a favorable product mix shift where higher margin businesses grow at a faster pace; and efficiencies in the Company’s sourcing operations. The +Company expects to continue to invest in order to more fully integrate PLG into its existing operations and expects further increases in reported operating expenses from incremental non-cash pension expense of approximately $10 million, normalized +full year incentive compensation expense compared to an unusually small amount of such expense in fiscal 2012, and brand investments to fuel future growth. The Company expects a full year effective tax rate in the range of 21% to 23% and fully +diluted earnings per share in the range of $2.10 to $2.25. +The acquisition of PLG resulted in two new operating segments including PLG +wholesale and PLG retail. PLG’s wholesale operations are included in the branded footwear, apparel and licensing reportable segment as a fourth operating group, and PLG’s retail operations are included in the Company’s consumer-direct +reportable segment. +The following is a discussion of the Company’s results of operations and liquidity and capital resources. This +section should be read in conjunction with the Company’s consolidated financial statements and related notes included elsewhere in this Annual Report. +RESULTS OF OPERATIONS – FISCAL 2012 COMPARED TO FISCAL 2011 +FINANCIAL SUMMARY +– 2012 VERSUS 2011 +2012 +2011 +Change +(Millions of Dollars, Except Per Share Data) +$ +% of +Total +$ +% of +Total +$ +% +Revenue +Branded wholesale footwear, apparel and licensing +$ +1,419.1 +86.5% +$ +1,274.1 +90.4% +$ +145.0 +11.4% +Consumer-direct +183.9 +11.2% +101.9 +7.2% +82.0 +80.5% +Other business units +37.8 +2.3% +33.1 +2.4% +4.7 +14.2% +Total Revenue +$ +1,640.8 +100.0% +$ +1,409.1 +100.0% +$ +231.7 +16.4% +30 +2012 +2011 +Change +(Millions of Dollars, Except Per Share Data) +$ +% of +Revenue +$ +% of +Revenue +$ +% +Gross Profit +Branded wholesale footwear, apparel and licensing +$ +527.1 +37.1% +$ +497.4 +39.0% +$ +29.7 +6.0% +Consumer-direct +96.0 +52.2% +53.4 +52.4% +42.6 +79.8% +Other business units +5.1 +13.5% +6.0 +18.1% +(0.9 +) +(15.0% +) +Total Gross Profit +$ +628.2 +38.3% +$ +556.8 +39.5% +$ +71.4 +12.8% +Selling, general and administrative expenses +$ +481.9 +29.4% +$ +386.5 +27.4% +$ +95.4 +24.7% +Non-recurring transaction and integration costs +32.5 +2.0% +– +– +32.5 +100.0% +Total Operating Expenses +$ +514.4 +31.4% +$ +386.5 +27.4% +$ +127.9 +33.1% +Interest expense – net +$ +14.1 +0.9% +$ +1.1 +0.0% +$ +13.0 +1181.9% +Non-recurring acquisition related interest expense +5.2 +1.2% +– +– +5.2 +100.0% +Other expense (income) – net +0.3 +0.0% +0.3 +0.0% +– +– +Earnings before income taxes +94.2 +5.7% +168.9 +12.0% +(74.7 +) +(44.2% +) +Net earnings attributable to Wolverine +World Wide, Inc. +$ +80.7 +4.9% +$ +123.3 +8.8% +$ +(42.6 +) +(34.5% +) +Diluted earnings per share +$ +1.63 +– +$ +2.48 +– +$ +(0.85 +) +(34.3% +) +For fiscal year 2012, the Company included four operating groups within its branded wholesale footwear, apparel and +licensing reportable segment: +• +Outdoor Group , consisting of Merrell ® , Chaco ® and +Patagonia ® footwear and Merrell ® brand apparel; +• +Heritage Group , consisting of Wolverine ® footwear and +Wolverine ® brand apparel, Cat ® footwear, Bates ® , +Harley-Davidson ® footwear , and HyTest ® ; +• +Lifestyle Group , consisting of Hush Puppies ® footwear and apparel, Sebago ® +footwear and apparel, Cushe ® and Soft Style ® ; and +• +Performance + Lifestyle Group consisting of Keds ® footwear , Saucony ® +footwear and apparel, Sperry Top-Sider ® footwear and apparel, and Stride Rite ® footwear. +Retail operations across the entire portfolio are collectively reported within the consumer-direct reportable segment, consisting of both brick-and-mortar retail locations and eCommerce websites. +The Company’s other operating group, which does not collectively comprise a separate reportable segment, consists of the Wolverine +Leathers Division which markets pigskin leather primarily for use in the footwear industry. +Subsequent to the end of fiscal 2012, the Company +announced a realignment of its branded wholesale operating groups, reducing the number of operating groups within the branded wholesale footwear, apparel and licensing reportable segment from four to three. +31 +The following is supplemental information on total revenue: +TOTAL REVENUE +2012 +2011 +Change +$ +% of +Total +$ +% of +Total +$ +% +(Millions of Dollars) +Outdoor Group +$ +545.3 +33.2% +$ +551.8 +39.2% +$ +(6.5 +) +(1.2% +) +Heritage Group +502.7 +30.6% +500.3 +35.5% +2.4 +0.5% +Lifestyle Group +203.5 +12.4% +206.3 +14.6% +(2.8 +) +(1.4% +) +Performance + Lifestyle Group +150.2 +9.2% +– +– +150.2 +100.0% +Other +17.4 +1.1% +15.7 +1.1% +1.7 +10.8% +Total branded wholesale footwear, apparel and licensing revenue +$ +1,419.1 +86.5% +$ +1,274.1 +90.4% +$ +145.0 +11.4% +Consumer-direct +183.9 +11.2% +101.9 +7.2% +82.0 +80.5% +Other business units +37.8 +2.3% +33.1 +2.4% +4.7 +14.2% +Total Revenue +$ +1,640.8 +100.0% +$ +1,409.1 +100.0% +$ +231.7 +16.4% +REVENUE +Revenue for fiscal 2012 increased $231.7 million from fiscal 2011, to $1,640.8 million. The PLG business contributed $219.4 million of the increase since +the date of acquisition. Changes in foreign exchange rates decreased reported revenue by $10.9 million. The remainder of the increase in revenues is due to increased volumes. International revenue represented 34.2% of total reported revenue in +fiscal 2012 compared to 40.2% in fiscal 2011. The decrease in International revenue as a percent of total revenue is driven by PLG revenues included in the fiscal 2012 results, which are primarily within the U.S. +The Outdoor Group’s branded wholesale footwear, apparel and licensing revenue declined $6.5 million or 1.2% compared to +the prior year. Merrell ® , the largest brand in this group, was negatively impacted by the challenging +macroeconomic environment in both Europe and Canada and unseasonably warm weather conditions, resulting in a full year revenue decline in the low single digits. Patagonia ® footwear’s revenues also decreased at a rate in the low single digits in fiscal 2012, driven by lower revenues in Europe. Revenue for Chaco ® grew at a rate in the high teens compared to fiscal 2011, driven by continued momentum in the sandal category and +expansion in men’s, women’s and children’s categories. +The Heritage Group’s branded wholesale +footwear, apparel and licensing revenue increased $2.4 million, or 0.5%, compared to the prior year. High single digit revenue growth in the Wolverine ® brand footwear business and mid-teens growth in the Wolverine ® brand apparel business reflect the strength of the brand’s core industrial work boot position, along with growing momentum from the brand’s 1000 Mile ® product offering. Cat ® U.S. footwear revenue grew at a rate in the low twenties over the prior year on the strength of its industrial business. Cat ® global footwear revenue experienced a mid single digit decline in revenue driven by poor economic conditions in +Europe. Harley-Davidson ® Footwear revenue decreased at a rate in the mid twenties compared to fiscal 2011 +reflecting the impact of more restrictive distribution channels imposed by a modified license agreement with the brand’s owner. +The Lifestyle Group’s branded wholesale footwear, apparel and licensing revenue declined $2.8 million, or 1.4%, compared to the prior year. Hush Puppies ® revenue decreased at a rate in the high single digits, as increases in the U.S. and certain third-party distributor +markets were more than offset by declines in Canada and Europe due to retailer consolidations and overall economic conditions in those regions. Revenue for Cushe ® increased at a rate in the mid teens as the brand continued to realize the benefit of new product initiatives. Revenue for Sebago ® increased at a rate in the low teens due to increased department store penetration and success with web and catalog +based retailers. +32 +The Performance + Lifestyle Group added $150.2 million of revenue to the branded +wholesale footwear, apparel and licensing segment since the date of acquisition, led by strong performance from Sperry Top-Sider ® Stride Rite ® , and +Keds ® . The PLG brands benefitted from strong momentum and excitement around new product introductions and +brand endorsements. +Consumer-direct includes both Wolverine retail’s and PLG retail’s consumer-direct businesses. Wolverine +retail reported revenue growth at a rate in the low teens in fiscal 2012 compared to fiscal 2011 as a result of growth at a rate in the mid teens in the Company’s eCommerce channel and growth at a low single digit rate in comparable store +sales. Wolverine retail operated 99 retail stores worldwide at the end of fiscal 2012 and operated 101 retail stores at the end of fiscal 2011. PLG retail reported revenue of $69.2 million for the period since acquisition. PLG retail operated 345 +stores at the end of fiscal 2012. +The Company’s other business unit, the Wolverine Leathers Division reported a revenue increase at a +rate in the mid teens, as a result of high demand for its pigskin leathers. +GROSS MARGIN +For fiscal 2012, the Company’s consolidated gross margin decreased 120 basis points compared to fiscal 2011. Approximately 70 basis points of +the decrease was caused by shifts in the mix of products sold. The Company incurred $4.5 million of non-recurring transaction and integration costs relating to the fair value adjustment to acquisition-date inventory and severance costs, which +contributed to approximately 30 basis points of the decrease. The remainder of the decrease was caused by increased product costs only partially offset by higher selling prices. +OPERATING EXPENSES +Operating expenses increased $127.9 million, from $386.5 million in +fiscal 2011 to $514.4 million in fiscal 2012. Approximately $77.8 million of the increase relates to the inclusion of PLG within the Company’s consolidated results since the date of acquisition. Approximately $32.5 million of the increase +relates to non-recurring transaction and integration costs associated with the acquisition of PLG. The non-recurring costs include professional and legal fees, taxes paid on behalf of the seller, retention bonus expense, onetime software license +fees and other onetime costs of $14.9 million, $9.7 million, $2.7 million, $2.4 million and $2.8 million, respectively. Pension expense for fiscal 2012 increased approximately $10.4 million compared to fiscal 2011 driven by a lower discount rate in +the current year. Changes in foreign exchange rates had a $3.6 million favorable impact on reported operating expenses. The remainder of the increase was due to incremental variable expenses. +INTEREST, OTHER AND TAXES +Total net interest expense increased $18.2 million to $19.3 +million in fiscal 2012 from $1.1 million in fiscal 2011. Approximately $5.2 million of the increase is due to non-recurring financing commitment and refinancing fees associated with the Company’s acquisition of PLG. Approximately $1.8 million +of the increase is due to the amortization of deferred financing costs included within interest expense. The remainder of the increase is due to an increase in long-term debt in the period of time from the date of PLG acquisition to the end of the +fiscal year. +The Company’s full year effective tax rate in fiscal 2012 was 14.2%, compared to 27.0% in fiscal 2011. The lower effective +tax rate reflects the non-recurring benefits of a favorable court decision in the first half of fiscal 2012 in a foreign tax jurisdiction supporting the Company’s long-term global tax planning strategies. The lower tax rate in the current year +was also the result of acquisition-related expense deductions in high statutory tax rate jurisdictions in the second half of the year. The Company maintains certain strategic management and operational activities in overseas subsidiaries, and its +foreign earnings are taxed at rates that are generally lower than the U.S. federal statutory income tax rate. A significant amount of the Company’s earnings are generated by its Canadian, European and Asia Pacific subsidiaries and, to a lesser +extent, in jurisdictions that are not subject to income tax and free trade zones where the Company owns manufacturing operations. The Company has not provided for U.S. taxes for earnings generated in foreign jurisdictions because it plans to +reinvest these earnings +33 +indefinitely outside the U.S. However, if certain foreign earnings previously treated as permanently reinvested are repatriated, the additional U.S. tax liability could have a material adverse +effect on the Company’s after-tax results of operations and financial position. +NET EARNINGS AND EARNINGS PER SHARE +As a result of the revenue, gross margin and expense changes discussed above, the Company had net earnings of $80.7 million in fiscal 2012, compared to +$123.3 million in fiscal 2011, a decrease of $42.6 million. +Diluted net earnings per share decreased 34.3% in fiscal 2012, to $1.63, from +$2.48 in fiscal 2011. The Company repurchased approximately 65,000 shares of common stock in fiscal 2012 for approximately $2.4 million and repurchased approximately 1,840,000 shares in fiscal 2011 for approximately $65.3 million, both of which +lowered the average shares outstanding in fiscal 2012. +RESULTS OF OPERATIONS – FISCAL 2011 COMPARED TO FISCAL 2010 +FINANCIAL SUMMARY – 2011 VERSUS 2010 +2011 +2010 +Change +(In Millions of Dollars, Except Per Share Data) +$ +% of +Total +$ +% of +Total +$ +% +Revenue +Branded wholesale footwear, apparel and licensing +$ +1,274.1 +90.4% +$ +1,117.6 +89.5% +$ +156.5 +14.0% +Consumer-direct +101.9 +7.2% +87.1 +7.0% +14.8 +17.0% +Other business units +33.1 +2.4% +43.8 +3.5% +(10.7 +) +24.4% +Total Revenue +$ +1,409.1 +100.0% +$ +1,248.5 +100.0% +$ +160.6 +12.9% +$ +% of +Revenue +$ +% of +Revenue +$ +% +Gross Profit +Branded wholesale footwear, apparel and licensing +$ +497.4 +39.0% +$ +440.1 +39.4% +$ +57.3 +13.0% +Consumer-direct +53.4 +52.4% +45.9 +52.7% +7.5 +16.1% +Other business units +6.0 +18.1% +6.6 +15.1% +(0.6 +) +(9.1% +) +Total Gross Profit +$ +556.8 +39.5% +$ +492.6 +39.5% +$ +64.2 +13.0% +Selling, general and administrative expenses +$ +386.5 +27.4% +$ +347.5 +27.8% +$ +39.0 +11.2% +Restructuring and other transition costs +– +– +2.8 +0.2% +(2.8 +) +(100% +) +Total Operating Expenses +$ +386.5 +27.4% +$ +350.3 +28.1% +$ +36.2 +10.3% +Interest expense – net +$ +1.1 +0.0% +$ +0.4 +0.0% +$ +0.7 +175% +Other expense (income) – net +0.3 +0.0% +(1.3 +) +(0.1% +) +(1.6 +) +nm +Earnings before income taxes +168.9 +12.0% +143.2 +11.5% +25.7 +17.9% +Net earnings +$ +123.3 +8.8% +$ +104.5 +8.4% +$ +18.8 +18.0% +Diluted earnings per share +$ +2.48 +– +$ +2.11 +– +$ +0.37 +17.5% +34 +The following is supplemental information on total revenue: +TOTAL REVENUE +2011 +2010 +Change +$ +% of +Total +$ +% of +Total +$ +% +(Millions of Dollars) +Outdoor Group +$ +551.8 +39.2% +$ +467.6 +37.5% +$ +84.2 +18.0% +Heritage Group +500.3 +35.5% +454.6 +36.4% +45.7 +10.1% +Lifestyle Group +206.3 +14.6% +182.9 +14.6% +23.4 +12.8% +Other +15.7 +1.1% +12.5 +1.0% +3.2 +25.6% +Total branded wholesale footwear, apparel and licensing revenue +$ +1,274.1 +90.4% +$ +1,117.6 +89.5% +$ +156.5 +14.0% +Consumer-direct +101.9 +7.2% +87.1 +7.0% +14.8 +17.0% +Other business units +33.1 +2.4% +43.8 +3.5% +(10.7 +) +(24.4% +) +Total Revenue +$ +1,409.1 +100.0% +$ +1,248.5 +100.0% +$ +160.6 +12.9% +REVENUE +Revenue for fiscal 2011 increased $160.6 million from fiscal 2010, to $1.409 billion. The growth was driven by double digit percentage increases in +revenue for all three branded wholesale footwear, apparel and licensing operating groups. Changes in foreign exchange rates increased reported revenue by $17.3 million versus the prior year. International revenue represented 40.2% of total reported +revenue in fiscal 2011 compared to 38.4% in fiscal 2010. +The Outdoor Group’s branded wholesale footwear, +apparel and licensing revenue increased 18.0% in fiscal 2011 compared to fiscal 2010. Leading the group’s growth, the Merrell ® brand enjoyed increased demand for performance products, including its new Merrell ® Barefoot Collection. Fueling the growth for Merrell ® branded footwear was a mid teens growth rate in units sold. The increase in Merrell ® brand apparel was driven by a strong double digit increase in revenue generated by the Outerwear category and a low triple digit rate increase in revenue generated by +the Sportswear category. Patagonia ® footwear’s revenue increased at a rate in the high teens in +fiscal 2011 due to continued strong demand from key outdoor retailers. Revenue from the Chaco ® brand grew +at a rate in the high teens compared to fiscal 2010 as the brand expanded its closed-toe product offerings for fall, extending the brand’s reach to become a year-round footwear option for consumers. +The Heritage Group’s branded wholesale footwear, apparel and licensing revenue increased 10.1% in fiscal 2011 compared +to fiscal 2010. Driving the revenue growth for the group was a mid twenties rate increase in revenue from the +Cat ® footwear brand and a high single digit rate increase in revenue from Wolverine ® brand footwear and apparel. The Cat ® footwear revenue increase was driven by revenue growth in the mid-teens or higher in each of its major geographic regions compared to fiscal 2010. The +Wolverine ® brand’s revenue grew as a result of low single digit unit volume growth in the U.S. +rugged casual and core work boot business and a growth rate in the low thirties for the Wolverine ® brand +apparel business. Harley-Davidson ® Footwear revenue decreased at a mid single digit rate compared to +fiscal 2010, as a high single digit decline in the U.S. market was partially offset by an increase at a rate in the high seventies in the European market. +The Lifestyle Group’s branded wholesale footwear, apparel and licensing revenue increased 12.8% in fiscal 2011 compared to fiscal 2010. Revenue from the Hush Puppies ® brand increased at a high single digit rate as a result of mid twenties rate growth in its third-party licensing +business; growth in the European markets at a rate in the mid teens; and high single digit rate growth in the Canadian market. These increases were partially offset by a mid single digit rate decline in Hush Puppies ® revenue in the U.S. The Sebago ® brand generated revenue growth in the mid teens in fiscal 2011 as a result of growth in Europe. The Cushe ® brand’s revenue almost doubled compared to fiscal 2010, as the brand continues to benefit from excellent placement in specialty, outdoor and surf retail venues. +35 +Consumer-direct reported revenue growth in the mid teens in fiscal 2011 compared to fiscal 2010 as a +result of a high twenties growth rate in the Company’s e-commerce channel and a mid single digit growth rate in comparable store sales from Company-owned stores. The Company operated 101 retail stores worldwide at the end of fiscal 2011 and +operated 88 retail stores in fiscal 2010, with sixteen new store openings in fiscal 2011 partially offset by the closure of three existing locations during fiscal 2011. +The Company’s other business unit, the Wolverine Leathers Division business reported a revenue decline at a rate in the mid twenties as a result of soft demand from certain key customers and the +divestiture of its low-margin procurement division in the fourth quarter of 2010. +GROSS MARGIN +For fiscal 2011, the Company’s consolidated gross margin was flat compared to fiscal 2010. Higher product input costs and a negative shift in the mix +of product sold decreased consolidated gross margin by approximately 150 basis points and 110 basis points, respectively. These decreases were offset by the positive impact from strategic selling price increases and benefits from foreign exchange +fluctuations of approximately 230 basis points and 30 basis points, respectively. +OPERATING EXPENSES +Operating expenses increased $36.2 million, from $350.3 million in fiscal 2010 to $386.5 million in fiscal 2011. The higher operating expense was due to +an increase at a rate in the mid teens in distribution costs, which vary with revenue, and increases in advertising and marketing expenses at a rate in the low teens, designed to enhance brand awareness. In addition, selling commissions, which vary +with revenue, increased at a rate in the low teens and changes in foreign exchange rates had a $5.0 million unfavorable impact on reported operating expenses. These increases were partially offset by a $2.8 million dollar reduction in restructuring +and other transition costs in fiscal 2011 compared to fiscal 2010. +INTEREST, OTHER AND TAXES +The increase in net interest expense reflects the increase in revolver borrowings for fiscal 2011 compared to fiscal 2010. +The increase in other income is due to the sale of Wolverine Procurement assets in the fourth quarter of fiscal 2010, which resulted in a $1.1 million +gain, with the remainder of the increase due to the change in realized gains or losses on foreign denominated assets and liabilities. +The +Company’s full year effective tax rate in fiscal 2011 was 27.0%, compared to 27.1% in fiscal 2010. The modestly lower effective tax rate reflects the fact that a higher percentage of the Company’s earnings in fiscal 2011 were attributable +to foreign jurisdictions, where tax rates are lower than in the U.S. or nontaxable based on specific tax rulings and legislation. The Company maintains certain strategic management and operational activities in overseas subsidiaries, and its foreign +earnings are taxed at rates that are generally lower than the U.S. federal statutory income tax rate. A significant amount of the Company’s earnings are generated by its Canadian, European and Asia Pacific subsidiaries and, to a lesser extent, +in jurisdictions that are not subject to income tax and free trade zones where the Company owns manufacturing operations. The Company has not provided for U.S. taxes for earnings generated in foreign jurisdictions because it plans to reinvest these +earnings indefinitely outside the U.S. However, if certain foreign earnings previously treated as permanently reinvested are repatriated, the additional U.S. tax liability could have a material adverse effect on the Company’s after-tax results +of operations and financial position. +NET EARNINGS AND EARNINGS PER SHARE +As a result of the revenue, gross margin and expense changes discussed above, the Company had net earnings of $123.3 million in fiscal 2011, compared to $104.5 million in fiscal 2010, an increase of $18.8 +million or 18.0%. +36 +Diluted net earnings per share increased 17.5% in fiscal 2011 to $2.48, from $2.11 in fiscal 2010. The +increase was attributable to increased revenue, stable gross margin and lower restructuring and other transition costs, as detailed above. The Company repurchased approximately 1,840,000 shares of common stock in fiscal 2011 for approximately $65.3 +million and repurchased approximately 1,795,000 shares in fiscal 2010 for approximately $51.2 million, both of which lowered the average shares outstanding. +LIQUIDITY AND CAPITAL RESOURCES +Fiscal Year-Ended +2012 +2011 +2010 +(Millions of Dollars) +Cash and cash equivalents +$ +171.4 +$ +140.0 +$ +150.4 +Cash provided by operating activities +91.6 +78.8 +67.9 +Cash used in investing activities +(1,246.1 +) +(22.6 +) +(17.0 +) +Cash provided (used) in financing activities +1,183.4 +(62.3 +) +(59.1 +) +Additions to property, plant and equipment +14.9 +19.4 +16.4 +Depreciation and amortization +27.7 +15.9 +16.2 +Interest-bearing debt +1,250.0 +11.5 +1.0 +Available revolving credit facility (1) +$ +198.1 +$ +139.0 +$ +150.0 +(1) +For fiscal 2012, amount shown is net of outstanding letters of credit, which are applied against the Company’s Revolving Credit Facility. Amounts shown for +fiscal 2011 and fiscal 2010 are under the Company’s previous revolving credit facility and are shown net of borrowings. +Liquidity +Cash and cash equivalents of +$171.4 million as of December 29, 2012 were $31.4 million higher compared to the prior year. Accounts receivable and inventories of $819.8 million increased $368.1 million compared to the prior year, driven by the acquisition of PLG. +In addition to the cash and cash equivalents balance of $171.4 million at December 29, 2012, the Company had an additional $198.1 +million available under its Revolving Credit Facility. +Operating Activities +Net cash provided by operating activities in fiscal 2012 was $91.6 million versus $78.8 million in fiscal 2011, an increase of $12.8 million. Lower earnings performance in fiscal 2012 was more than +offset by lower investments in working capital and reduced cash pension contributions compared to fiscal 2011. +Investing Activities +The majority of the capital expenditures for the year were for information system enhancements, manufacturing equipment and building +improvements. The Company leases machinery, equipment and certain warehouse, office and retail store space under operating lease agreements that expire at various dates through 2023. +Included in the fiscal 2012 investing activities is a net cash outflow of $1,225.9 million related to the acquisition of the PLG business. The Company funded the acquisition primarily through net proceeds +from term loan debt, the issuance of senior notes, and cash on hand of approximately $88.8 million. +Financing Activities +On October 9, 2012, the Company entered into a new credit agreement (the “New Credit Agreement”) with a bank syndicate. The New Credit +Agreement provides the Company with a $1.1 billion secured credit facility consisting of a term loan A facility in an aggregate amount of up to $550.0 million, a term loan B facility in an aggregate amount up to $350.0 million and a Revolving Credit +Facility in an aggregate amount of up to $200.0 million (the “Revolving Credit Facility”). The New Credit Agreement also provides the Company with the option +37 +to increase the aggregate principal amount of all facilities by up to an additional amount such that the total amount of all of the facilities does not exceed $1.3 billion. As of +December 29, 2012, the only usage against the Revolving Credit Facility is related to outstanding standby letters of credit totaling approximately $1.9 million. The provisions of the New Credit Agreement require the Company to adhere to certain +covenants and maintain certain performance ratios. The Company was in compliance with all such covenants and performance ratios during fiscal 2012 and expects to continue to be in compliance in future periods. +On October 9, 2012, the Company also issued $375.0 million of senior notes, which bear interest at a 6.125 % fixed rate and are due in 2020 +(“Notes”). Related interest payments are due semi-annually. The Notes are guaranteed by certain of the Company’s domestic subsidiaries. +The Company used the net proceeds from the Notes, together with the borrowings under the term loan facilities and cash on hand, to finance the acquisition of PLG, repay any amounts outstanding under and +terminate its existing Revolving Credit Facility, and provide for the working capital needs of the Company, including the payment of transaction expenses in connection with the acquisition. +Interest-bearing debt at the end of fiscal 2012 was $1,250.0 million compared to $11.5 million at the end of fiscal 2011. The increase in debt in fiscal 2012 is a result of net proceeds from the +Company’s term loans and senior notes. Net payments in fiscal 2012 on the Company’s previous Revolving Credit Facility were $11.0 million. The Company also made a $25.0 million voluntary payment on the term loan B debt during the fourth +quarter of fiscal 2012. +At the end of fiscal 2012, the Company had cash and cash equivalents of $171.4 million including cash in foreign +locations of $101.6 million. The Company’s intends to permanently reinvest cash in foreign locations. +Cash flow from operations, along +with proceeds from the Revolving Credit Facility, if any, are expected to be sufficient to meet working capital needs for the foreseeable future. Any excess cash flows from operating activities are expected to be used to purchase property, plant and +equipment, reduce debt, fund internal and external growth initiatives, pay dividends or repurchase the Company’s common stock. +The +Company’s Board of Directors approved a common stock repurchase program on February 11, 2010 (the “February 2010 Program”). The February 2010 Program authorizes the repurchase of up to $200.0 million in common stock over a +four-year period. The Company repurchased 64,612 shares at an average price of $37.09 in the first quarter of fiscal 2012 and did not repurchase any shares in the second, third or fourth quarter of fiscal 2012 under the February 2010 Program. The +Company repurchased 142,198 shares at an average price of $35.57 in the first quarter of 2011, 478,747 shares at an average price of $37.74 in the second quarter of 2011, 948,256 shares at an average price of $34.45 in the third quarter of 2011 and +270,882 shares at an average price of $35.08 in the fourth quarter of 2011 under the February 2010 Program. The primary purpose of the stock repurchase programs is to increase stockholder value. The Company may continue to repurchase shares of its +common stock under the February 2010 Program from time to time in open market or privately negotiated transactions, depending upon market conditions and other factors. +2012 +2011 +Cumulative +(Thousands of Dollars, Except Share Data) +Authorization +effective date +Shares +repurchased +Market price +of shares +repurchased +Shares +repurchased +Market price +of shares +repurchased +Shares +repurchased +Market price +of shares +repurchased +February 11, 2010 +64,612 +$ 2,397 +1,840,083 +$65,296 +3,499,846 +$ +113,583 +In addition to the repurchases noted above under the February 2010 program, the Company acquired 289,799 shares at an +average price of $40.45 per share during fiscal 2012 and 55,810 shares at an average price of $36.48 per share during fiscal 2011 related to employee transactions. +38 +The Company declared total dividends of $0.48 per share for fiscal 2012 and fiscal 2011. On February 7, +2013 the Company declared a quarterly cash dividend of $0.12 per share of common stock, to be paid on May 1, 2013 to stockholders of record on April 1, 2013. +NEW ACCOUNTING STANDARDS +In February 2013, the Financial Accounting Standards Board (FASB) +issued Accounting Standards Update (ASU) 2013-02, Comprehensive Income (Topic 220) Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income (“ASU 2013-02”). ASU 2013-02 requires preparers to report, in one +place, information about reclassifications out of accumulated other comprehensive income (AOCI). For significant items reclassified out of AOCI to net income in their entirety in the same reporting period, reporting (either on the face of the +statement where net income is presented or in the notes) is required about the effect of the reclassifications on the respective line items in the statement where net income is presented. For items that are not reclassified to net income in their +entirety in the same reporting period, a cross reference to other disclosures currently required under US GAAP is required in the notes. The above information must be presented in one place (parenthetically on the face of the financial +statements by income statement line item or in a note). The ASU is effective prospectively for reporting periods beginning after December 15, 2012. The Company plans to adopt the provisions of this ASU in the first quarter of fiscal 2013. The +Company does not expect the ASU to have a material effect on the Company’s consolidated financial position, results of operations or cash flows. +In July 2012, the FASB issued ASU 2012-02, Intangibles-Goodwill and Other (ASC Topic 350) Testing Indefinite-Lived Intangible Assets for Impairment (“ASU 2012-02”). ASU 2012-02 amends +prior indefinite-lived intangible asset impairment testing guidance. Under ASU 2012-02, the Company has the option to first assess qualitative factors to determine whether it is more likely than not (a likelihood of more than 50%) that an +indefinite-lived intangible asset is impaired. If, after considering the totality of events and circumstances, an entity determines it is more likely than not that an indefinite-lived intangible asset is not impaired, then calculating the fair value +of such asset is unnecessary. The Company adopted the applicable requirements of this ASU in the fourth quarter of fiscal 2012, and the adoption did not affect the Company’s consolidated financial position, results of operations or cash flows. +In September 2011, the FASB issued ASU No. 2011-08, Testing Goodwill for Impairment (ASU No. 2011-08). ASU No. 2011-08 +amended the provisions of FASB ASC 350-20-35 by allowing an entity the option to make a qualitative evaluation about the likelihood of goodwill impairment to determine whether it should calculate the fair value of a reporting unit. The +amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company adopted the applicable requirements of this ASU in the fourth quarter of fiscal 2011, and +the adoption did not affect the Company’s consolidated financial position, results of operations or cash flows. +In June 2011, the FASB +issued ASU 2011-05, Comprehensive Income (Topic 220), Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 eliminates the option to present other comprehensive income (“OCI”) in the statement of +stockholders’ equity. Under ASU 2011-05, the Company has the option to present the total of comprehensive income, the components of net income and the components of OCI in either a continuous statement of comprehensive income or in two separate +continuous statements. Earnings per share would continue to be based on net income. Also in December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220), Deferral of the Effective Date for Amendments to the Presentation of +Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 (“ASU 2011-12”). ASU 2011-12 defers the ASU 2011-05 requirement that companies present reclassification +adjustments for each component of accumulated other comprehensive income in both net income and OCI on the face of the financial statements. The Company adopted the current required provisions of ASU 2011-05 in the first quarter of fiscal 2012. The +adoption of ASU 2011-12 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows. +In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820), Amendments to achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (“ASU +2011-04”). +39 +ASU 2011-04 amends the fair value measurement and disclosure guidance in ASC 820, Fair Value Measurement , to converge U.S. GAAP and IFRS requirements for measuring amounts at fair +value as well as disclosures about these measurements. ASU 2011-04 was effective for interim and annual periods beginning after December 15, 2011 and was adopted in the first quarter of fiscal 2012. The adoption of ASU 2011-04 did not affect +the Company’s consolidated financial position, results of operations or cash flows. +CRITICAL ACCOUNTING POLICIES +The preparation of the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles +generally accepted in the U.S., requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates these estimates. Estimates are based +on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily +apparent from other sources. Historically, actual results have not been materially different from the Company’s estimates. However, actual results may differ materially from these estimates under different assumptions or conditions. +The Company has identified the following critical accounting policies used in determining estimates and assumptions in the amounts reported. Management +believes that an understanding of these policies is important to an overall understanding of the Company’s consolidated financial statements. +REVENUE RECOGNITION +Revenue is recognized on the sale of products manufactured or sourced +by the Company when the related goods have been shipped, legal title has passed to the customer and collectability is reasonably assured. Revenue generated through licensees and distributors involving products bearing the Company’s trademarks +is recognized as earned according to stated contractual terms upon either the purchase or shipment of branded products by licensees and distributors. +The Company records provisions for estimated sales returns and allowances at the time of sale based on historical rates of returns and allowances and specific identification of outstanding returns not yet +received from customers. However, estimates of actual returns and allowances in any future period are inherently uncertain and actual returns and allowances for the relevant periods may differ from these estimates. If actual or expected future +returns and allowances were significantly greater or lower than established reserves, an adjustment to net revenues would be recorded in the period the determination was made. +ACCOUNTS RECEIVABLE +The Company maintains an allowance for uncollectible accounts +receivable for estimated losses resulting from its customer’s failure to make required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical +collection experience. Historically, losses have been within the Company’s expectations. Adjustments to these estimates may be required if the financial condition of the Company’s customers were to change. If the Company were to determine +adjustments to the allowance for uncollectible accounts were appropriate, the Company would record either an increase or decrease to general and administrative expenses in the period in which the Company made such a determination. At +December 29, 2012 and December 31, 2011, management believed that it had provided sufficient reserves to address future collection uncertainties. +INVENTORY +The Company values its inventory at the lower of cost or market. Cost is +determined by the last-in, first-out (“LIFO”) method for all domestic raw materials and work-in-process inventories and certain domestic finished goods inventories. Cost is determined using the first-in, first-out (“FIFO”) method +for all raw materials, work-in-process and finished goods inventories in foreign countries. The FIFO method is also used for all finished goods inventories of the Company’s retail business, due to the unique nature of those operations, and for +certain other domestic finished goods inventories. The Company has applied these inventory cost valuation methods consistently from year to year. +40 +The Company reduces the carrying value of its inventories to the lower of cost or market for excess or +obsolete inventories based upon assumptions about future demand and market conditions. If the Company were to determine that the estimated market value of its inventory is less than the carrying value of such inventory, the Company would provide a +reserve for such difference as a charge to cost of sales. If actual market conditions are different from those projected, adjustments to those inventory reserves may be required. The adjustments would increase or decrease the Company’s cost of +sales and net income in the period in which they were realized or recorded. Inventory quantities are verified at various times throughout the year by performing physical inventory observations and perpetual inventory cycle count procedures. If the +Company determines that adjustments to the inventory quantities are appropriate, an adjustment to the Company’s cost of goods sold and inventory is recorded in the period in which such determination was made. At December 29, 2012 and +December 31, 2011, management believed that it had provided sufficient reserves for excess or obsolete inventories. +DEFERRED +FINANCING COSTS +Deferred financing costs represent commitment fees, legal and other third party costs associated with obtaining +commitments for financing which result in a closing of such financings for the Company. These costs are amortized into earnings through interest expense over the terms of the respective agreements. Costs incurred in seeking financing transactions +which do not close are expensed in the period in which it is determined that the financing will not close. +ACQUISITIONS +The Company accounts for acquired businesses using the purchase method of accounting. Under the purchase method, the Company’s consolidated financial +statements include the operations of an acquired business starting from the date of acquisition. In addition, the assets acquired and liabilities assumed must be recorded at the date of acquisition at their respective estimated fair values, with any +excess of the purchase price over the estimated fair values of the net assets acquired recorded as goodwill. +Significant judgment is required +in estimating the fair value of intangible assets and in assigning their respective useful lives. Accordingly, the Company typically obtains the assistance of third-party valuation specialists for significant items. The fair value estimates are +based on available historical information and on future expectations and assumptions deemed reasonable by management, but are inherently uncertain. +The Company typically uses an income method to estimate the fair value of intangible assets, which is based on forecasts of the expected future cash flows attributable to the respective assets. +Significant estimates and assumptions inherent in the valuations reflect a consideration of other marketplace participants and include the amount and timing of future cash flows (including expected growth rates and profitability), the underlying +product or technology life cycles, the economic barriers to entry and the discount rate applied to the cash flows. Unanticipated market or macroeconomic events and circumstances may occur that could affect the accuracy or validity of the estimates +and assumptions. +Determining the useful life of an intangible asset also requires judgment. Certain intangibles are expected to have +indefinite lives based on their history and the Company’s plans to continue to support and build the acquired brands. Other acquired intangible assets (e.g., certain patents, customer relationships and technologies) are expected to have +determinable useful lives. The Company’s assessment as to those intangibles that have an indefinite life and those that have a determinable life is based on a number of factors including competitive environment, market share, underlying product +life cycles, operating plans and the macroeconomic environment of the countries in which the brands are sold. The Company’s estimates of the useful lives of determinable-lived intangibles are based primarily on these same factors. All of the +Company’s acquired technology and customer-related intangibles are expected to have determinable useful lives. The costs of determinable-lived intangibles are amortized to expense over their estimated life. +GOODWILL AND OTHER NON-AMORTIZABLE INTANGIBLES +Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually. The Company has adopted the provisions of ASU 2011-08, which +permits the Company to +41 +qualitatively assess indicators of the Company’s reporting unit’s fair value when it is unlikely that a reporting unit is impaired. After completing the qualitative assessment, the +Company may also use assumptions about expected future operating performance and utilize a discounted cash flow analysis to estimate fair value. If the recorded values of these assets are not recoverable, based on either the assessment screen or +discounted cash flow analysis, management performs the next step, which compares the fair value of the reporting unit to the fair value of the tangible and intangible assets of the reporting units. Goodwill is considered impaired if the fair value +of the tangible and intangible assets exceeds the fair value of the reporting unit. +The Company adopted the provisions of ASU 2012-02, which +allows the Company to first assess qualitative factors to determine whether it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying value. The Company would not be required to quantitatively +determine the fair value of the indefinite-lived intangible unless the Company determines, based on the qualitative assessment, that it is more likely than not that its fair value is less than the carrying value. After completing the qualitative +assessment, the Company may determine it necessary to test indefinite-lived intangibles by comparison of the individual carrying values to the fair value. Future cash flows of the individual indefinite-lived intangible assets are used to measure +their fair value after consideration by management of certain assumptions, such as forecasted growth rates and cost of capital, which are derived from internal projections and operating plans. +The Company performs its annual testing for goodwill and indefinite-lived intangible asset impairment at the beginning of the fourth quarter of the +fiscal year for all reporting units. The Company did not recognize any impairment charges for goodwill or indefinite-lived intangible assets during the fiscal years ended December 29, 2012 or December 31, 2011, as the annual impairment +testing indicated that all reporting unit goodwill and indefinite-lived intangible asset fair values exceed their respective recorded values. +INCOME TAXES +The Company maintains +certain strategic management and operational activities in overseas subsidiaries, and its foreign earnings are taxed at rates that are generally lower than the U.S. federal statutory income tax rate. A significant amount of the Company’s +earnings are generated by its Canadian, European and Asia Pacific subsidiaries and, to a lesser extent, in jurisdictions that are not subject to income tax and free trade zones where the Company owns manufacturing operations. The Company has not +provided for U.S. taxes for earnings generated in foreign jurisdictions because it plans to reinvest these earnings indefinitely outside the U.S. However, if certain foreign earnings previously treated as permanently reinvested are repatriated, the +additional U.S. tax liability could have a material adverse effect on the Company’s after-tax results of operations and financial position. Income tax audits associated with the allocation of this income and other complex issues may require an +extended period of time to resolve and may result in income tax adjustments if changes to the income allocation are required between jurisdictions with different income tax rates. Because income tax adjustments in certain jurisdictions can be +significant, the Company records accruals representing management’s best estimate of the resolution of these matters. To the extent additional information becomes available, such accruals are adjusted to reflect the revised estimated outcome. +The Company believes its tax accruals are adequate to cover exposures related to changes in income allocation between tax jurisdictions. The carrying value of the Company’s deferred tax assets assumes that the Company will be able to generate +sufficient taxable income in future years to utilize these deferred tax assets. If these assumptions change, the Company may be required to record valuation allowances against its gross deferred tax assets in future years, which would cause the +Company to record additional income tax expense in its consolidated statements of operations. Management evaluates the potential the Company will be able to realize its gross deferred tax assets and assesses the need for valuation allowances on a +quarterly basis. +On a periodic basis, the Company estimates what the effective tax rate will be for the full fiscal year and records a +quarterly income tax provision in accordance with the projected full year rate. As the fiscal year progresses, that estimate is refined based upon actual events and the distribution of earnings in each tax jurisdiction during the year. This +continual estimation process periodically results in a change to the expected effective tax rate for the fiscal year. When this occurs, the Company adjusts the income tax provision during the quarter in which the change in estimate occurs so that +the year-to-date provision reflects the revised anticipated annual rate. +42 +RETIREMENT BENEFITS +The determination of the obligation and expense for retirement benefits is dependent on the selection of certain actuarial assumptions used in calculating such amounts. These assumptions include, among +others, the discount rate, expected long-term rate of return on plan assets and rates of increase in compensation. These assumptions are reviewed with the Company’s actuaries and updated annually based on relevant external and internal factors +and information, including but not limited to, long-term expected asset returns, rates of termination, regulatory requirements and plan changes. +The Company utilizes a bond matching calculation to determine the discount rate used to calculate its year-end pension liability and subsequent year pension expense. A hypothetical bond portfolio is +created based on a presumed purchase of individual bonds to settle the plan’s expected future benefit payments. The discount rate is the resulting yield of the hypothetical bond portfolio. The bonds selected are listed as high grade by at least +two recognized ratings agency and are non-callable, currently purchasable and non-prepayable. The discount rate at year-end fiscal 2012 was 4.30%. Pension expense is also impacted by the expected long-term rate of return on plan assets, which the +Company determined to be 7.68% in fiscal 2012. This determination is based on both actual historical rates of return experienced by the pension assets and the long-term rate of return of a composite portfolio of equity and fixed income securities +that reflects the approximate diversification of the pension assets. +STOCK-BASED COMPENSATION +The Company accounts for stock-based compensation in accordance with the fair value recognition provisions of FASB ASC Topic 718, +Compensation—Stock Compensation . The Company utilizes the Black-Scholes model, which requires the input of subjective assumptions. These assumptions include estimating (a) the length of time employees will retain their vested stock +options before exercising them (“expected term”), (b) the volatility of the Company’s common stock price over the expected term and (c) the number of options that are expected to be forfeited. Changes in these assumptions +can materially affect the estimate of fair value of stock-based compensation and, consequently, the related expense amounts recognized in the consolidated statements of operations. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +In the normal course of +business, our financial position and results of operations are routinely subject to a variety of risks, including market risk associated with interest rate movements on borrowings and investments and currency rate movements on non-U.S. dollar +denominated assets, liabilities and cash flows. We regularly assess these risks and have established policies and business practices that should mitigate a portion of the adverse effect of these and other potential exposures. +Foreign Exchange Risk +The +Company faces market risk to the extent that changes in foreign currency exchange rates affect the Company’s foreign assets, liabilities and inventory purchase commitments and to the extent that its long-term debt requirements are affected by +changes in interest rates. The Company manages these risks by attempting to denominate contractual and other foreign arrangements in U.S. dollars. +Under the provisions of FASB ASC Topic 815, Derivatives and Hedging , the Company is required to recognize all derivatives on the balance sheet at fair value. Derivatives that are not qualifying +hedges must be adjusted to fair value through earnings. If a derivative is a qualifying hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of the hedged assets, +liabilities, or firm commitments through earnings or recognized in accumulated other comprehensive income until the hedged item is recognized in earnings. +The Company conducts wholesale operations outside of the U.S. in the United Kingdom, continental Europe and Canada where the functional currencies are primarily the British pound, euro and Canadian +dollar, respectively. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with U.S. +43 +dollar inventory purchases made by non-U.S. wholesale operations in the normal course of business. At December 29, 2012 and December 31, 2011, the Company had outstanding forward +currency exchange contracts to purchase $111.9 million and $106.3 million, respectively, of U.S. dollars with maturities ranging up to 336 days for both fiscal years. +The Company also has production facilities in the Dominican Republic and sourcing locations in Asia, where financial statements reflect the U.S. dollar as the functional currency. However, operating costs +are paid in the local currency. Royalty revenue generated by the Company from third-party foreign licensees is calculated in the licensees’ local currencies, but paid in U.S. dollars. Accordingly, the Company’s reported results are subject +to foreign currency exposure for this stream of revenue and expenses. +Assets and liabilities outside the U.S. are primarily located in the +United Kingdom, Canada and the Netherlands. The Company’s investments in foreign subsidiaries with a functional currency other than the U.S. dollar are generally considered long-term. Accordingly, the Company currently does not hedge these net +investments. At December 29, 2012, a weaker U.S. dollar compared to foreign currencies increased the value of these investments in net assets by $5.7 million. At December 31, 2011, a stronger U.S. dollar compared to foreign currencies +versus the prior year decreased the value of these investments in net assets by $11.3 million. These changes resulted in cumulative foreign currency translation adjustments at December 29, 2012 and December 31, 2011 of $5.9 million and +$0.3 million, respectively, that are deferred and recorded as a component of accumulated other comprehensive income in stockholders’ equity. +Interest Rate Risk +The Company is exposed to interest rate changes primarily as a +result of interest expense on borrowings used to finance acquisitions and working capital requirements. The Company’s total variable-rate debt was $875.0 million at the end of fiscal 2012. At the end of fiscal 2012, the Company held one +interest rate swap agreement denominated in US dollars that effectively converts $462.2 million of its variable-rate debt to fixed-rate debt. The interest rate swap derivative instrument is held and used by the Company as a tool for managing +interest rate risk. The counterparty to the swap instrument is a large financial institution that the Company believes is of high-quality creditworthiness. While the Company may be exposed to potential losses due to the credit risk of +non-performance by this counterparty, such losses are not anticipated. The fair value of the interest rate swap was recorded within other liabilities for $1.5 million at the end of fiscal 2012. As of December 29, 2012, the weighted-average +interest rate on the company’s variable-rate debt was approximately 3.0 percent. Based on the level of variable-rate debt outstanding as of that date, a one percentage-point increase in the weighted-average interest rate would increase the +company’s annual pre-tax interest expense by approximately $8.8 million. +The Company does not enter into contracts for speculative or +trading purposes, nor is it a party to any leveraged derivative instruments. +OFF-BALANCE SHEET ARRANGEMENTS +The Company has no off-balance sheet arrangements as of December 29, 2012. +44 +CONTRACTUAL OBLIGATIONS +The Company has the following payments under contractual obligations due by period: +Total +Less than +1 year +1-3 years +3-5 years +More than +5 years +(Thousands of Dollars) +Operating leases +$ +285,555 +$ +50,791 +$ +86,609 +$ +59,158 +$ +88,997 +Debt obligations (1 ) +1,565,860 +76,743 +214,969 +498,826 +775,322 +Purchase obligations (2 ) +396,558 +396,558 +– +– +– +Deferred compensation +3,790 +689 +998 +845 +1,258 +Pension (3 ) +2,367 +2,367 +– +– +– +SERP +35,591 +2,367 +7,127 +7,577 +18,520 +Dividends declared +5,869 +5,869 +– +– +– +Minimum royalties +5,237 +2,067 +3,170 +– +– +Minimum advertising +31,353 +6,695 +16,531 +5,470 +2,657 +Other ( 4 ) +5,376 +5,351 +25 +– +– +Total ( 5 ) +$ +2,337,556 +$ +549,497 +$ +329,429 +$ +571,876 +$ +886,754 +(1) +Includes interest payments on the Company’s long-term debt and payments on the interest rate swap. Estimated future interest payments on outstanding debt +obligations are based on interest rates as of December 29, 2012. Actual cash outflows may differ significantly due to changes in underlying interest rates. +(2) +Purchase obligations related primarily to inventory and capital expenditure commitments. +(3) +Pension obligations reflect expected pension funding as there are currently no required funding obligations under government regulation. Funding amounts are calculated +on an annual basis and no required or planned funding beyond one year has been determined. +(4) +The amounts in the other category relate primarily to employee retention commitments. +(5) +The Company adopted FASB ASC Topic 740, Income Taxes, on December 31, 2006. The total amount of unrecognized tax benefits on the Consolidated Balance Sheet +at December 29, 2012 is $8.5 million. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes. As a +result, this amount is not included in the table above. +At December 29, 2012, the Company had $198.1 million of additional +borrowing capacity available under the Revolving Credit Facility which terminates on October 9, 2017. +Item 7A. Quantitative and Qualitative Disclosures About Market +Risk +The response to this Item is set forth under the caption “Quantitative and Qualitative Disclosures About Market Risk” +in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and is incorporated herein by reference. +Item 8. Financial Statements and Supplementary Data +The response to this Item is set forth in Appendix A of this Annual Report on Form 10-K and is incorporated herein by reference. +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +None. +Item 9A. Controls and Procedures +Evaluation of Disclosure Controls and Procedures +An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of +the design and +45 +operation of the Company’s disclosure controls and procedures. Based on and as of the time of such evaluation, the Company’s management, including the Chief Executive Officer and Chief +Financial Officer, concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report. +Management’s Report on Internal Control Over Financial Reporting +Management is +responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Under the supervision and with the participation of management, including our Chief +Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of internal control over financial reporting as of December 29, 2012, based on the framework in Internal Control—Integrated Framework issued by +the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on that evaluation, management concluded that internal control over financial reporting was effective as of December 29, 2012. +Based on the Securities and Exchange Commission’s staff interpretation guidance for newly acquired businesses, management’s assessment of and +conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of the Performance + Lifestyle Group Business, which was included in the Company’s fiscal 2012 consolidated financial statements +since the acquisition date of October 9, 2012. PLG constituted 66% of total assets as of December 29, 2012 and 13% of revenues for the year then fiscal year-ended. +The effectiveness of the Company’s internal control over financial reporting as of December 29, 2012 has been audited by Ernst & Young LLP, an independent registered public accounting +firm, as stated in its report, which is included in Appendix A and is incorporated into this Item 9A by reference. +Changes in +Internal Control Over Financial Reporting +There was no change in the Company’s internal control over financial reporting that +occurred during the sixteen-week period ended December 29, 2012 that has materially affected, or that is reasonably likely to materially affect, the Company’s internal control over financial reporting. +Item 9B. Other Information +None. +PART III +Item 10. Directors, Executive Officers and Corporate Governance +The +Company’s Audit Committee is comprised of four Board members, all of whom are independent under independence standards adopted by the Board and applicable SEC regulations and New York Stock Exchange standards (including independence standards +related specifically to Audit Committee membership). The Audit Committee members each have financial and business experience with companies of substantial size and complexity and have an understanding of financial statements, internal controls and +audit committee functions. The Company’s Board of Directors has determined that Jeffrey M. Boromisa and William K. Gerber are audit committee financial experts, as defined by the SEC. Additional information regarding the Audit Committee is +provided in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 18, 2013, under the caption “Corporate Governance” under the subheading “Board Committees.” +The Company has adopted an Accounting and Finance Code of Ethics that applies to the Company’s principal executive officer, principal +financial officer and principal accounting officer, and has adopted a Code of Conduct & Compliance that applies to the Company’s directors and employees. The Accounting and Finance +46 +Code of Ethics and the Code of Conduct & Compliance are available on the Company’s website at www.wolverineworldwide.com/investor-relations/corporate-governance . Any waiver +from the Accounting and Finance Code of Ethics or the Code of Conduct & Compliance with respect to the Company’s executive officers and directors will be disclosed on the Company’s website. Any amendment to the Accounting and +Finance Code of Ethics and the Code of Conduct & Compliance will be disclosed on the Company’s website. +The information +regarding directors of the Company contained under the caption “Board of Directors” in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 18, 2013, is incorporated +herein by reference. +The information regarding directors and executive officers of the Company under the caption “Additional +Information” under the subheading “Section 16(a) Beneficial Ownership Reporting Compliance” in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 18, 2013, is +incorporated herein by reference. +Item 11. Executive +Compensation +The information contained under the captions “Non-Employee Director Compensation in Fiscal Year 2012,” +“Compensation Discussion and Analysis,” “Compensation Committee Report,” “Summary Compensation Table,” “Grants of Plan-Based Awards in Fiscal Year 2012,” “Outstanding Equity Awards at 2012 Fiscal +Year-End,” “Option Exercises and Stock Vested in Fiscal Year 2012,” “Pension Plans and 2012 Pension Benefits” and “Potential Payments Upon Termination or Change in Control” in the Definitive Proxy Statement of the +Company with respect to the Annual Meeting of Stockholders to be held on April 18, 2013, is incorporated herein by reference. The information contained under the caption “Corporate Governance” under the subheadings “Risk +Considerations in Compensation Programs” and “Board Committees” in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 18, 2013, is also incorporated herein by +reference. +Item 12. Security Ownership of +Certain Beneficial Owners and Management and Related Stockholder Matters +The information contained under the caption “Securities +Ownership of Officers and Directors and Certain Beneficial Owners” and “Equity Compensation Plan Information” contained in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on +April 18, 2013, is incorporated herein by reference. +Item 13. Certain Relationships and Related Transactions, and Director +Independence +The information contained under the caption “Related Party Matters” under the subheadings “Certain +Relationships and Related Transactions” and “Related Person Transactions Policy” contained in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 18, 2013, is +incorporated herein by reference. The information contained under the caption “Corporate Governance” under the subheading “Director Independence” contained in the Definitive Proxy Statement of the Company with respect to the +Annual Meeting of Stockholders to be held on April 18, 2013, is incorporated herein by reference. +Item 14. Principal Accountant Fees and Services +The information contained under the caption “Independent Registered Public Accounting Firm” in the Definitive Proxy Statement of the Company +with respect to the Annual Meeting of Stockholders to be held on April 18, 2013, is incorporated herein by reference. +47 +PART IV +Item 15. Exhibits and Financial Statement Schedules +Item 15(a)(1). Financial Statements Attached as Appendix A +The following consolidated financial statements of Wolverine World Wide, Inc. and its subsidiaries are filed as a part of this report: +• +Consolidated Balance Sheets as of December 29, 2012 and December 31, 2011. +• +Consolidated Statements of Stockholders’ Equity for the Fiscal Years Ended December 29, 2012, December 31, 2011 and January 1, +2011. +• +Consolidated Statements of Operations and Comprehensive Income for the Fiscal Years Ended December 29, 2012, December 31, 2011 and +January 1, 2011. +• +Consolidated Statements of Cash Flows for the Fiscal Years Ended December 29, 2012, December 31, 2011 and January 1, 2011. +• +Notes to the Consolidated Financial Statements. +• +Reports of Independent Registered Public Accounting Firm. +Item 15(a)(2). Financial Statement Schedules Attached as Appendix B +The following consolidated financial statement schedule of Wolverine World Wide, Inc. and its subsidiaries is filed as a part of this report: +• +Schedule II—Valuation and Qualifying Accounts. +All other schedules (I, III, IV, and V) for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and, therefore, +have been omitted. +Item 15(a)(3). Exhibits +The following exhibits are filed as part of this report: +Exhibit +Number +Document +2.1 +Agreement and Plan of Merger, dated as of May 1, 2012, by and among WBG-PSS Holdings LLC, WBG-PSS Merger Sub Inc., Collective Brands, Inc. and Wolverine World Wide, +Inc. Previously filed as Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on May 4, 2012. Here incorporated by reference. +3.1 +Restated Certificate of Incorporation. Previously filed as Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the period ended December 30, 2006. Here incorporated by +reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on October 16, 2012. Here incorporated by +reference. +4.1 +Senior Notes Indenture, dated October 9, 2012, among Wolverine World Wide, Inc., the guarantors named therein, and Wells Fargo Bank, National Association. Previously filed as +Exhibit 4.1 to the Company’s Current Report on Form 8-K filed on October 9, 2012. Here incorporated by reference. +4.2 +Form of 6.125% Senior Note due 2020. Previously filed as Exhibit 4.2 to the Company’s Current Report on Form 8-K filed on October 9, 2012. Here incorporated by +reference. +4.3 +Registration Rights Agreement, dated October 9, 2012, among the Wolverine World Wide, Inc., the guarantors named therein and J.P. Morgan Securities LLC, as representative of the +several initial purchasers. Previously filed as Exhibit 4.3 to the Company’s Current Report on Form 8-K filed on October 9, 2012. Here incorporated by reference. +48 +Exhibit +Number +Document +10.1 +1993 Stock Incentive Plan, as amended and restated.* Previously filed as Exhibit 10.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10.2 +Amended and Restated 1995 Stock Incentive Plan.* Previously filed as Exhibit 10.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.3 +Amended and Restated 1997 Stock Incentive Plan.* Previously filed as Exhibit 10.3 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.4 +Amended and Restated Stock Incentive Plan of 1999.* Previously filed as Exhibit 10.4 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.5 +Amended and Restated Stock Incentive Plan of 2001.* Previously filed as Exhibit 10.5 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.6 +Amended and Restated Stock Incentive Plan of 2003.* Previously filed as Exhibit 10.6 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.7 +Amended and Restated Stock Incentive Plan of 2005.* Previously filed as Exhibit 10.7 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.8 +Amended and Restated Directors’ Stock Option Plan.* Previously filed as Exhibit 10.8 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10.9 +Amended and Restated Outside Directors’ Deferred Compensation Plan.* Previously filed as Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the fiscal year ended +December 29, 2007. Here incorporated by reference. +10.10 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on April 20, +2012. Here incorporated by reference. +10.11 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on +April 20, 2012. Here incorporated by reference. +10.12 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 29, 2007. Here +incorporated by reference. +10.13 +Executive Severance Agreement.* Previously filed as Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated by reference. A +participant schedule of current executive officers who are parties to this agreement is attached as Exhibit 10.13. +10.14 +Executive Severance Agreement.* Previously filed as Exhibit 10.14 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011. Here incorporated by +reference. A participant schedule of current executive officers who are parties to this agreement is attached as Exhibit 10.14. +49 +Exhibit +Number +Document +10.15 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and with Messrs. Grimes, Guerre, Jeppesen, Krueger and Zwiers and +Ms. Linton. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.16 +Amended and Restated Benefit Trust Agreement dated April 25, 2007.* Previously filed as Exhibit 10.5 to the Company’s Current Report on Form 8-K filed on April 25, 2007. +Here incorporated by reference. +10.17 +Employees’ Pension Plan (Restated as amended through January 1, 2013).* +10.18 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 15, 2005. Here incorporated by +reference. +10.19 +Form of Non-Qualified Stock Option Agreement for Blake W. Krueger and Timothy J. O’Donovan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 15, 2005. Here incorporated by reference. +10.20 +Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.19 applies.* Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 15, 2005. Here incorporated by reference. +10.21 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company’s Current Report on Form 8-K filed on February 15, 2005. Here incorporated by +reference. +10.22 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 17, 2006. Here incorporated by +reference. +10.23 +Form of Non-Qualified Stock Option Agreement for Blake W. Krueger and Timothy J. O’Donovan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 17, 2006. Here incorporated by reference. +10.24 +Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.23 applies.* Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 17, 2006. Here incorporated by reference. +10.25 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company’s Current Report on Form 8-K filed on February 17, 2006. Here incorporated by +reference. +10.26 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October 16, 2012. Here incorporated by +reference. +10.27 +Form of Stock Option Agreement for non-employee directors.* Previously filed as Exhibit 10.23 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 1, +2005. Here incorporated by reference. +10.28 +2009 Form of Non-Qualified Stock Option Agreement for Donald T. Grimes, Blake W. Krueger, Pamela L. Linton and James D. Zwiers.* Previously filed as Exhibit 10.26 to the +Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.29 +2009 Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.28 applies.* Previously filed as Exhibit 10.27 to the Company’s +Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.30 +Form of Performance Share Award Agreement (2011 – 2013 performance period).* Previously filed as Exhibit 10.30 to the Company’s Annual Report on Form 10-K for the fiscal +year ended January 1, 2011. Here incorporated by reference. +50 +Exhibit +Number +Document +10.31 +Form of Performance Share Award Agreement (2012 – 2014 performance period).* Previously filed as Exhibit 10.32 to the Company’s Annual Report on Form 10-K for the fiscal +year ended December 31, 2011. Here incorporated by reference. +10.32 +Form of Performance Share Award Agreement (2013 – 2015 performance period).* +10.33 +Separation Agreement between Wolverine World Wide, Inc. and Blake W. Krueger, dated as of March 13, 2008, as amended.* Previously filed as Exhibit 10.1 to the Company’s +Quarterly Report on Form 10-Q for the period ended March 22, 2008. Here incorporated by reference. +10.34 +First Amendment to Separation Agreement between Wolverine World Wide, Inc. and Blake W. Krueger, dated as of December 11, 2008.* Previously filed as Exhibit 10.30 to the +Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.35 +409A Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated by +reference. A participant schedule of current executive officers who participate in this plan is attached as Exhibit 10.35. +10.36 +Form of 409A Supplemental Retirement Plan Participation Agreement with Blake W. Krueger.* Previously filed as Exhibit 10.32 to the Company’s Annual Report on Form 10-K for the +fiscal year ended January 3, 2009. Here incorporated by reference. +10.37 +Outside Directors’ Deferred Compensation Plan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated +by reference. +10.38 +Stock Incentive Plan of 2010.* Previously filed as Exhibit 10.1 to the Company’s Registration Statement on Form S-8 filed on March 4, 2010. Here incorporated by +reference. +10.39 +Limited Guarantee, dated as of May 1, 2012, entered into by Wolverine World Wide, Inc. in favor of Collective Brands, Inc. Previously filed as Exhibit 10.1 to the +Company’s Current Report on Form 8-K filed on May 4, 2012. Here incorporated by reference. +10.40 +Purchase Agreement, dated as of May 1, 2012, by and between Open Water Ventures, LLC and WBG-PSS Holdings LLC. Previously filed as Exhibit 10.2 to the Company’s +Current Report on Form 8-K filed on May 4, 2012. Here incorporated by reference +10.41 +Interim Agreement, dated as of May 1, 2012, by and among Wolverine World Wide, Inc., WBG-PSS Holdings LLC, WBG-PSS Merger Sub Inc., Golden Gate Capital Opportunity Fund, L.P. and +Blum Strategic Partners IV, L.P. Previously filed as Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on May 4, 2012. Here incorporated by reference. +10.42 +Separation Agreement, dated as of May 1, 2012, by and between Wolverine World Wide, Inc. and WBG-PSS Holdings LLC. Previously filed as Exhibit 10.4 to the Company’s +Current Report on Form 8-K filed on May 4, 2012. Here incorporated by reference. +10.43 +Amendment No. 1 to Separation Agreement, dated as of October 9, 2012, by and between the Company and WBG–PSS Holdings LLC. Previously filed as Exhibit 10.2 to the +Company’s Current Report on Form 8-K filed on October 9, 2012. Here incorporated by reference. +10.44 +Amendment No. 1 to Purchase Agreement, dated as of October 9, 2012, by and between Open Water Ventures, LLC and WBG–PSS Holdings LLC. Previously filed as Exhibit 10.5 to the +Company’s Quarterly Report on Form 10-Q for the period ended September 8, 2012. Here incorporated by reference. +51 +Exhibit +Number +Document +10.45 +Credit Agreement, dated as of July 31, 2012, by and among Wolverine World Wide, Inc., as borrower, JPMorgan Chase Bank, N.A., as administrative agent and as a lender, J.P. +Morgan Europe Limited, as foreign currency agent, Wells Fargo Bank, National Association, as syndication agent and as a lender, Fifth Third Bank as documentation agent and as a lender, and PNC Bank, National Association, as documentation agent and +as a lender. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on August 1, 2012. Here incorporated by reference. +10.46 +First Amendment to Credit Agreement, dated as of September 28, 2012, by and among Wolverine World Wide, Inc., as borrower, JPMorgan Chase Bank, N.A., as administrative agent and as +a lender, J.P. Morgan Europe Limited, as foreign currency agent, Wells Fargo Bank, National Association, as syndication agent and as a lender, Fifth Third Bank as documentation agent and as a lender, and PNC Bank, National Association, as +documentation agent and as a lender. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October 4, 2012. Here incorporated by reference. +10.47 +Second Amendment to the Credit Agreement, dated as of October 8, 2012, among Wolverine World Wide, Inc., as borrower, JPMorgan Chase Bank, N.A., as administrative agent and as a +lender, J.P. Morgan Europe Limited, as foreign currency agent, Wells Fargo Bank, National Association, as syndication agent and as a lender, Fifth Third Bank, as documentation agent and as a lender, and PNC Bank, National Association, as +documentation agent and as a lender. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October 9, 2012. Here incorporated by reference. +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31.1 +Certification of Chairman, Chief Executive Officer and President under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Senior Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +101.INS +XBRL Instance Document +101.SCH +XBRL Taxonomy Extension Schema Document +101.CAL +XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF +XBRL Taxonomy Extension Definition Linkbase Document +101.LAB +XBRL Taxonomy Extension Label Linkbase Document +101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +* +Management contract or compensatory plan or arrangement. +The Company will furnish a copy of any exhibit listed above to any stockholder without charge upon written request to Mr. R. Paul Guerre, General Counsel and Secretary, 9341 Courtland Drive N.E., +Rockford, Michigan 49351. +52 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed +on its behalf by the undersigned, thereunto duly authorized. +WOLVERINE WORLD WIDE, INC. +Dated: February 27, 2013 +By: +/s/ Blake W. Krueger +Blake W. Krueger +Chairman, +Chief Executive Officer and President (Principal Executive Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following +persons on behalf of the Registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ Blake W. Krueger +Blake W. Krueger +Chairman, Chief Executive Officer and +President (Principal Executive Officer) +February 27, 2013 +/s/ Donald T. Grimes +Donald T. Grimes +Senior Vice President, Chief Financial +Officer and Treasurer +(Principal Financial and Accounting Officer) +February 27, 2013 +*/s/ Jeffrey M. Boromisa +Jeffrey M. Boromisa +Director +February 27, 2013 +*/s/ William K. Gerber +William K. Gerber +Director +February 27, 2013 +*/s/ Alberto L. Grimoldi +Alberto L. Grimoldi +Director +February 27, 2013 +*/s/ Joseph R. Gromek +Joseph R. Gromek +Director +February 27, 2013 +*/s/ David T. Kollat +David T. Kollat +Director +February 27, 2013 +/s/ Blake W. Krueger +Blake W. Krueger +Director +February 27, 2013 +*/s/ Brenda J. Lauderback +Brenda J. Lauderback +Director +February 27, 2013 +*/s/ Nicholas T. Long +Nicholas T. Long +Director +February 27, 2013 +*/s/ Timothy J. O’Donovan +Timothy J. O’Donovan +Director +February 27, 2013 +53 +Signature +Title +Date +*/s/ Shirley D. Peterson +Shirley D. Peterson +Director +February 27, 2013 +*/s/ Michael A. Volkema +Michael A. Volkema +Director +February 27, 2013 +*By /s/ Blake W. Krueger +Blake W. Krueger +Attorney-in-Fact +Chairman, Chief Executive Officer and +President +February 27, 2013 +54 +APPENDIX A +Financial Statements +CONSOLIDATED BALANCE SHEETS +As of Fiscal Year-End +2012 +2011 +(Thousands of Dollars, Except Share and Per Share Data) +ASSETS +Current assets: +Cash and cash equivalents +$ +171,411 +$ +140,012 +Accounts receivable, less allowances (2012 – $14,829; 2011 – $12,688) +353,615 +219,963 +Inventories +Finished products +431,817 +204,546 +Raw materials and work-in-process +34,413 +27,192 +466,230 +231,738 +Deferred income taxes +27,955 +9,801 +Prepaid expenses and other current assets +55,714 +32,982 +Total current assets +1,074,925 +634,496 +Property, plant and equipment: +Land +3,926 +826 +Buildings and improvements +107,027 +73,926 +Machinery and equipment +180,030 +135,118 +Software +93,812 +83,809 +384,795 +293,679 +Accumulated depreciation +(235,067 +) +(215,190 +) +149,728 +78,489 +Other assets: +Goodwill and indefinite-lived intangibles +1,139,725 +56,269 +Other amortizable intangibles, net +153,478 +1,125 +Deferred income taxes +946 +42,349 +Deferred financing costs, net +38,894 +– +Other +56,738 +38,924 +1,389,781 +138,667 +Total assets +$ +2,614,434 +$ +851,652 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable +$ +160,895 +$ +57,099 +Accrued salaries and wages +36,374 +22,635 +Income taxes +2,556 +2,822 +Taxes, other than income taxes +14,536 +8,093 +Restructuring reserve +75 +330 +Other accrued liabilities +71,720 +44,033 +Accrued pension liabilities +2,428 +2,151 +Current maturities of long-term debt +30,750 +515 +Borrowings under revolving credit agreement +– +11,000 +Total current liabilities +319,334 +148,678 +Long-term debt, less current maturities +1,219,250 +– +Accrued pension liabilities +165,462 +103,825 +Deferred income taxes +240,523 +– +Other liabilities +26,168 +20,499 +Stockholders’ equity: +Common stock, $1 par value: authorized 160,000,000 shares; shares issued, including treasury shares: 2012 – 66,515,620; 2011 +– 65,019,406 +66,515 +65,019 +Additional paid-in capital +173,915 +138,585 +Retained earnings +946,766 +889,765 +Accumulated other comprehensive loss +(87,542 +) +(71,029 +) +Cost of shares in treasury: 2012 – 17,182,019 shares; 2011 – 16,848,374 +shares +(457,262 +) +(443,690) +Total Wolverine World Wide, Inc. stockholders’ equity +642,392 +578,650 +Non-controlling interest +1,305 +– +Total stockholders’ equity +643,697 +578,650 +Total liabilities and stockholders’ equity +$ +2,614,434 +$ +851,652 +See accompanying notes to consolidated financial statements. +A-1 +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +Fiscal Year +2012 +2011 +2010 +(Thousands of Dollars, Except Share and Per Share Data) +COMMON STOCK OUTSTANDING +Balance at beginning of the year +$ +65,019 +$ +63,976 +$ +62,764 +Common stock issued under stock incentive plans, net of forfeitures (2012 – +1,496,214 shares; 2011 – 1,043,019 shares; 2010 – 1,212,463 shares) +1,496 +1,043 +1,212 +Balance at end of the year +66,515 +65,019 +63,976 +ADDITIONAL PAID-IN CAPITAL +Balance at beginning of the year +138,585 +108,286 +81,021 +Stock-based compensation expense +14,988 +14,074 +11,543 +Amounts associated with common stock issued under stock incentive plans: +Proceeds over par value +9,556 +4,919 +6,289 +Income tax benefits +10,983 +4,071 +4,094 +Issuance of performance-based shares (2012 – 197,304 shares; +2011 – 206,148 shares; 2010 – 215,027 +shares) +(197 +) +7,550 +5,197 +Issuance of treasury shares (2012 –20,766 shares; 2011 – 24,354 shares; 2010 – 25,829 shares) +– +(315 +) +142 +Balance at end of the year +173,915 +138,585 +108,286 +RETAINED EARNINGS +Balance at beginning of the year +889,765 +789,684 +706,439 +Net earnings attributable to Wolverine World Wide, Inc. +80,686 +123,287 +104,470 +Cash dividends declared (2012 – $0.48 per share; 2011 – $0.48 per share; 2010 – $0.44 per share) +(23,685 +) +(23,206 +) +(21,225 +) +Balance at end of the year +946,766 +889,765 +789,684 +ACCUMULATED OTHER COMPREHENSIVE LOSS +Balance at beginning of the year +(71,029 +) +(41,123 +) +(42,806 +) +Other comprehensive income (loss) +(16,513 +) +(29,906 +) +1,683 +Balance at end of the year +(87,542 +) +(71,029 +) +(41,123 +) +COST OF SHARES IN TREASURY +Balance at beginning of the year +(443,690 +) +(376,926 +) +(325,385 +) +Common stock acquired for treasury (2012 – 354,411 shares; +2011 – 1,895,893 shares; 2010 – 1,832,193 +shares) +(14,121 +) +(67,388 +) +(52,190 +) +Issuance of treasury shares (2012 – 20,766 shares; 2011 – 24,354 shares; 2010 – 25,829 +shares) +549 +624 +649 +Balance at end of the year +(457,262 +) +(443,690 +) +(376,926 +) +Total Wolverine World Wide, Inc. equity +642,392 +578,650 +543,897 +NON-CONTROLLING INTEREST +Balance at beginning of the year +– +– +– +Net earnings +78 +– +– +Capital contribution from non-controlling interest +1,225 +– +– +Foreign currency translation +2 +– +– +Balance at end of the year +1,305 +– +– +TOTAL STOCKHOLDERS’ EQUITY +$ +643,697 +$ +578,650 +$ +543,897 +See accompanying notes to consolidated financial statements. +A-2 +CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME +Fiscal Year +2012 +2011 +2010 +(Thousands of Dollars, Except Per Share Data) +Revenue +$ +1,640,838 +$ +1,409,068 +$ +1,248,517 +Cost of goods sold +1,008,197 +852,316 +754,537 +Non-recurring transaction and integration costs +4,481 +– +– +Restructuring and other transition costs +– +– +1,406 +Gross profit +628,160 +556,752 +492,574 +Selling, general and administrative expenses +481,899 +386,534 +347,499 +Non-recurring transaction and integration costs +32,537 +– +– +Restructuring and other transition costs +– +– +2,828 +Operating profit +113,724 +170,218 +142,247 +Other expenses (income): +Interest expense +14,597 +1,395 +571 +Non-recurring acquisition related interest expense +5,197 +– +– +Interest income +(565 +) +(370 +) +(184 +) +Other expense (income)—net +317 +283 +(1,366 +) +19,546 +1,308 +(979 +) +Earnings before income taxes +94,178 +168,910 +143,226 +Income taxes +13,414 +45,623 +38,756 +Net earnings +80,764 +123,287 +104,470 +Net earnings attributable to non-controlling interests +78 +– +– +Net earnings attributable to Wolverine World Wide, Inc. +$ +80,686 +$ +123,287 +$ +104,470 +Net earnings per share (see Note 1): +Basic +$ +1.67 +$ +2.54 +$ +2.15 +Diluted +$ +1.63 +$ +2.48 +$ +2.11 +Other comprehensive income (loss), net of tax: +Foreign currency translation adjustments +$ +5,684 +$ +(11,290 +) +$ +(2,929 +) +Change in fair value of foreign exchange contracts +(5,025 +) +5,110 +1,731 +Change in fair value of interest rate swap +(1,001 +) +– +– +Pension adjustments +(16,171 +) +(23,726 +) +2,881 +Other comprehensive income +(16,513 +) +(29,906 +) +1,683 +Comprehensive income +64,251 +93,381 +106,153 +Less: comprehensive loss attributable to non-controlling interest +(35 +) +– +– +Comprehensive income attributable to Wolverine World Wide, Inc. +$ +64,286 +$ +93,381 +$ +106,153 +See accompanying notes to consolidated financial statements. +A-3 +CONSOLIDATED STATEMENTS OF CASH FLOWS +Fiscal Year +2012 +2011 +2010 +(Thousands of Dollars) +OPERATING ACTIVITIES +Net earnings +$ +80,764 +$ +123,287 +$ +104,470 +Adjustments necessary to reconcile net earnings to net cash provided by operating activities: +Depreciation +21,173 +14,870 +14,509 +Amortization +6,478 +1,037 +1,692 +Deferred income taxes +(4,248 +) +7,676 +(4,298 +) +Stock-based compensation expense +14,988 +14,074 +11,543 +Excess tax benefits from stock-based compensation +(9,928 +) +(3,255 +) +(1,362 +) +Pension contribution +(26,657 +) +(31,800 +) +(10,400 +) +Pension expense +27,902 +17,502 +16,286 +Restructuring and other transition costs +– +– +4,234 +Cash payments related to restructuring and other transition costs +– +(984 +) +(7,516 +) +Other +4,802 +11,271 +3,524 +Changes in operating assets and liabilities: +Accounts receivable +15,136 +(24,802 +) +(32,466 +) +Inventories +(29,334 +) +(25,101 +) +(49,084 +) +Other operating assets +(17,084 +) +(21,578 +) +(1,009 +) +Accounts payable +5,907 +(7,054 +) +21,672 +Income taxes +(266 +) +76 +(11,888 +) +Other operating liabilities +2,007 +3,595 +7,959 +Net cash provided by operating activities +91,640 +78,814 +67,866 +INVESTING ACTIVITIES +Business acquisition, net of cash acquired +(1,225,880 +) +– +– +Additions to property, plant and equipment +(14,942 +) +(19,397 +) +(16,370 +) +Investments in joint venture +(2,942 +) +– +– +Proceeds from sales of property, plant and equipment +49 +50 +1,756 +Other +(2,391 +) +(3,236 +) +(2,424 +) +Net cash used in investing activities +(1,246,106 +) +(22,583 +) +(17,038 +) +FINANCING ACTIVITIES +Net borrowings (repayments) under revolver +(11,000 +) +11,000 +– +Borrowings of long-term debt +1,275,000 +– +– +Payments of long-term debt +(25,515 +) +(530 +) +(538 +) +Payments of debt issuance costs +(40,121 +) +– +– +Cash dividends paid +(23,649 +) +(22,737 +) +(21,414 +) +Purchase of common stock for treasury +(14,121 +) +(67,388 +) +(52,190 +) +Proceeds from shares issued under stock incentive plans +11,642 +14,083 +13,631 +Excess tax benefits from stock-based compensation +9,928 +3,255 +1,362 +Contributions from non-controlling interests +1,225 +– +– +Net cash provided by (used) in financing activities +1,183,389 +(62,317 +) +(59,149 +) +Effect of foreign exchange rate changes +2,476 +(4,302 +) +(1,718 +) +Increase (decrease) in cash and cash equivalents +31,399 +(10,388 +) +(10,039 +) +Cash and cash equivalents at beginning of the year +140,012 +150,400 +160,439 +Cash and cash equivalents at end of the year +$ +171,411 +$ +140,012 +$ +150,400 +OTHER CASH FLOW INFORMATION +Interest paid +$ +10,030 +$ +840 +$ +192 +Net income taxes paid +$ +16,258 +$ +29,967 +$ +30,604 +See accompanying notes to consolidated financial statements. +A-4 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +All amounts are in thousands of dollars except share and per share data and elsewhere as noted. +1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Nature of Operations +Wolverine World Wide, Inc. is a leading designer, manufacturer and marketer of a broad range of quality casual footwear and apparel; performance outdoor and athletic footwear and apparel; children’s +footwear, industrial work shoes, boots and apparel; and uniform shoes and boots. The Company’s portfolio of owned and licensed brands includes: Bates ® , Cat ® Footwear, +Chaco ® , Cushe ® , Harley-Davidson ® +Footwear, Hush Puppies ® , HyTest ® , Keds ® , Merrell ® , Patagonia ® Footwear, Saucony ® , Sebago ® , Soft Style ® Sperry Top-Sider ® , Stride +Rite ® and Wolverine ® Licensing and distribution arrangements with third parties extend the global reach of the Company’s brand portfolio. The Company also operates a consumer-direct +division to market both its own brands and branded footwear and apparel from other manufacturers as well as a leathers division that markets Wolverine Performance Leathers ™. +Principles of Consolidation +The +consolidated financial statements include the accounts of Wolverine World Wide, Inc. and its wholly-owned subsidiaries (collectively, the “Company”). All intercompany accounts and transactions have been eliminated in consolidation. +Fiscal Year +The +Company’s fiscal year is the 52- or 53-week period that ends on the Saturday nearest to December 31. All fiscal years presented herein are 52-week periods. +Use of Estimates +The preparation of financial statements in conformity with accounting +principles generally accepted in the United States (U.S.) requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those +estimates. +Revenue Recognition +Revenue is recognized on the sale of products manufactured or sourced by the Company when the related goods have been shipped, legal title has passed to the customer and collectability is reasonably +assured. Revenue generated through licensees and distributors involving products bearing the Company’s trademarks is recognized as earned according to stated contractual terms upon either the purchase or shipment of branded products by +licensees and distributors. +The Company records provisions for estimated sales returns and allowances at the time of sale based on historical +rates of returns and allowances and specific identification of outstanding returns not yet received from customers. However, estimates of actual returns and allowances in any future period are inherently uncertain and actual returns and allowances +may differ from these estimates. If actual or expected future returns and allowances were significantly greater or lower than established reserves, a reduction or increase to net revenues would be recorded in the period this determination was made. +Cost of Goods Sold +Cost of +goods sold includes the actual product costs, including inbound freight charges and certain outbound freight charges, purchasing, sourcing, inspection and receiving costs. Warehousing costs are included in selling, general and administrative +expenses. +Shipping and Handling Costs +Shipping and handling costs that are charged to and reimbursed by the customer are recognized as revenue, while the related expenses incurred by the Company are recorded as cost of goods sold. +A-5 +Cash Equivalents +Cash equivalents include highly liquid investments with an original maturity of three months or less. Cash equivalents are stated at cost, which approximates market. +Allowance for Uncollectible Accounts +The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from its customers’ inability to make +required payments. Company management evaluates the allowance for uncollectible accounts receivable based on a review of current customer status and historical collection experience. +Inventories +The Company values its inventory at the lower of cost or market. Cost is +determined by the last-in, first-out (“LIFO”) method for all domestic raw materials and work-in-process inventories and certain domestic finished goods inventories. Cost is determined using the first-in, first-out (“FIFO”) method +for all raw materials, work-in-process and finished goods inventories in foreign countries; certain domestic finished goods inventories; and for all finished goods inventories of the Company’s consumer-direct business, due to the unique nature +of those operations. The Company has applied these inventory cost valuation methods consistently from year to year. +Property, Plant and +Equipment +Property, plant and equipment are stated on the basis of cost and include expenditures for computer hardware and software, store +furniture and fixtures, office furniture and machinery and equipment. Normal repairs and maintenance are expensed as incurred. +Depreciation +of property, plant and equipment is computed using the straight-line method. The depreciable lives range from 14 to 20 years for buildings and improvements and from 3 to 10 years for machinery, equipment and software. Leasehold improvements are +depreciated at the lesser of the estimated useful life or lease term, including reasonably-assured lease renewals as determined at lease inception. +Deferred Financing Costs +Deferred financing costs represent commitment fees, legal and +other third party costs associated with obtaining commitments for financing which result in a closing of such financings for the Company. These costs are amortized into earnings through interest expense over the terms of the respective agreements. +Costs incurred in seeking financing transactions which do not close are expensed in the period in which it is determined that the financing will not close. +Acquisitions +The Company accounts for acquired businesses using the purchase method of +accounting. Under the purchase method, the Company’s consolidated financial statements include the operations of an acquired business from the date of acquisition. In addition, the assets acquired and liabilities assumed are recorded at the +date of acquisition at their respective estimated fair values, with any excess of the purchase price over the estimated fair values of the net assets acquired recorded as goodwill. +Significant judgment is required in estimating the fair value of intangible assets and in assigning their respective useful lives. Accordingly, the Company typically obtains the assistance of third-party +valuation specialists for significant items. The fair value estimates are based on available historical information and on future expectations and assumptions deemed reasonable by management, but are inherently uncertain. +The Company typically uses an income method to estimate the fair value of intangible assets, which is based on forecasts of the expected future cash +flows attributable to the respective assets. Significant estimates and assumptions inherent in the valuations reflect a consideration of other marketplace participants and include the amount and timing of future cash flows (including expected growth +rates and profitability), the underlying product or technology life cycles, the economic barriers to entry and the discount rate applied to the cash flows. Unanticipated market or macroeconomic events and circumstances may occur that could affect +the accuracy or validity of the estimates and assumptions. +A-6 +Determining the useful life of an intangible asset also requires judgment. Certain intangibles are expected +to have indefinite lives based on their history and the Company’s plans to continue to support and build the acquired brands. Other acquired intangible assets (e.g., certain trademarks or brands, customer relationships, patents and +technologies) are expected to have determinable useful lives. The Company’s assessment as to trademarks and brands that have an indefinite life and those that have a determinable life is based on a number of factors including competitive +environment, market share, trademark and/or brand history, underlying product life cycles, operating plans and the macroeconomic environment of the countries in which the trademarks or brands are sold. The Company’s estimates of the useful +lives of determinable-lived intangibles are based primarily on these same factors. All of the Company’s acquired technology and customer-related intangibles are expected to have determinable useful lives. The costs of determinable-lived +intangibles are amortized to expense over their estimated life. +Goodwill and Other Intangibles +Goodwill represents the excess of the purchase price over the fair value of net tangible and identifiable intangible assets of acquired businesses. Other +intangibles consist primarily of trademarks and patents. Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment tests at least annually. The Company has adopted the provisions of ASU 2011-08, +which permits the Company to qualitatively assess indicators of the Company’s reporting unit’s fair value when it is unlikely that a reporting unit is impaired. After completing the qualitative assessment, the Company may also use +assumptions about expected future operating performance and utilize a discounted cash flow analysis to estimate fair value. If the recorded values of these assets are not recoverable, based on either the assessment screen or discounted cash flow +analysis, management performs the next step, which compares the fair value of the reporting unit to the recorded value of the tangible and intangible assets of the reporting units. Goodwill is considered impaired if the fair value of the tangible +and intangible assets exceeds the fair value of the reporting unit. +The Company adopted the provisions of ASU 2012-02, which allows the +Company to first assess qualitative factors to determine whether it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying value. The Company would not be required to quantitatively determine +the fair value of the indefinite-lived intangible unless the Company determines, based on the qualitative assessment, that it is more likely than not that its fair value is less than the carrying value. After completing the qualitative assessment, +the Company may determine it necessary to test indefinite-lived intangibles by comparison of the individual carrying values to the fair value. Future cash flows of the individual indefinite-lived intangible assets are used to measure their fair +value after consideration by management of certain assumptions, such as forecasted growth rates and cost of capital, which are derived from internal projections and operating plans. +The Company did not recognize any impairment charges for goodwill or indefinite-lived intangible assets during the fiscal years ended December 29, 2012, December 31, 2011 or January 1, 2011 +as the Company’s annual impairment testing indicated that all reporting unit goodwill and indefinite-lived intangible asset fair values exceed their respective recorded values. +A-7 +Other amortizable intangible assets are amortized using the straight-line method over their estimated useful +lives. Other amortizable intangible assets are included in other assets on the consolidated balance sheets. They consist primarily of customer relationships, patents, licensing arrangements, developed product technology and a customer backlog +intangible asset. The combined gross carrying value and accumulated amortization for these amortizable intangibles was as follows: +December 29, 2012 +Average +remaining +life (years) +Gross carrying +value +Accumulated +amortization +Net +Customer relationships +19 +$ +110,470 +$ +1,305 +$ +109,165 +Patent and trademarks +2 +8,362 +7,865 +497 +Licensing arrangements +4 +28,120 +1,533 +26,587 +Developed product technology +5 +14,547 +694 +13,853 +Backlog +1 +5,100 +2,354 +2,746 +Net favorable leases and other +2 +689 +59 +630 +Total +$ +167,288 +$ +13,810 +$ +153,478 +December 31, 2011 +Average +remaining +life (years) +Gross carrying +value +Accumulated +amortization +Net +Patent and trademarks +2 +$ +8,573 +$ +7,448 +$ +1,125 +Estimated aggregate amortization expense for such intangibles for each of the five fiscal years subsequent to 2012 is as +follows: +2013 +2014 +2015 +2016 +2017 +Amortization expense +$ +18,569 +$ +15,606 +$ +15,453 +$ +13,750 +$ +8,821 +The changes in the carrying amount of goodwill and other non-amortizable intangibles for the years ended +December 29, 2012 and December 31, 2011 are as follows: +Goodwill +Other +non-amortizable +intangibles +Total +Balance at January 1, 2011 +$ +39,014 +$ +16,464 +$ +55,478 +Intangibles purchased +— +1,074 +1,074 +Intangibles disposed +— +(11 +) +(11 +) +Foreign currency translation effects +(120 +) +(152 +) +(272 +) +Balance at December 31, 2011 +$ +38,894 +$ +17,375 +$ +56,269 +Acquisition of PLG +419,611 +661,765 +1,081,376 +Foreign currency translation effects +1,417 +663 +2,080 +Balance at December 29, 2012 +$ +459,922 +$ +679,803 +$ +1,139,725 +Impairment of Long-Lived Assets +The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or an asset group may not be recoverable. Each impairment +test is based on a comparison of the carrying amount of the asset or asset group to the future undiscounted net cash flows expected to be generated by the asset or asset group. If such assets are considered to be impaired, the impairment amount to +be recognized is the amount by which the carrying value of the assets exceeds their fair value. +A-8 +Retirement Benefits +The determination of the obligation and expense for retirement benefits is dependent on the selection of certain actuarial assumptions used in calculating such amounts. These assumptions include, among +others, the discount rate, expected long-term rate of return on plan assets and rates of increase in compensation. These assumptions are reviewed with the Company’s actuaries and updated annually based on relevant external and internal factors +and information, including, but not limited to, long-term expected asset returns, rates of termination, regulatory requirements and plan changes. See Note 6 to the consolidated financial statements for additional information. +Stock-Based Compensation +The Company +accounts for stock-based compensation in accordance with the fair value recognition provisions of FASB ASC Topic 718, Compensation – Stock Compensation (“ASC 718”). The Company recognized compensation expense of $14,988, +$14,074, and $11,543 and related income tax benefits of $4,877, $4,540, and $3,552 for grants under its stock-based compensation plans in the statements of operations for the years ended December 29, 2012, December 31, 2011, and +January 1, 2011, respectively. +Stock-based compensation expense recognized in the consolidated condensed statements of operations for +the years ended December 29, 2012, December 31, 2011, and January 1, 2011, is based on awards ultimately expected to vest and, as such, has been reduced for estimated forfeitures. ASC 718 requires forfeitures to be estimated at +the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience. +The Company estimated the fair value of employee stock options on the date of grant using the Black-Scholes model. The estimated weighted-average fair value for each option granted was $10.72, $10.46, and +$6.97 per share for fiscal years 2012, 2011, and 2010, respectively, with the following weighted-average assumptions: +2012 +2011 +2010 +Expected market price volatility (1) +37.8% +38.6% +37.9% +Risk-free interest rate (2) +0.6% +1.8% +1.9% +Dividend yield (3) +1.3% +1.6% +1.9% +Expected term (4) +4 years +4 years +4 years +(1) +Based on historical volatility of the Company’s common stock. The expected volatility is based on the daily percentage change in the price of the stock over the +four years prior to the grant. +(2) +Represents the U.S. Treasury yield curve in effect for the expected term of the option at the time of grant. +(3) +Represents the Company’s cash dividend yield for the expected term. +(4) +Represents the period of time that options granted are expected to be outstanding. As part of the determination of the expected term, the Company concluded that all +employee groups exhibit similar exercise and post-vesting termination behavior. +The Company issued 1,917,020 shares of common +stock in connection with the exercise of stock options and new restricted stock grants during fiscal 2012. The Company cancelled 49,207 shares of common stock issued under restricted stock awards as a result of forfeitures during fiscal 2012. +Income Taxes +The provision +for income taxes is based on the geographic dispersion of the earnings reported in the consolidated financial statements. A deferred income tax asset or liability is determined by applying currently-enacted tax laws and rates to the cumulative +temporary differences between the carrying values of assets and liabilities for financial statement and income tax purposes. +The Company +records an increase in liabilities for income tax accruals associated with tax benefits claimed on tax returns but not recognized for financial statement purposes (unrecognized tax benefits). The Company recognizes interest and penalties related to +unrecognized tax benefits through interest expense and income tax expense, respectively. +A-9 +Earnings Per Share +The Company calculates earnings per share in accordance with FASB ASC Topic 260, Earnings Per Share (“ASC 260”). ASC 260 addresses whether instruments granted in share-based payment +transactions are participating securities prior to vesting, and therefore need to be included in the earnings allocation in computing earnings per share under the two-class method. Under the guidance in ASC 260, the Company’s unvested +share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents, whether paid or unpaid, are participating securities and must be included in the computation of earnings per share pursuant to the two-class method. +The following table sets forth the computation of basic and diluted earnings per share: +2012 +2011 +2010 +Numerator: +Net earnings attributable to Wolverine World Wide, Inc. +$ +80,686 +$ +123,287 +$ +104,470 +Adjustment for earnings allocated to nonvested restricted common stock +(1,669 +) +(2,627 +) +(1,608 +) +Net earnings used to calculate basic earnings per share +79,017 +120,660 +102,862 +Adjustment for earnings reallocated to nonvested restricted common stock +57 +112 +38 +Net earnings used to calculate diluted earnings per share +$ +79,074 +$ +120,772 +$ +102,900 +Denominator: +Weighted average shares outstanding +48,816,168 +48,910,599 +49,051,739 +Adjustment for nonvested restricted common stock +(1,378,918 +) +(1,432,541 +) +(1,206,460 +) +Shares used to calculate basic earnings per share +47,437,250 +47,478,058 +47,845,279 +Effect of dilutive stock options +1,077,076 +1,250,612 +1,011,731 +Shares used to calculate diluted earnings per share +48,514,326 +48,728,670 +48,857,010 +Net earnings per share: +Basic +$ +1.67 +$ +2.54 +$ +2.15 +Diluted +$ +1.63 +$ +2.48 +$ +2.11 +Options granted to purchase 387,591 shares of common stock in fiscal 2012, 338,877 shares in fiscal 2011, and 865,072 +shares in fiscal 2010 have not been included in the denominator for the computation of diluted earnings per share for each of those fiscal years because the related exercise prices were greater than the average market price for the year, and they +were, therefore, anti-dilutive. +Foreign Currency +For most of the Company’s international subsidiaries, the local currency is the functional currency. Assets and liabilities of these subsidiaries are translated into U.S. dollars at the year-end +exchange rate. Operating statement amounts are translated at average exchange rates for each period. The cumulative translation adjustments resulting from changes in exchange rates are included in the consolidated balance sheets as a component of +accumulated other comprehensive income (loss) in stockholders’ equity. Transaction gains and losses are included in the consolidated statements of operations and comprehensive income and were not material for fiscal years 2012, 2011 and 2010. +A-10 +Financial Instruments and Risk Management +The Company follows FASB ASC Topic 820, Fair Value Measurements and Disclosures (“ASC 820”), which provides a consistent definition of fair value, focuses on exit price, prioritizes the +use of market-based inputs over entity-specific inputs for measuring fair value and establishes a three-tier hierarchy for fair value measurements. This topic requires fair value measurements to be classified and disclosed in one of the following +three categories: +Level 1: +Fair value is measured using quoted prices (unadjusted) in active markets for identical assets and liabilities. +Level 2: +Fair value is measured using either direct or indirect inputs, other than quoted prices included within Level 1, which are observable for similar assets or +liabilities. +Level 3: +Fair value is measured using valuation techniques in which one or more significant inputs are unobservable. +The Company’s financial instruments consist of cash and cash equivalents, accounts and notes receivable, accounts +payable, foreign currency forward exchange contracts, an interest rate swap agreement, borrowings under the Company’s Revolving Credit Facility and long-term debt. The carrying amount of the Company’s financial instruments is historical +cost, which approximates their fair value, except for the interest rate swap and foreign currency forward exchange contracts, which are carried at fair value. As of December 29, 2012, the carrying value and the fair value of the Company’s +long-term debt, including current maturities, was $1,250,000 and $1,308,895. The Company does not hold or issue financial instruments for trading purposes. +The Company follows FASB ASC Topic 815, Derivatives and Hedging , which is intended to improve transparency in financial reporting and requires that all derivative instruments be recorded on the +consolidated balance sheets at fair value by establishing criteria for designation and effectiveness of hedging relationships. The Company utilizes foreign currency forward exchange contracts to manage the volatility associated with U.S. dollar +inventory purchases made by non-U.S. wholesale operations in the normal course of business. At December 29, 2012 and December 31, 2011, foreign exchange contracts with a notional value of $111,905 and $106,265, respectively, were +outstanding to purchase U.S. dollars with maturities ranging up to 336 days for each fiscal year. These contracts have been designated as cash flow hedges. +As of December 29, 2012 and December 31, 2011, a liability of $2,264 and an asset of $4,015, respectively, have been recognized for the fair value of the Company’s foreign currency forward +exchange contracts. As of December 29, 2012, a liability of $1,540 has been recognized for the fair value of the Company’s interest rate swap agreement. In accordance with ASC 820, these assets and liabilities fall within Level 2 of the +fair value hierarchy. The prices for the financial instruments are determined using prices for recently-traded financial instruments with similar underlying terms as well as directly or indirectly observable inputs. The Company did not have any +additional assets or liabilities that were measured at fair value on a recurring basis at December 29, 2012 and December 31, 2011. +The fair value of the foreign currency forward exchange contracts represents the estimated receipts or payments necessary to terminate the contracts. +Hedge effectiveness is evaluated by the hypothetical derivative method. Any hedge ineffectiveness is reported within the cost of goods sold caption of the consolidated condensed statements of operations. Hedge ineffectiveness was not material to the +Company’s consolidated condensed financial statements for fiscal years 2012, 2011, or 2010. If, in the future, the foreign exchange forward contracts are determined to be ineffective hedges or terminated before their contractual termination +dates, the Company would be required to reclassify into earnings all or a portion of the unrealized amounts related to the cash flow hedges that are currently included in accumulated other comprehensive income (loss) within stockholders’ +equity. +The Company has one interest rate swap agreement which exchanges floating rate for fixed rate interest payments over the life of the +agreement without the exchange of the underlying notional amounts. The notional amounts of the interest rate swap agreement are used to measure interest to be paid or received and do not +A-11 +represent the amount of exposure to credit loss. The differential paid or received on the interest rate swap agreements is recognized as an adjustment to interest expense. The Company’s +interest rate swap has a notional amount of $462,175, which reduces the Company’s exposure to fluctuations in interest rates on its variable rate debt. This derivative instrument was designated as a cash flow hedge of the debt and will expire +on October 6, 2017. In accordance with ASC 815, the Company formally documented the relationship between the interest rate swap and the variable rate borrowings, as well as its risk management objective and strategy for undertaking the hedge +transaction. This process included linking the derivative to the specific liability or asset on the balance sheet. The Company also assessed, both at the hedge’s inception and on an ongoing basis, whether the derivative used in the hedging +transaction was highly effective in offsetting changes in the cash flows of the hedged item. The effective portion of unrealized gains (losses) is deferred as a component of accumulated other comprehensive income (loss) and will be recognized in +earnings at the time the hedged item affects earnings. Any ineffective portion of the change in fair value will be immediately recognized in earnings. +For the fiscal years ended December 29, 2012 the Company recognized a net loss of $1,001 in accumulated other comprehensive income (loss) related to the effective portion of its interest rate swap +agreement. +A-12 +Accumulated Other Comprehensive Income (Loss) +Comprehensive income (loss) is comprised of all changes in shareholders’ equity during the period other than from transactions with shareholders. The +changes in accumulated balances for each component of other comprehensive income (loss) are as follows: +Foreign +Currency +translation +adjustments +Foreign +exchange +contracts +Interest +rate +swap +Pension +adjustments +Total +Balance of accumulated comprehensive income (loss) as of January 2, 2010 +$ +14,477 +$ +(3,546 +) +– +$ +(53,737 +) +$ +(42,806 +) +Foreign currency translation adjustments +(2,929 +) +(2,929 +) +Effective portion of changes related to foreign exchange contracts: +Net gain arising during the period, net of taxes: +2010 — ($228) +457 +457 +Reclassification adjustments into cost of goods sold, net of taxes: 2010 — ($522) +1,274 +1,274 +Pension adjustments: +Actuarial loss arising during the period, net of taxes: +2010 — $2,056 +(3,817 +) +(3,817 +) +Less: amortization of prior actuarial losses, net of taxes: 2010 — ($3,516) +6,530 +6,530 +Less: amortization of prior service cost, net of taxes: +2010 — ($90) +168 +168 +Balance of accumulated comprehensive income (loss) as of January 1, 2011 +11,548 +(1,815 +) +– +(50,856 +) +(41,123 +) +Foreign currency translation adjustments +(11,290 +) +(11,290 +) +Effective portion of changes related to foreign exchange contracts: +Net gain arising during the period, net of taxes: +2011 — ($977) +2,161 +2,161 +Reclassification adjustments into cost of goods sold, net of taxes: 2011 — ($1,369) +2,949 +2,949 +Pension adjustments: +Actuarial loss arising during the period, net of taxes: +2011 — $17,002 +(31,576 +) +(31,576 +) +Less: amortization of prior actuarial losses, net of taxes: 2011 — ($4,176) +7,756 +7,756 +Less: amortization of prior service cost, net of taxes: +2011 — ($51) +94 +94 +Balance of accumulated comprehensive income (loss) as of December 31, 2011 +258 +3,295 +– +(74,582 +) +(71,029 +) +Foreign currency translation adjustments +5,685 +5,685 +Effective portion of changes related to foreign exchange contracts: +Net loss arising during the period, net of taxes: +2012 — $981 +(2,147 +) +(2,147 +) +Reclassification adjustments into cost of goods sold, net of taxes: 2012 — $1,340 +(2,879 +) +(2,879 +) +Unrealized loss on interest rate swap, net of taxes: 2012 — $539 +(1,001 +) +(1,001 +) +Pension adjustments: +Actuarial loss arising during the period, net of taxes: +2012 — $16,045 +(29,797 +) +(29,797 +) +Less: amortization of prior actuarial losses, net of taxes: 2012 — ($7,293) +13,544 +13,544 +Less: amortization of prior service cost, net of taxes: +2012 — ($44) +82 +82 +Balance of accumulated comprehensive income (loss) as of December 29, 2012 +$ +5,943 +$ +(1,731 +) +$ +(1,001 +) +$ +(90,753 +) +$ +(87,542 +) +A-13 +2. INVENTORIES +Inventories of $62,731 at December 29, 2012 and $63,210 at December 31, 2011 have been valued using the LIFO method. If the +FIFO method had been used, inventories would have been $18,993 and $15,301 higher than reported at December 29, 2012 and December 31, 2011, respectively. +3. INDEBTEDNESS +Total borrowings consist of the following obligations: +2012 +2011 +Term Loan A, due October 9, 2017 +$ +550,000 +$ +– +Term Loan B, due October 9, 2019 +325,000 +– +Senior notes, 6.125% interest, due October 15, 2020 +375,000 +– +Notes payable +– +515 +Total debt obligations +1,250,000 +515 +Less: current maturities +30,750 +(515 +) +Total long-term debt +$ +1,219,250 +$ +– +In 2009, the Company entered into a $1.6 million note payable in connection with the Cushe ® acquisition. The note was payable over three years at a fixed interest rate of 4.5%. The Company paid the remaining +balance on this note during fiscal 2012. +On July 31, 2012, the Company entered into a new credit agreement (the “New Credit +Agreement”) with a bank syndicate. The New Credit Agreement provided the Company with a $1.1 billion secured credit facility consisting of a Term Loan A Facility in an aggregate amount of up to $550.0 million (the “Term Loan A +Facility”), a Term Loan B Facility in an aggregate amount up to $350.0 million (the “Term Loan B Facility”) and a Revolving Credit Facility in an aggregate amount of up to $200.0 million (the “Revolving Facility”). The New +Credit Agreement also provides the Company with the option to increase the aggregate principal amount of all facilities by up to an additional amount such that the total amount of all of the facilities does not exceed $1.3 billion As of +December 29, 2012, the only usage against the Revolving Facility was related to outstanding standby letters of credit totaling approximately $1.9 million. +As required by the New Credit Agreement, the Company also entered into an interest rate swap with a notional amount of $462.2 million that reduces the Company’s exposure to fluctuations in interest +rates on its variable rate debt. This derivative instrument was designated as a cash flow hedge of the debt. +The Term Loan A Facility and the +Revolving Credit Facility each have a term of five years and the Term Loan B Facility has a term of seven years. The initial interest rates applicable to amounts outstanding under the Term Loan A Facility and to U.S. dollar denominated amounts +outstanding under the Revolving Credit Facility will be, at the Company’s option, either (1) the alternate base rate as defined in the New Credit Agreement plus an applicable margin of 1.25%, or (2) the Eurocurrency Rate as defined in +the New Credit Agreement plus an applicable margin of 2.25%. The interest rate applicable to amounts outstanding under the Term Loan B Facility will be, at the Company’s option, either (1) the alternate base rate plus an applicable margin +of 2.00%, or (2) the Eurocurrency Rate plus an applicable margin of 3.00%. For fiscal 2012, the weighted average interest rates for Term Loan A and Term Loan B were 2.5% and 4.0%, respectively. +The Revolving Credit Facility includes a $100.0 million foreign currency subfacility under which borrowings may be made, subject to certain conditions, +in Canadian dollars, pounds sterling, euros, Hong Kong dollars, Swedish kronor, Swiss francs and such additional currencies determined in accordance with the New Credit Agreement. The Revolving Credit Facility also includes a $35.0 million swingline +subfacility and a $50.0 million letter of credit subfacility. +A-14 +The obligations of the Company pursuant to the New Credit Agreement will be guaranteed by substantially all +of the Company’s material domestic subsidiaries and secured by substantially all of the personal and real property of the Company and its material domestic subsidiaries, subject to certain exceptions. +The New Credit Agreement also contains certain affirmative and negative covenants, including covenants that limit the ability of the Company and its +Restricted Subsidiaries (as defined in the New Credit Agreement) to, among other things: incur or guarantee indebtedness; incur liens; pay dividends or repurchase stock; enter into transactions with affiliates; consummate asset sales, acquisitions +or mergers; prepay certain other indebtedness; or make investments, as well as covenants restricting the activities of certain foreign subsidiaries of the Company that hold intellectual property related assets. Further, the New Credit Agreement +requires compliance with the following financial covenants: a maximum Consolidated Leverage Ratio (as defined in the New Credit Agreement); a maximum Consolidated Secured Leverage Ratio; and a minimum Consolidated Interest Coverage Ratio (in each +case, as defined in the New Credit Agreement). As of December 29, 2012 the Company was in compliance with all such restrictions and financial covenants. +On October 9, 2012, the Company also issued a total of $375.0 million in senior notes in a private placement offering. The notes bear interest at 6.125% and are due in 2020 (the “Notes”). +Related interest payments are due semi-annually. The Notes are guaranteed by certain of the Company’s domestic subsidiaries. +The Company +incurred debt issuance costs of approximately $40.1 million to obtain financing, including underwriter, banker, legal and accounting fees that are capitalized and amortized to interest expense over the terms of the related borrowings. The Company +amortized approximately $1.8 million of deferred financing costs to interest expense during fiscal 2012. +The Company used the net proceeds +from the Notes, together with the borrowings under the Term Loan Facilities and cash on hand, to finance the acquisition of PLG, repay any amounts outstanding under, and terminate its existing Revolving Credit Facility and to provide for the working +capital needs of the Company, including the payment of transaction expenses in connection with the acquisition. +Cash flow from operations, +along with borrowings under the Revolving Credit Facility, if any, are expected to be sufficient to meet working capital needs for the foreseeable future. Any excess cash flows from operating activities are expected to be used to purchase property, +plant and equipment, reduce debt, fund internal and external growth initiatives, pay dividends or repurchase the Company’s common stock. +Annual maturities of long-term debt for the five fiscal years subsequent to December 29, 2012, are as follows: +2013 +2014 +2015 +2016 +2017 +Thereafter +Annual maturities of long-term debt +$ +30,750 +$ +59,063 +$ +61,688 +$ +82,313 +$ +332,438 +$ +683,748 +The above maturities exclude the recorded fair value of the Company’s interest rate swap arrangement, which was +recorded at fair value of $1.5 million within other liabilities as of December 29, 2012. Additional information regarding the interest rate swap is provided in Note 1 of the consolidated financial statements. +4. LEASES +The Company leases machinery, equipment, and certain warehouse, office and retail store space under operating lease agreements that +expire at various dates through 2023. Certain leases contain renewal provisions and generally require the Company to pay utilities, insurance, taxes and other operating expenses. +At December 29, 2012, minimum rental payments due under all non-cancelable leases were as follows: +2013 +2014 +2015 +2016 +2017 +Thereafter +Minimum rental payments +$ +50,791 +$ +45,998 +$ +40,611 +$ +34,688 +$ +24,470 +$ +88,997 +A-15 +Rental expense under all operating leases, consisting primarily of minimum rentals, totaled $29,414 in +fiscal 2012, $20,117 in fiscal 2011 and $18,919 in fiscal 2010. +5. CAPITAL STOCK +The Company has 2,000,000 authorized shares of $1 par value preferred stock, of which none was issued or outstanding as of +December 29, 2012 or December 31, 2011. The Company has designated 150,000 shares of preferred stock as Series A junior participating preferred stock and 500,000 shares of preferred stock as Series B junior participating preferred stock +for possible future issuance. +As of December 29, 2012, the Company had stock options outstanding under various stock incentive plans. As +of December 29, 2012, the Company had approximately 1,893,495 stock incentive units (stock options, stock appreciation rights, restricted stock, restricted stock units and common stock) available for issuance. Each option or stock appreciation +right granted counts as one stock incentive unit and all other awards granted, including restricted stock, count as two stock incentive units. Options granted under each plan have an exercise price equal to the fair market value of the underlying +stock on the grant date, expire no later than ten years from the grant date, and generally vest over three years. Restricted stock issued under these plans is subject to certain restrictions, including a prohibition against any sale, transfer, or +other disposition by the officer or employee during the vesting period (except for certain transfers for estate planning purposes for certain officers), and a requirement to forfeit all or a certain portion of the award upon certain terminations of +employment or upon failure to achieve performance criteria in certain instances. These restrictions typically lapse over a three- to five-year period from the date of the award. The Company has elected to recognize expense for these stock-based +incentive plans ratably over the vesting term on a straight-line basis. Certain option and restricted share awards provide for accelerated vesting under various scenarios, including retirement and upon a change in control of the Company. With regard +to acceleration of vesting upon retirement, employees of eligible retirement age are vested in accordance with plan provisions and applicable stock option and restricted stock agreements. The Company issues shares to plan participants upon exercise +or vesting of stock-based incentive awards from either authorized, but unissued, shares or treasury shares. +A summary of the transactions +under the stock option plans is as follows: +Shares +Under +Option +Weighted- +Average +Exercise +Price +Average +Remaining +Contractual +Term +(Years) +Aggregate +Intrinsic +Value +Outstanding at January 2, 2010 +4,619,346 +$ +20.17 +5.8 +$ +34,212 +Granted +537,807 +25.55 +Exercised +(848,106 +) +16.83 +Cancelled +(60,137 +) +23.84 +Outstanding at January 1, 2011 +4,248,910 +$ +21.47 +5.7 +$ +44,254 +Granted +398,749 +36.75 +Exercised +(887,671 +) +19.90 +Cancelled +(65,004 +) +26.79 +Outstanding at December 31, 2011 +3,694,984 +$ +23.40 +5.5 +$ +45,663 +Granted +451,277 +39.70 +Exercised +(1,364,751 +) +19.90 +Cancelled +(31,019 +) +35.55 +Outstanding at December 29, 2012 +2,750,491 +$ +27.67 +5.9 +$ +34,447 +Estimated forfeitures +(3,679 +) +Vested or expected to vest at December 29, 2012 +2,746,812 +$ +27.65 +5.9 +$ +34,444 +Nonvested at December 29, 2012 and expected to vest +(759,886 +) +Exercisable at December 29, 2012 +1,986,926 +$ +24.37 +5.0 +$ +31,419 +A-16 +The total pretax intrinsic value of options exercised during the years ended December 29, +2012, December 31, 2011 and January 1, 2011 was $30,088, $14,931 and $10,407, respectively. As of December 29, 2012, there was $2,931 of unrecognized compensation expense related to stock option grants that is expected to be +recognized over a weighted-average period of 1.2 years. As of December 31, 2011 and January 1, 2011, there was $2,414 and $2,393, respectively, of unrecognized compensation expense related to stock option awards that was expected to be +recognized over a weighted-average period of 1.0 and 1.1 years, respectively. +The aggregate intrinsic value in the preceding table represents +the total pretax intrinsic value, based on the Company’s closing stock price of $40.18 as of December 29, 2012, which would have been received by the option holders had all option holders exercised in-the-money options as of that date. The +total number of in-the-money options exercisable as of December 29, 2012 was 1,986,114 and the weighted-average exercise price was $24.36. As of December 31, 2011, 2,831,883 outstanding options were exercisable and the weighted-average +exercise price was $21.85. +Beginning in 2009, the Board of Directors has awarded an annual grant of performance share awards to the officers +of the Company. The number of performance-based shares that will be earned (and eligible to vest) during the performance period will depend on the Company’s level of success in achieving two specifically identified performance targets. Any +portion of the performance shares that are not earned by the end of the three-year measurement period will be forfeited. The final determination of the number of shares to be issued in respect to an award is determined by the Compensation Committee +of the Company’s Board of Directors. +A summary of the nonvested restricted shares issued under stock award plans is as follows: +Restricted +Awards +Weighted- +Average +Grant Date +Fair Value +Performance +Awards +Weighted- +Average +Grant Date +Fair Value +Nonvested at January 2, 2010 +640,470 +$ +21.34 +263,905 +$ +17.22 +Granted +262,342 +25.51 +215,027 +24.30 +Vested +(117,438 +) +22.71 +– +– +Forfeited +(21,828 +) +21.93 +(4,407 +) +17.11 +Nonvested at January 1, 2011 +763,546 +$ +22.55 +474,525 +$ +20.43 +Granted +200,427 +36.57 +206,148 +36.63 +Vested +(165,186 +) +24.27 +– +– +Forfeited +(52,858 +) +24.72 +(39,343 +) +24.76 +Nonvested at December 31, 2011 +745,929 +$ +25.78 +641,330 +$ +25.37 +Granted +351,674 +40.27 +200,595 +39.78 +Vested +(365,217 +) +25.02 +(436,176 +) +21.26 +Forfeited +(33,155 +) +32.26 +(16,052 +) +25.64 +Nonvested at December 29, 2012 +699,231 +$ +33.16 +389,697 +$ +37.85 +As of December 29, 2012, there was $11,638 of unrecognized compensation expense related to nonvested share-based +compensation arrangements granted under restricted stock award plans. That cost is expected to be recognized over a weighted-average period of 2.1 years. The total fair value of shares vested during the year-ended December 29, 2012 was $14,946. +As of December 31, 2011, there was $6,466 of unrecognized compensation expense related to nonvested share-based compensation arrangements granted under restricted stock award plans. That cost was expected to be recognized over a +weighted-average period of 2.0 years. The total fair value of shares vested during the year-ended December 31, 2011 was $6,203. As of January 1, 2011, there was $6,194 of unrecognized compensation expense related to nonvested share-based +compensation arrangements granted under restricted stock award plans that was expected to be recognized over a weighted-average period of 1.6 years. The total fair value of shares vested during the year-ended January 1, 2011 was $3,012. +A-17 +As of December 29, 2012, there was $3,478 of unrecognized compensation expense related to nonvested +share-based compensation arrangements granted under performance-based award plans. That cost is expected to be recognized over a weighted-average period of 1.2 years. The total fair value of shares vested during the year-ended December 29, 2012 +was $17,475. As of December 31, 2011, there was $4,718 of unrecognized compensation expense related to nonvested share-based compensation arrangements granted under performance-based restricted stock award plans. That cost was expected to be +recognized over a weighted-average period of 2.0 years. The total fair value of shares vested during the year-ended December 31, 2011 was $4,699. As of January 1, 2011, there was $4,950 of unrecognized compensation expense related to +nonvested share-based compensation arrangements granted under performance-based restricted stock award plans that was expected to be recognized over a weighted-average period of 2.0 years. The total fair value of shares vested during the year-ended +January 1, 2011 was $3,203. +6. RETIREMENT PLANS +The Company has three non-contributory, defined benefit pension plans covering a majority of its domestic employees. The Company’s +principal defined benefit pension plan provides benefits based on the employee’s years of service and final average earnings. Subsequent to the end of fiscal 2012, the Company closed this plan to new participants. The Company’s second plan +provides benefits at a fixed rate per year of service for certain employees under a collectively bargaining arrangement. The Company’s third noncontributory defined benefit pension plan, which no longer accrues future benefits, covers certain +eligible PLG associates. Prior to the freezing of the plan, eligible PLG participants accrued pension benefits at a fixed unit rate based on the participant’s service and compensation. +The Company has a Supplemental Executive Retirement Plan (the “SERP”) for certain current and former employees that entitles a participating employee to receive payments from the Company +following retirement based on the employee’s years of service and final average earnings (as defined in the SERP). Under the SERP, the employees can elect early retirement with a corresponding reduction in benefits. The Company also has +individual deferred compensation agreements with certain former employees that entitle these employees to receive payments from the Company for a period of 15 to 18 years following retirement. The Company maintains life insurance policies with a +cash surrender value of $46,701 at December 29, 2012 and $38,203 at December 31, 2011 that are intended to fund deferred compensation benefits under the SERP and deferred compensation agreements. +The Company has two defined contribution 401(k) plans covering substantially all domestic employees that provides for Company contributions based on +earnings. The Company recognized expense for its defined contribution plans of $2,872 in fiscal 2012, $2,500 in fiscal 2011 and $2,061 in fiscal 2010. +The Company has certain defined contribution plans at foreign subsidiaries. Contributions to these plans were $867 in fiscal 2012, $918 in fiscal 2011 and $858 in fiscal 2010. The Company also has a +benefit plan at a foreign location that provides for retirement benefits based on years of service. The obligation recorded under this plan was $2,986 at December 29, 2012 and $3,139 at December 31, 2011 and was recognized as a deferred +compensation liability on the accompanying balance sheet. +A-18 +The following summarizes the status of and changes in the Company’s assets and related obligations for +its pension plans (which include the Company’s defined benefit pension plans and the SERP) for the fiscal years: +2012 +2011 +Change in projected benefit obligations: +Projected benefit obligations at beginning of the year +$ +269,099 +$ +230,114 +PLG projected benefit obligations at acquisition date +109,705 +– +Service cost pertaining to benefits earned during the year +7,709 +6,499 +Interest cost on projected benefit obligations +15,314 +13,326 +Actuarial losses +55,665 +30,320 +Benefits paid to plan participants +(12,307 +) +(11,160 +) +Projected benefit obligations at end of the year +$ +445,185 +$ +269,099 +Change in fair value of pension assets: +Fair value of pension assets at beginning of the year +$ +163,123 +$ +144,411 +PLG fair value of pension assets at acquisition date +71,963 +– +Actual return on plan assets +26,001 +(3,857 +) +Company contributions - pension +26,657 +31,800 +Company contributions - SERP +1,858 +1,929 +Benefits paid to plan participants +(12,307 +) +(11,160 +) +Fair value of pension assets at end of the year +$ +277,295 +$ +163,123 +Funded status +$ +(167,890 +) +$ +(105,976 +) +Amounts recognized in the consolidated balance sheets: +Current liabilities +$ +(2,428 +) +$ +(2,151 +) +Non current liabilities +(165,462 +) +(103,825 +) +Net amount recognized +$ +(167,890 +) +$ +(105,976 +) +Amounts recognized in accumulated other comprehensive loss: +Unrecognized net actuarial loss (amount net of tax: 2012 – $(90,525); +2011 – $(74,272)) +$ +(137,910 +) +$ +(113,789 +) +Unrecognized prior service cost (amount net of tax: 2012 – $(228); 2011 – $(310)) +(350 +) +(477 +) +Net amount recognized +$ +(138,260 +) +$ +(114,266 +) +Funded status of pension plans and SERP (supplemental): +Funded status of qualified defined benefit plans and SERP +$ +(167,890 +) +$ +(105,976 +) +Nonqualified trust assets (cash surrender value of life insurance) recorded in other assets and intended to satisfy the projected +benefit obligation of unfunded SERP obligations +46,701 +38,203 +Net funded status of pension plans and SERP (supplemental) +$ +(121,189 +) +$ +(67,773 +) +The accumulated benefit obligations for all defined benefit pension plans and the SERP were $425,443 at December 29, +2012 and $254,198 at December 31, 2011. +A-19 +The following is a summary of net pension and SERP expense recognized by the Company: +2012 +2011 +2010 +Service cost pertaining to benefits earned during the year +$ +(7,709 +) +$ +(6,499 +) +$ +(5,729 +) +Interest cost on projected benefit obligations +(15,314 +) +(13,326 +) +(12,719 +) +Expected return on pension assets +15,958 +14,255 +12,208 +Net amortization loss +(20,837 +) +(11,932 +) +(10,046 +) +Net pension expense +$ +(27,902 +) +$ +(17,502 +) +$ +(16,286 +) +The prior service cost and actuarial loss included in accumulated other comprehensive loss and expected to be recognized +in net periodic pension expense during 2013 is $118 and $30,391, respectively. Expense for qualified defined benefit pension plans was $20,229 in fiscal 2012, $12,579 in fiscal 2011 and $11,903 in fiscal 2010. +The weighted-average actuarial assumptions used to determine the benefit obligation amounts and the net periodic benefit cost for the Company’s +pension and post-retirement plans are as follows. +2012 +2011 +Weighted-average assumptions used to determine benefit obligations at fiscal year-end: +Discount rate +4.30% +5.42% +Rate of compensation increase - pension +4.85% +4.85% +Rate of compensation increase - SERP +7.00% +7.00% +Weighted average assumptions used to determine net periodic benefit cost for the years ended: +Discount rate +5.14% +5.94% +Expected long-term rate of return on plan assets +7.68% +8.00% +Rate of compensation increase - pension +4.85% +4.85% +Rate of compensation increase - SERP +7.00% +7.00% +Unrecognized net actuarial losses exceeding certain corridors are amortized over a five-year period, unless the minimum +amortization method based on average remaining service periods produces a higher amortization. The Company utilizes a bond matching calculation to determine the discount rate. A hypothetical bond portfolio is created based on a presumed purchase of +high-quality corporate bonds with maturities that match the plan’s expected future cash outflows. The discount rate is the resulting yield of the hypothetical bond portfolio. The discount rate is used in the calculation of the year-end pension +liability and service cost for the subsequent year. +The long-term rate of return is based on overall market expectations for a balanced +portfolio with an asset mix similar to the Company’s, utilizing historic returns for broad market and fixed income indices. The Company’s asset allocations at fiscal year-end by asset category and fair value measurement are as follows: +2012 +Level 1 +Level 2 +Total +Equity securities +$ +12,780 +$ +185,621 +$ +198,401 +71.6% +Fixed income investments +25,428 +53,390 +78,818 +28.4% +Cash and money market investments +29 +– +29 +0.0% +Fair value of plan assets +$ +38,237 +$ +239,011 +$ +277,248 +100.0% +A-20 +2011 +Level 1 +Level 2 +Total +Equity securities +$ +– +$ +119,444 +$ +119,444 +73.2% +Fixed income investments +– +43,581 +43,581 +26.7% +Cash and money market investments +– +98 +98 +0.1% +Fair value of plan assets +$ +– +$ +163,123 +$ +163,123 +100.0% +The Company’s investment policy for plan assets uses a blended approach of U.S. and foreign equities combined with +U.S. fixed income investments. Policy guidelines indicate that total equities should not exceed 80% and fixed income securities should not exceed 35%. Within the equity and fixed income classifications, the investments are diversified. +The Company expects to contribute approximately $2,367 to its qualified defined benefit pension plans and approximately $2,367 to the SERP in fiscal +2013. +Expected benefit payments for the five years subsequent to 2012 and the sum of the five years following those are as follows: +2013 +2014 +2015 +2016 +2017 +2018-2022 +Expected benefit payments +$ +16,727 +$ +18,619 +$ +19,372 +$ +20,385 +$ +21,125 +$ +118,956 +7. INCOME TAXES +The geographic components of earnings before income taxes are as follows: +2012 +2011 +2010 +United States +$ +38,294 +$ +105,470 +$ +86,817 +Foreign +55,884 +63,440 +56,409 +$ +94,178 +$ +168,910 +$ +143,226 +The provisions for income taxes consist of the following: +2012 +2011 +2010 +Current expense: +Federal +$ +15,259 +$ +22,860 +$ +28,620 +State +1,435 +99 +1,866 +Foreign +3,135 +15,134 +13,759 +Deferred expense (credit): +Federal +(5,121 +) +5,848 +(4,896 +) +State +(405 +) +458 +(351 +) +Foreign +(889 +) +1,224 +(242 +) +$ +13,414 +$ +45,623 +$ +38,756 +A-21 +A reconciliation of the Company’s total income tax expense and the amount computed by applying the +statutory federal income tax rate of 35% to earnings before income taxes is as follows: +2012 +2011 +2010 +Income taxes at U.S. statutory rate +$ +32,963 +$ +59,119 +$ +50,129 +State income taxes, net of federal income tax +164 +1,008 +557 +Nontaxable earnings of foreign affiliates +(4,857 +) +(4,611 +) +(4,586 +) +Research and development credits +– +(600 +) +(600 +) +Foreign earnings taxed at rates different from the U.S. statutory rate +(13,101 +) +(13,415 +) +(9,226 +) +Adjustments for uncertain tax positions +(6,662 +) +3,506 +2,142 +Non deductible expenses +4,912 +654 +73 +Other +(5 +) +(38 +) +267 +$ +13,414 +$ +45,623 +$ +38,756 +Significant components of the Company’s deferred income tax assets and liabilities as of the end of fiscal years +2012 and 2011 are as follows: +2012 +2011 +Deferred income tax assets: +Accounts receivable and inventory valuation allowances +$ +16,506 +$ +5,341 +Deferred compensation accruals +9,881 +3,146 +Accrued pension expense +58,947 +36,560 +Stock-based compensation +7,551 +11,182 +Net operating loss and foreign tax credit carryforward +3,924 +2,755 +Other amounts not deductible until paid +10,127 +7,285 +Other +1,420 +– +Total gross deferred income tax assets +108,356 +66,269 +Less valuation allowance +(3,165 +) +(2,463 +) +Net deferred income tax assets +105,191 +63,806 +Deferred income tax liabilities: +Tax depreciation in excess of book depreciation +(9,911 +) +(6,045 +) +Intangible assets +(301,967 +) +– +Other +(4,935 +) +(5,611 +) +Total deferred income tax liabilities +(316,813 +) +(11,656 +) +Net deferred income tax assets (liabilities) +$ +(211,622 +) +$ +52,150 +The valuation allowance for deferred income tax assets as of December 29, 2012 and December 31, 2011, was +$3,165 and $2,463 respectively. The net change in the total valuation allowance for each of the years ended December 29, 2012, and December 31, 2011, was $702 and $1,066 respectively. The valuation allowance was related to foreign net +operating loss carryforwards and tax credit carryforwards in foreign jurisdictions that, in the judgment of management, are not more likely than not to be realized. The ultimate realization of the carryforwards depends on the generation of future +taxable income in the foreign tax jurisdictions. +At December 29, 2012, the Company had foreign net operating loss carryforwards of +$8,482, which have expiration periods ranging from eight years to an unlimited term during which they are available to offset future foreign taxable income. The Company also had foreign tax credit carryforwards in foreign jurisdictions of $942, +which are available for an unlimited carryforward period to offset future foreign taxable income. +A-22 +The following table summarizes the activity related to the Company’s unrecognized tax benefits: +2012 +2011 +Beginning balance +$ +13,825 +$ +10,741 +Increase related to current year business acquisition +2,638 +– +Increases related to current year tax positions +1,478 +5,293 +Decreases related to prior years positions +(4,826) +(1,139 +) +Settlements +(2,727) +– +Decrease due to lapse of statute +(587) +(1,070) +Ending balance +$ +9,801 +$ +13,825 +The portion of the unrecognized tax benefits that, if recognized currently, would reduce the annual effective tax rate +was $8,535 as of December 29, 2012 and $13,137 as of December 31, 2011. The Company recognizes interest and penalties related to unrecognized tax benefits through interest expense and income tax expense, respectively. Interest accrued +related to unrecognized tax benefits was $1,956 as of December 29, 2012 and $789 as of December 31, 2011. +The Company is subject to +periodic audits by domestic and foreign tax authorities. Currently, the Company is undergoing routine periodic audits in both domestic and foreign tax jurisdictions. It is reasonably possible that the amounts of unrecognized tax benefits could +change in the next 12 months as a result of the audits; however, any payment of tax is not expected to be significant to the consolidated financial statements. +For the majority of tax jurisdictions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2008. +No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the remaining +undistributed earnings of foreign subsidiaries of $313,898 at December 29, 2012, as the Company expects such earnings will remain reinvested overseas indefinitely. +In January 2013, the American Taxpayer Relief Act of 2012 was signed into law and various tax provisions including the research credit that had expired as of December 31, 2011 were reinstated +retroactively to January 1, 2012. In accordance with ASC 740-45-15, the effects of changes in tax rates and laws on deferred tax balances and tax rates are recognized in the period the legislation is enacted. As a result, the impact of the new +legislation will be reflected in the Company’s consolidated financial position and results of operations in fiscal 2013. +8. LITIGATION AND CONTINGENCIES +The Company is involved in various environmental claims and other legal actions arising in the normal course of business. The +environmental claims include sites where the U.S. Environmental Protection Agency has notified the Company that it is a potentially responsible party with respect to environmental remediation. These remediation claims are subject to ongoing +environmental impact studies, assessment of remediation alternatives, allocation of costs between responsible parties and concurrence by regulatory authorities and have not yet advanced to a stage where the Company’s liability is fixed. +However, after taking into consideration legal counsel’s evaluation of all actions and claims against the Company, it is management’s opinion that the outcome of these matters will not have a material adverse effect on the Company’s +consolidated financial position, results of operations or cash flows. +The Company is involved in routine litigation incidental to its +business and is a party to legal actions and claims, including, but not limited to, those related to employment and intellectual property. Some of the legal proceedings include claims for compensatory as well as punitive damages. While the final +outcome of these matters cannot be predicted with certainty, considering, among other things, the meritorious legal defenses available and liabilities that have been recorded along with applicable insurance, it is management’s opinion that the +outcome of these items will not have a material adverse effect on the Company’s financial position, results of operations or cash flows. +A-23 +The Company has future minimum royalty and advertising obligations due under the terms of certain licenses +held by the Company. These minimum future obligations are as follows: +2013 +2014 +2015 +2016 +Beyond +Minimum royalties +$ +2,067 +$ +1,670 +$ +1,500 +$ +– +$ +– +Minimum advertising +6,695 +7,724 +8,807 +2,890 +5,237 +Minimum royalties are based on both fixed obligations and assumptions regarding the consumer price index. Royalty +obligations in excess of minimum requirements are based upon future sales levels. In accordance with these agreements, the Company incurred royalty expense of $2,792, $3,270, and $3,028 for fiscal years 2012, 2011, and 2010, respectively. +The terms of certain license agreements also require the Company to make advertising expenditures based on the level of sales. In accordance +with these agreements, the Company incurred advertising expense of $4,132, $3,273, and $2,998 for fiscal years 2012, 2011, and 2010, respectively. +9. BUSINESS SEGMENTS +The acquisition of PLG resulted in two new operating segments comprised of PLG wholesale and PLG retail. PLG’s wholesale +operations are included in the branded footwear, apparel and licensing reportable segment as a fourth operating group. PLG retail along with the Company’s Wolverine retail operating group are aggregated into the Company’s consumer-direct +reportable segment. +Further, the Company now identifies four operating groups within the branded footwear, apparel and licensing reportable +segment, which is engaged in designing, manufacturing, sourcing, marketing, licensing and distributing branded footwear, apparel and accessories. Revenue from this segment is derived from the sale of branded footwear, apparel and accessories to +third-party customers and royalty income from the licensing of the Company’s trademarks and brand names to third-party licensees and distributors. The Outdoor, Heritage, Lifestyle, and Performance + Lifestyle Wholesale operating groups, which +are aggregated into the branded footwear, apparel and licensing reportable segment, all source, market and distribute products in a similar manner. +Retail operations across the entire portfolio are collectively reported within the consumer-direct reportable segment, consisting of both brick-and-mortar retail locations and eCommerce websites. PLG +retail along with the Company’s Wolverine retail segment are aggregated into the Company’s consumer-direct reportable segment. At December 29, 2012, the Company owned and operated 444 brick-and-mortar retail stores in the U.S., Canada +and the United Kingdom and operated 63 consumer-direct websites. +The other business unit in the following tables consist of the +Company’s, leather marketing and pigskin procurement operations. Substantially all of the assets of the pigskin procurement operations were sold to a third-party buyer on December 29, 2010. +The Company measures segment profits as earnings before income taxes. The accounting policies used to determine profitability and total assets of the +branded footwear, apparel and licensing segment, consumer-direct segment and the other business unit are the same as disclosed in Note 1. +A-24 +Business segment information is as follows: +2012 +Branded +Footwear, +Apparel +and Licensing +Consumer- +direct +Other +Businesses +Corporate +Consolidated +Revenue +$ +1,419,064 +$ +183,926 +$ +37,848 +$ +– +$ +1,640,838 +Intersegment revenue +87,393 +– +4,042 +– +91,435 +Interest expense – net +– +– +– +19,229 +19,229 +Depreciation expense +5,452 +6,121 +30 +9,570 +21,173 +Earnings (loss) before income taxes +223,219 +10,443 +2,866 +(142,350 +) +94,178 +Total assets +2,201,906 +220,114 +10,941 +181,473 +2,614,434 +Additions to property, plant and equipment +4,957 +4,102 +36 +5,847 +14,942 +2011 +Branded +Footwear, +Apparel +and Licensing +Consumer- +direct +Other +Businesses +Corporate +Consolidated +Revenue +$ +1,274,069 +$ +101,959 +$ +33,040 +$ +– +$ +1,409,068 +Intersegment revenue +53,500 +– +2,178 +– +55,678 +Interest expense – net +– +– +– +1,025 +1,025 +Depreciation expense +6,260 +3,397 +10 +5,203 +14,870 +Earnings (loss) before income taxes +203,959 +6,076 +3,422 +(44,547 +) +168,910 +Total assets +663,388 +64,847 +6,389 +117,028 +851,652 +Additions to property, plant and equipment +7,517 +7,132 +150 +4,598 +19,397 +2010 +Branded +Footwear, +Apparel +and Licensing +Consumer- +direct +Other +Businesses +Corporate +Consolidated +Revenue +$ +1,117,644 +$ +87,100 +$ +43,773 +$ +– +$ +1,248,517 +Intersegment revenue +44,721 +– +2,789 +– +47,510 +Interest expense – net +– +– +– +387 +387 +Depreciation expense +6,067 +3,270 +103 +5,069 +14,509 +Earnings (loss) before income taxes +174,563 +6,637 +3,923 +(41,396 +) +143,226 +Total assets +599,354 +38,185 +3,795 +145,241 +786,575 +Additions to property, plant and equipment +8,282 +4,329 +– +3,759 +16,370 +Geographic information, based on shipping destination, related to revenue from external customers included in the +consolidated statements of operations is as follows: +2012 +2011 +2010 +United States +$ +1,079,867 +$ +841,988 +$ +768,594 +Foreign: +Europe +310,140 +336,949 +218,542 +Canada +112,598 +113,970 +103,374 +Other +138,234 +116,161 +158,007 +Total from foreign territories +560,971 +567,080 +479,923 +$ +1,640,838 +$ +1,409,068 +$ +1,248,517 +A-25 +The location of the Company’s long-lived assets (primarily property, plant and equipment) is as +follows: +2012 +2011 +United States +$ +136,752 +$ +71,418 +Foreign countries +14,185 +8,917 +$ +150,937 +$ +80,335 +The Company does not believe that it is dependent upon any single customer because no customer accounts for more than 10% +of consolidated revenue. +The Company sources approximately 95% (based on pairs) of its footwear products from third-party suppliers located +primarily in the Asia Pacific region. The remainder is produced at Company-owned manufacturing facilities in the U.S. and the Dominican Republic. All apparel and accessories are sourced from third-party suppliers. While changes in suppliers could +cause delays in manufacturing and a possible loss of sales, management believes that other suppliers could provide similar products on comparable terms. +Subsequent to the end of fiscal 2012, the Company realigned its branded wholesale operating groups, reducing the number of operating groups within the branded wholesale footwear, apparel and licensing +reportable segment from four to three. +10. RESTRUCTURING AND OTHER TRANSITION COSTS +On January 7, 2009, the Board of Directors of the Company approved a strategic restructuring plan designed to create significant +operating efficiencies, improve the Company’s supply chain and create a stronger global platform. On October 7, 2009, the Company announced an expansion of its restructuring plan to include the consolidation of two domestic manufacturing +facilities into one and to finalize realignment in certain of the Company’s product creation organizations. The strategic restructuring plan and all actions under the plan, except for certain cash payments, were completed as of June 19, +2010. Accordingly, the Company did not incur any restructuring or other transition costs for the years ended December 29, 2012 and December 31, 2011. For the year-ended January 1, 2011 the Company incurred restructuring and other +transition costs of $4,234 ($3,087 on an after-tax basis), or $0.06 per diluted share. +Restructuring +The Company did not incur restructuring charges for the years ended December 29, 2012 and December 31, 2011. For the year-ended January 1, +2011 the Company incurred restructuring charges of $2,239 ($1,632 on an after-tax basis). +The following is a summary of the activity with +respect to a reserve established by the Company in connection with the restructuring plan, by category of costs: +Severance and +employee related +Facility exit costs +and other +Total +Balance at January 2, 2010 +$ +3,866 +$ +2,060 +$ +5,926 +Charges incurred +571 +1,668 +2,239 +Amounts paid or utilized +(4,150 +) +(2,701 +) +(6,851 +) +Balance at January 1, 2011 +$ +287 +$ +1,027 +$ +1,314 +Amounts paid or utilized +(287 +) +(697 +) +(984 +) +Balance at December 31, 2011 +$ +– +$ +330 +$ +330 +Amounts paid or utilized +– +(255 +) +(255 +) +Balance at December 29, 2012 +$ +– +$ +75 +$ +75 +A-26 +Other Transition Costs +Incremental costs incurred related to the restructuring plan that do not qualify as restructuring costs under the provisions of FASB ASC Topic 420, Exit or Disposal Cost Obligations , have been +included in the Company’s consolidated condensed statements of operations on the line items titled “Restructuring and other transition costs”. These primarily include costs related to closure of facilities, new employee training and +transition to outsourced services. All costs included in this caption were solely related to the transition and implementation of the restructuring plan and do not include ongoing business operating costs. There were no other transition costs +incurred during the years ended December 29, 2012 and December 31, 2011. Other transition costs for the year-ended January 1, 2011, were $1,995 ($1,454 on an after-tax basis). +11. BUSINESS ACQUISITIONS +On October 9, 2012, the Company acquired all of the outstanding equity interests of Collective Brands, +Inc’s Performance + Lifestyle Group business (“PLG”) as well as certain other assets. Consideration paid to acquire PLG was approximately $1,249.5 million in cash. PLG markets casual and athletic footwear, apparel and related +accessories for adults and children under well-known brand names including Sperry Top-Sider ® , Saucony ® , Stride Rite ® , and Keds ® . The +acquisition expands the Company’s existing portfolio of brands to 16. The Company accounted for the acquisition under the provisions of FASB ASC Topic 805, Business Combinations . The related assets acquired and liabilities assumed were +recorded at fair value on the acquisition date. The operating results for PLG are included in the Company’s consolidated results of operations beginning October 9, 2012. The operating results for PLG are included in the PLG wholesale and +PLG retail operating groups. The PLG wholesale group is aggregated into the branded, footwear, apparel and Licensing segment. The PLG retail group is aggregated into the consumer-direct segment. +The Company funded the transaction using a combination of cash on hand of approximately $88,800 and debt financing. The Company’s debt financing +included net proceeds from the term loan debt associated with the Company’s New Credit Agreement as well as net proceeds from the Company’s senior notes. +The Company incurred non-recurring transaction and integration costs of $42,215 during fiscal 2012 of which $4,481, $32,537 and $5,197 were included within cost of goods sold, selling, general, and +administrative expenses and interest expense, respectively, within the Company’s consolidated statements of operations and comprehensive income. The non-recurring charge to cost of goods sold of $4,481 relates to the fair value adjustment to +acquisition-date inventory and severance costs. The non-recurring costs within selling, general, and administrative expenses include professional and legal fees ($14,925), taxes paid on behalf of the seller ($9,701), severance ($2,678), onetime +software license fees ($2,413) and other onetime costs of $2,820, respectively. The $5,197 of non-recurring interest expense relates to a non-recurring financing commitment fee and refinancing fees associated with the Company’s acquisition of +PLG. +A-27 +The preliminary allocation of the purchase price through December 29, 2012 was: +Cash +$ +23,609 +Accounts receivable +146,937 +Inventories +203,443 +Deferred income taxes +13,621 +Other current assets +13,235 +Property, plant and equipment +77,074 +Goodwill +419,611 +Intangible assets +820,555 +Other +11,210 +Total assets acquired +1,729,295 +Accounts payable +97,400 +Other accrued liabilities +39,976 +Deferred income taxes +294,681 +Accrued pension liabilities +37,742 +Other liabilities +10,007 +Total liabilities assumed +479,806 +Net assets acquired +$ +1,249,489 +The allocation of the purchase price above is considered preliminary and was based upon valuation information available +and estimates and assumptions made at December 29, 2012. The Company is still in the process of verifying data and finalizing information related to the valuation and recording of identifiable intangible assets, deferred income taxes, uncertain +tax provisions and accrued pension liabilities and the resulting effects on the amount of recorded goodwill. The Company expects to finalize these matters within the measurement period, which is currently expected to remain open through the second +quarter of fiscal 2013. +The excess of the purchase price over the fair value of net assets acquired, amounting to $419,611, was preliminarily +recorded as goodwill in the condensed consolidated balance sheet and was assigned to the PLG wholesale and PLG retail operating segments, which were also determined to be reporting units. This resulted in the following addition to goodwill within +the Company’s reportable segments: +Goodwill from the +acquisition of PLG +Branded wholesale, footwear, apparel and licensing +$ +373,632 +Consumer-direct +$ +45,979 +Total +$ +419,611 +The goodwill recognized is attributable primarily to expected synergies and the assembled workforce of PLG. Substantially +all of the goodwill is not amortizable for income tax purposes. +Intangible assets acquired in the acquisition were preliminarily valued as +follows: +Intangible Asset +Useful life +Trade names and trademarks +$ +661,765 +Indefinite +Customer lists +110,470 +3-20 years +Licensing agreements +28,120 +4-5 years +Developed product technology +14,547 +3-5 years +Backlog +5,100 +6 months +Net favorable leases +553 +10 years +Total intangible assets acquired +$ +820,555 +A-28 +Management preliminarily assigned fair values to the identifiable intangible assets through a combination of +the relief from royalty and the excess earnings methods. +At the time of the acquisition, a step-up in the value of inventory of $3,983 was +recorded in the allocation of the purchase price based on valuation estimates, all of which was charged to cost of sales in the fourth quarter of fiscal 2012 as the inventory was sold. In addition, fixed assets were written up by approximately +$18,800 to their estimated fair market value based on a valuation method that included both the cost and market approaches. This additional step-up in value is being depreciated over the estimated remaining useful lives of the assets. +The results of operations for PLG have been included in the consolidated statements of operations since the date of acquisition. The amount of fiscal +2012 revenue and net loss, which includes interest expense associated with the New Credit Agreement and senior notes, amortization of acquired intangibles and incremental operating costs, attributable to PLG included in the consolidated statements +of operations consists of the following: +2012 +Revenue +$ +219,400 +Net loss +$ +(2,400 +) +The following supplemental pro forma financial information presents net sales and net earnings for the Company as if the +PLG business acquisition had occurred at the beginning of fiscal 2011. This pro forma information is not necessarily indicative of the results that would have actually been obtained if the acquisition had occurred at the beginning of the periods +presented or that may be attained in the future. +2012 +2011 +Revenue +$ +2,548,200 +$ +2,428,300 +Net earnings attributable to Wolverine World Wide, Inc. +$ +128,600 +$ +80,390 +For 2011, the primary adjustments include: i) the addition of a non-recurring charge to cost of goods sold related to the +fair value adjustment to acquisition-date inventory and severance of $4,481, ii) the addition of $32,061 of amortization and depreciation for acquired intangibles and property and equipment, iii) the addition of $32,537 of non-recurring acquisition +related expenses and iv) the addition of $63,245 of interest expense. For 2012, the primary adjustments include: i) the elimination of the non-recurring charge to cost of goods sold related to the fair value adjustment to acquisition-date inventory +and severance of $4,481, ii) the elimination of $32,537 of non-recurring acquisition related expenses, iii) the addition of $24,662 of amortization and depreciation for acquired intangibles and property and equipment, and iv) the addition of $34,990 +of interest expense. +Subsequent to the end of fiscal 2012, the Company incurred approximately $5.2 million of severance costs related to the +integration of PLG. +12. Quarterly Results of Operations (Unaudited) +The Company reports its quarterly results of operations on the basis of 12-week periods for each of the first three fiscal quarters and +a 16- or 17-week period for the fiscal fourth quarter. The fourth quarter of fiscal 2012 and fiscal 2011 consists of 16 weeks. The aggregate quarterly earnings per share amounts disclosed in the table below may not equal the annual per share amounts +due to rounding and the fact that results for each quarter are calculated independently of the full fiscal year. +A-29 +The Company’s unaudited quarterly results of operations are as follows: +2012 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Revenue +$ +322,807 +$ +312,720 +$ +353,067 +$ +652,244 +Gross profit +132,193 +118,070 +138,555 +239.342 +Net earnings (loss) attributable to Wolverine World Wide, Inc. +31,180 +20,496 +32,727 +(3,717 +) +Net earnings (loss) per share: +Basic +$ +0.65 +$ +0.43 +$ +0.68 +$ +(0.08 +) +Diluted +0.64 +0.42 +0.66 +(0.08 +) +2011 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Revenue +$ +330,872 +$ +310,139 +$ +361,590 +$ +406,466 +Gross profit +137,797 +122,117 +146,683 +150,153 +Net earnings attributable to Wolverine World Wide, Inc. +35,863 +23,963 +40,435 +23,026 +Net earnings per share: +Basic +$ +0.74 +$ +0.49 +$ +0.84 +$ +0.48 +Diluted +0.72 +0.48 +0.82 +0.47 +A-30 +Report of Independent Registered Public Accounting Firm +The Board of Directors and Shareholders of Wolverine World Wide, Inc. +We have audited the accompanying consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of December 29, 2012 and December 31, 2011, and the related consolidated statements +of stockholders’ equity, operations and comprehensive income, and cash flows for each of the three fiscal years in the period ended December 29, 2012. Our audits also included the financial statement schedule listed in the Index at +Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that +we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial +statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for +our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial +position of Wolverine World Wide, Inc. and subsidiaries at December 29, 2012 and December 31, 2011, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended +December 29, 2012, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly +in all material respects the information set forth therein. +We also have audited, in accordance with the standards of the Public Company +Accounting Oversight Board (United States), Wolverine World Wide, Inc.’s internal control over financial reporting as of December 29, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of +Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2013 expressed an unqualified opinion thereon. +/s/ +Ernst & Young LLP +Grand Rapids, Michigan +February 27, 2013 +A-31 +Report of Independent Registered Public Accounting Firm +The Board of Directors and Shareholders of Wolverine World Wide, Inc. +We have audited Wolverine World Wide, Inc.’s internal control over financial reporting as of December 29, 2012, based on criteria established in Internal Control—Integrated Framework issued +by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Wolverine World Wide, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of +the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control +over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting +Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included +obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing +such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial +reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that +(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as +necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors +of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of +any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +As indicated in the accompanying Management’s Report on Internal Control over Financial Reporting, management’s assessment of and conclusion of +the effectiveness of internal control over financial reporting did not include internal controls of the Performance + Lifestyle Group Business, which is included in the fiscal 2012 consolidated financial statements of Wolverine World Wide, Inc. and +constituted 66% of total assets as of December 29, 2012 and 13% of revenue for the fiscal year then ended. Our audit of internal controls over financial reporting of Wolverine World Wide, Inc. also did not include an evaluation of internal +controls over financial reporting of the Performance + Lifestyle Group Business. +In our opinion, Wolverine World Wide, Inc. maintained, in +all material respects, effective internal control over financial reporting as of December 29, 2012, based on the COSO criteria. +We also +have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of December 29, 2012 and December 31, 2011, +and the related consolidated statements of stockholders’ equity, operations and comprehensive income, and cash flows for each of the three fiscal years in the period ended December 29, 2012, and our report dated February 27, 2013 +expressed an unqualified opinion thereon. +/s/ Ernst & Young LLP +Grand Rapids, Michigan +February 27, 2013 +A-32 +APPENDIX B +Schedule II - Valuation and Qualifying Accounts +Wolverine World Wide, +Inc. and Subsidiaries +Column A +Column B +Column C +Column D +Column E +Additions +Description +Balance at +Beginning of +Period +(1) +Charged to +Costs +and +Expenses +(2) +Charged to +Other +Accounts +(Describe) +Deductions +(Describe) +Balance at +End of +Period +Fiscal year-ended December 29, 2012 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +4,780,000 +$ +8,657,000 +$ +10,839,000 +(A) +$ +2,598,000 +Allowance for sales returns +5,197,000 +53,943,000 +50,138,000 +(B) +9,002,000 +Allowance for cash discounts +2,711,000 +11,813,000 +11,295,000 +(C) +3,229,000 +Inventory valuation allowances +10,330,000 +7,749,000 +5,560,000 +(D) +12,519,000 +$ +23,018,000 +$ +82,162,000 +$ +77,832,000 +$ +27,348,000 +Fiscal year-ended December 31, 2011 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +5,754,000 +$ +5,953,000 +$ +6,927,000 +(A) +$ +4,780,000 +Allowance for sales returns +4,474,000 +48,484,000 +47,761,000 +(B) +5,197,000 +Allowance for cash discounts +1,185,000 +10,084,000 +8,558,000 +(C) +2,711,000 +Inventory valuation allowances +8,619,000 +8,753,000 +7,042,000 +(D) +10,330,000 +$ +20,032,000 +$ +73,274,000 +$ +70,287,000 +$ +23,018,000 +Fiscal year-ended January 1, 2011 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +8,137,000 +$ +3,846,000 +$ +6,229,000 +(A) +$ +5,754,000 +Allowance for sales returns +4,649,000 +38,093,000 +38,268,000 +(B) +4,474,000 +Allowance for cash discounts +1,160,000 +10,568,000 +10,543,000 +(C) +1,185,000 +Inventory valuation allowances +6,350,000 +8,276,000 +6,007,000 +(D) +8,619,000 +$ +20,296,000 +$ +60,783,000 +$ +61,047,000 +$ +20,032,000 +(A) +Accounts charged off, net of recoveries. +(B) +Actual customer returns. +(C) +Discounts given to customers. +(D) +Adjustment upon disposal of related inventories. +EXHIBIT INDEX +Exhibit +Number +Document +2.1 +Agreement and Plan of Merger, dated as of May 1, 2012, by and among WBG-PSS Holdings LLC, WBG-PSS Merger Sub Inc., Collective Brands, Inc. and Wolverine World Wide, +Inc. Previously filed as Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on May 4, 2012. Here incorporated by reference. +3.1 +Restated Certificate of Incorporation. Previously filed as Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the period ended December 30, 2006. Here incorporated by +reference. +3.2 +Amended and Restated By-laws. Previously filed as Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on October 16, 2012. Here incorporated by +reference. +4.1 +Senior Notes Indenture, dated October 9, 2012, among Wolverine World Wide, Inc., the guarantors named therein, and Wells Fargo Bank, National Association. Previously filed as +Exhibit 4.1 to the Company’s Current Report on Form 8-K filed on October 9, 2012. Here incorporated by reference. +4.2 +Form of 6.125% Senior Note due 2020. Previously filed as Exhibit 4.2 to the Company’s Current Report on Form 8-K filed on October 9, 2012. Here incorporated by +reference. +4.3 +Registration Rights Agreement, dated October 9, 2012, among the Wolverine World Wide, Inc., the guarantors named therein and J.P. Morgan Securities LLC, as representative of the +several initial purchasers. Previously filed as Exhibit 4.3 to the Company’s Current Report on Form 8-K filed on October 9, 2012. Here incorporated by reference. +10.1 +1993 Stock Incentive Plan, as amended and restated.* Previously filed as Exhibit 10.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10.2 +Amended and Restated 1995 Stock Incentive Plan.* Previously filed as Exhibit 10.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.3 +Amended and Restated 1997 Stock Incentive Plan.* Previously filed as Exhibit 10.3 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.4 +Amended and Restated Stock Incentive Plan of 1999.* Previously filed as Exhibit 10.4 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.5 +Amended and Restated Stock Incentive Plan of 2001.* Previously filed as Exhibit 10.5 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.6 +Amended and Restated Stock Incentive Plan of 2003.* Previously filed as Exhibit 10.6 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.7 +Amended and Restated Stock Incentive Plan of 2005.* Previously filed as Exhibit 10.7 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here +incorporated by reference. +10.8 +Amended and Restated Directors’ Stock Option Plan.* Previously filed as Exhibit 10.8 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. +Here incorporated by reference. +10.9 +Amended and Restated Outside Directors’ Deferred Compensation Plan.* Previously filed as Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the fiscal year ended +December 29, 2007. Here incorporated by reference. +10.10 +Amended and Restated Executive Short-Term Incentive Plan (Annual Bonus Plan).* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on April 20, +2012. Here incorporated by reference. +Exhibit +Number +Document +10.11 +Amended and Restated Executive Long-Term Incentive Plan (3-Year Bonus Plan).* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on +April 20, 2012. Here incorporated by reference. +10.12 +Amended and Restated Stock Option Loan Program.* Previously filed as Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 29, 2007. Here +incorporated by reference. +10.13 +Executive Severance Agreement.* Previously filed as Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated by reference. A +participant schedule of current executive officers who are parties to this agreement is attached as Exhibit 10.13. +10.14 +Executive Severance Agreement.* Previously filed as Exhibit 10.14 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011. Here incorporated by +reference. A participant schedule of current executive officers who are parties to this agreement is attached as Exhibit 10.14. +10.15 +Form of Indemnification Agreement.* The Company has entered into an Indemnification Agreement with each director and with Messrs. Grimes, Guerre, Jeppesen, Krueger and Zwiers and +Ms. Linton. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on April 25, 2007. Here incorporated by reference. +10.16 +Amended and Restated Benefit Trust Agreement dated April 25, 2007.* Previously filed as Exhibit 10.5 to the Company’s Current Report on Form 8-K filed on April 25, 2007. Here +incorporated by reference. +10.17 +Employees’ Pension Plan (Restated as amended through January 1, 2013).* +10.18 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 15, 2005. Here incorporated by +reference. +10.19 +Form of Non-Qualified Stock Option Agreement for Blake W. Krueger and Timothy J. O’Donovan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 15, 2005. Here incorporated by reference. +10.20 +Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.19 applies.* Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 15, 2005. Here incorporated by reference. +10.21 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company’s Current Report on Form 8-K filed on February 15, 2005. Here incorporated by +reference. +10.22 +Form of Incentive Stock Option Agreement.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 17, 2006. Here incorporated by +reference. +10.23 +Form of Non-Qualified Stock Option Agreement for Blake W. Krueger and Timothy J. O’Donovan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed on February 17, 2006. Here incorporated by reference. +10.24 +Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.23 applies.* Previously filed as Exhibit 10.3 to the Company’s Current +Report on Form 8-K filed on February 17, 2006. Here incorporated by reference. +10.25 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.4 to the Company’s Current Report on Form 8-K filed on February 17, 2006. Here incorporated by +reference. +10.26 +Form of Restricted Stock Agreement.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October 16, 2012. Here incorporated by +reference. +10.27 +Form of Stock Option Agreement for non-employee directors.* Previously filed as Exhibit 10.23 to the Company’s Annual Report on Form 10-K for the fiscal year ended January 1, +2005. Here incorporated by reference. +Exhibit +Number +Document +10.28 +2009 Form of Non-Qualified Stock Option Agreement for Donald T. Grimes, Blake W. Krueger, Pamela L. Linton and James D. Zwiers.* Previously filed as Exhibit 10.26 to the +Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.29 +2009 Form of Non-Qualified Stock Option Agreement for executive officers other than those to whom Exhibit 10.28 applies.* Previously filed as Exhibit 10.27 to the Company’s +Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.30 +Form of Performance Share Award Agreement (2011 – 2013 performance period).* Previously filed as Exhibit 10.30 to the Company’s Annual Report on Form 10-K for the fiscal +year ended January 1, 2011. Here incorporated by reference. +10.31 +Form of Performance Share Award Agreement (2012 – 2014 performance period).* Previously filed as Exhibit 10.32 to the Company’s Annual Report on Form 10-K for the fiscal +year ended December 31, 2011. Here incorporated by reference. +10.32 +[Form of Performance Share Award Agreement (2013 – 2015 performance period).* +10.33 +Separation Agreement between Wolverine World Wide, Inc. and Blake W. Krueger, dated as of March 13, 2008, as amended.* Previously filed as Exhibit 10.1 to the Company’s +Quarterly Report on Form 10-Q for the period ended March 22, 2008. Here incorporated by reference. +10.34 +First Amendment to Separation Agreement between Wolverine World Wide, Inc. and Blake W. Krueger, dated as of December 11, 2008.* Previously filed as Exhibit 10.30 to the +Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2009. Here incorporated by reference. +10.35 +409A Supplemental Executive Retirement Plan.* Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated by +reference. A participant schedule of current executive officers who participate in this plan is attached as Exhibit 10.35. +10.36 +Form of 409A Supplemental Retirement Plan Participation Agreement with Blake W. Krueger.* Previously filed as Exhibit 10.32 to the Company’s Annual Report on Form 10-K for the +fiscal year ended January 3, 2009. Here incorporated by reference. +10.37 +Outside Directors’ Deferred Compensation Plan.* Previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on December 17, 2008. Here incorporated +by reference. +10.38 +Stock Incentive Plan of 2010.* Previously filed as Exhibit 10.1 to the Company’s Registration Statement on Form S-8 filed on March 4, 2010. Here incorporated by +reference. +10.39 +Limited Guarantee, dated as of May 1, 2012, entered into by Wolverine World Wide, Inc. in favor of Collective Brands, Inc. Previously filed as Exhibit 10.1 to the +Company’s Current Report on Form 8-K filed on May 4, 2012. Here incorporated by reference. +10.40 +Purchase Agreement, dated as of May 1, 2012, by and between Open Water Ventures, LLC and WBG-PSS Holdings LLC. Previously filed as Exhibit 10.2 to the Company’s +Current Report on Form 8-K filed on May 4, 2012. Here incorporated by reference +10.41 +Interim Agreement, dated as of May 1, 2012, by and among Wolverine World Wide, Inc., WBG-PSS Holdings LLC, WBG-PSS Merger Sub Inc., Golden Gate Capital Opportunity Fund, L.P. and +Blum Strategic Partners IV, L.P. Previously filed as Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on May 4, 2012. Here incorporated by reference. +10.42 +Separation Agreement, dated as of May 1, 2012, by and between Wolverine World Wide, Inc. and WBG-PSS Holdings LLC. Previously filed as Exhibit 10.4 to the Company’s +Current Report on Form 8-K filed on May 4, 2012. Here incorporated by reference. +10.43 +Amendment No. 1 to Separation Agreement, dated as of October 9, 2012, by and between the Company and WBG–PSS Holdings LLC. Previously filed as Exhibit 10.2 to the +Company’s Current Report on Form 8-K filed on October 9, 2012. Here incorporated by reference. +Exhibit +Number +Document +10.44 +Amendment No. 1 to Purchase Agreement, dated as of October 9, 2012, by and between Open Water Ventures, LLC and WBG–PSS Holdings LLC. Previously filed as Exhibit 10.5 to +the Company’s Quarterly Report on Form 10-Q for the period ended September 8, 2012. Here incorporated by reference. +10.45 +Credit Agreement, dated as of July 31, 2012, by and among Wolverine World Wide, Inc., as borrower, JPMorgan Chase Bank, N.A., as administrative agent and as a lender, J.P. Morgan +Europe Limited, as foreign currency agent, Wells Fargo Bank, National Association, as syndication agent and as a lender, Fifth Third Bank as documentation agent and as a lender, and PNC Bank, National Association, as documentation agent and as a +lender. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on August 1, 2012. Here incorporated by reference. +10.46 +First Amendment to Credit Agreement, dated as of September 28, 2012, by and among Wolverine World Wide, Inc., as borrower, JPMorgan Chase Bank, N.A., as administrative agent and as +a lender, J.P. Morgan Europe Limited, as foreign currency agent, Wells Fargo Bank, National Association, as syndication agent and as a lender, Fifth Third Bank as documentation agent and as a lender, and PNC Bank, National Association, as +documentation agent and as a lender. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October 4, 2012. Here incorporated by reference. +10.47 +Second Amendment to the Credit Agreement, dated as of October 8, 2012, among Wolverine World Wide, Inc., as borrower, JPMorgan Chase Bank, N.A., as administrative agent and as a +lender, J.P. Morgan Europe Limited, as foreign currency agent, Wells Fargo Bank, National Association, as syndication agent and as a lender, Fifth Third Bank, as documentation agent and as a lender, and PNC Bank, National Association, as +documentation agent and as a lender. Previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October 9, 2012. Here incorporated by reference. +21 +Subsidiaries of Registrant. +23 +Consent of Ernst & Young LLP. +24 +Powers of Attorney. +31.1 +Certification of Chairman, Chief Executive Officer and President under Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of Senior Vice President, Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to 18 U.S.C. § 1350. +101.INS +XBRL Instance Document +101.SCH +XBRL Taxonomy Extension Schema Document +101.CAL +XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF +XBRL Taxonomy Extension Definition Linkbase Document +101.LAB +XBRL Taxonomy Extension Label Linkbase Document +101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +* +Management contract or compensatory plan or arrangement. \ No newline at end of file diff --git a/raw/filings/0000110471/2012/0001193125-13-079739/filing_metadata.csv b/raw/filings/0000110471/2012/0001193125-13-079739/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..693718f6778117b23cbd4ae832452b26a1a7b059 --- /dev/null +++ b/raw/filings/0000110471/2012/0001193125-13-079739/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000110471,WWW,WOLVERINE WORLD WIDE INC /DE/,10-K,2013-02-27,2012-12-29,2013-02-27T20:14:11.000Z,0001193125-13-079739,d463484d10k.htm,10-K,13116269,1,0,https://www.sec.gov/Archives/edgar/data/110471/000119312513079739/d463484d10k.htm,https://www.sec.gov/Archives/edgar/data/110471/000119312513079739/,2012,2012,1 diff --git a/raw/filings/0000110471/2012/0001193125-13-079739/item1.txt b/raw/filings/0000110471/2012/0001193125-13-079739/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..ece22ec4803de8e7621991ce48c05c6ebc2c252f --- /dev/null +++ b/raw/filings/0000110471/2012/0001193125-13-079739/item1.txt @@ -0,0 +1,304 @@ +Item 1. Business +General +Wolverine World Wide, Inc. (the “Company”) is a leading designer, +manufacturer and marketer of a broad range of quality casual footwear and apparel, performance outdoor and athletic footwear and apparel, children’s footwear, industrial work boots and apparel, and uniform shoes and boots. The Company, a +Delaware corporation, is the successor of a Michigan corporation of the same name, originally organized in 1906, which, in turn, was the successor of a footwear business established in Grand Rapids, Michigan in 1883. +On October 9, 2012, the Company acquired the Performance + Lifestyle Group (“PLG”) business of Collective Brands, +Inc. for approximately $1,249.5 million in cash, which amount is subject to the finalization of certain post-closing adjustments. PLG designs and markets casual and athletic footwear, apparel and related accessories for adults and children under +well-known brand names, including Sperry Top-Sider ® , Saucony ® , Stride Rite ® and Keds ® . PLG +includes both wholesale and consumer-direct operations. The PLG acquisition expanded the Company’s portfolio to 16 brands that are marketed in approximately 200 countries and territories around the world. +The Company’s products generally feature contemporary styling with proprietary technologies designed to provide maximum comfort +and performance. The products are marketed under widely recognized brand names, including Bates ® , +Cat ® Footwear, Chaco ® , Cushe ® , +Harley-Davidson ® Footwear, Hush Puppies ® , HyTest ® , Keds ® , Merrell ® , Patagonia ® +Footwear, Sebago ® , Soft Style ® , Saucony ® , Sperry +Top-Sider ® , Stride Rite ® and Wolverine ® . The +Company believes that its primary competitive advantages are its well-recognized brand names, its patented proprietary designs, its diverse product offerings and comfort technologies, its wide range of distribution channels and its diversified +manufacturing and sourcing base. Cat ® is a registered trademark of Caterpillar, Inc., +Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. and Patagonia ® is a registered trademark of Patagonia, Inc. +The Company’s brands are sold at various price points targeting a wide range of consumers of casual, work, outdoor and athletic +footwear and apparel. The Company also licenses some of its brands for use on products other than footwear or apparel. Following the acquisition of PLG, as of December 29, 2012, the Company identifies four operating groups within its branded +wholesale footwear, apparel and licensing reportable segment: (i) the Outdoor Group , consisting of +Merrell ® , Patagonia ® and Chaco ® footwear, +and Merrell ® apparel and accessories, (ii) the Heritage Group , consisting of Wolverine ® footwear and apparel, and Cat ® , Bates ® , +Harley-Davidson ® and HyTest ® footwear, (iii) the Lifestyle Group , consisting of Hush Puppies ® , and Sebago ® +footwear and apparel, and Cushe ® and Soft Style ® footwear and, (iv) the Performance + Lifestyle Group, consisting of Sperry Top-Sider ® , Saucony ® , Stride Rite ® and Keds ® . As a result of the acquisition of PLG, the Company now also reports a second reportable segment for its +consumer-direct operations. The consumer-direct reportable segment represents the Company’s brick-and-mortar retail and eCommerce businesses that include both the Wolverine Retail and PLG Retail operating groups. +The Company’s Global Operations Group is responsible for manufacturing, sourcing, distribution and customer support. The Company +directly sells its products in the United States (U.S.), Canada and certain countries in Europe to a wide range of retail customers, including department stores, national chains, catalogs, specialty retailers, mass merchants and Internet retailers, +and to governments and municipalities. Many of the retailers carrying the Company’s products operate multiple storefront locations. The Company’s products are marketed worldwide in approximately 200 countries and territories through +Company-owned wholesale and retail operations and through licensees and distributors. +5 +For financial information regarding the Company, see the consolidated financial statements and the +accompanying notes, which are attached as Appendix A to this Annual Report on Form 10-K. As described above, the Company has two reportable segments consisting of the branded wholesale footwear, apparel and licensing and consumer-direct reportable +segments. The Company’s other operating segment consists of its Wolverine Leathers Division, which is described below. Financial information regarding the Company’s reportable segments and other operating group and financial information by +geographic area is found in Note 9 to the consolidated financial statements of the Company that are attached as Appendix A to this Annual Report on Form 10-K. +Branded Wholesale Footwear, Apparel and Licensing +The Company +sources and markets a broad range of footwear styles, including shoes, boots and sandals under many recognizable brand names, including Bates ® , Cat ® , Chaco ® , Cushe ® , +Harley-Davidson ® , Hush Puppies ® , HyTest ® , Keds ® , Merrell ® , Patagonia ® , +Saucony ® , Sebago ® , Soft Style ® , +Sperry Top-Sider ® , Stride Rite ® and Wolverine ® . The +Company combines quality materials and skilled workmanship to produce footwear according to its specifications at both Company-owned and third-party manufacturing facilities. The Company also markets Merrell ® , Saucony ® , Sebago ® , Sperry Top-Sider ® and Wolverine ® brand apparel and accessories and licenses some of its brands for use on non-footwear products, including Hush Puppies ® apparel, eyewear, watches, socks, handbags and plush toys, Wolverine ® brand eyewear and gloves, Keds ® apparel, Saucony ® +apparel , Sperry Top-Sider ® apparel , and Stride Rite ® apparel. +The operating groups for the Company’s branded wholesale footwear, apparel and licensing reportable segment for fiscal 2012 are described below. +1. +The Outdoor Group - The Outdoor Group consists of Merrell ® footwear, Merrell ® +apparel and accessories, Patagonia ® footwear and Chaco ® footwear. +Merrell ® Footwear: +Merrell ® footwear is designed to inspire and encourage participation in the outdoors. Known +for quality, durability and comfort, the Merrell ® footwear line uses a variety of proprietary designs and +technologies to create footwear with distinctive styling, performance and comfort features for use on the trail or in town. Merrell ® footwear products offer a wide range of styles from technical hiking, multi-sport footwear and the minimalist Merrell ® Barefoot Collection, to versatile lifestyle products for more casual outdoor adventures for men, women and kids. +Merrell ® footwear products are sold primarily through outdoor specialty retailers, sporting goods chains, +department stores, online retailers and catalogs. +Merrell ® Apparel and Accessories: The Merrell ® apparel line extends the +Merrell ® commitment to an active outdoor lifestyle with a versatile line of apparel built for the summit +or the street. The apparel line features stylized lifestyle silhouettes built with the technical, high performance, weather fighting materials that consumers expect from an outdoor brand. In addition to Merrell ® apparel, the Outdoor Group markets Merrell ® accessories, including packs, bags and luggage for men and women. +Patagonia ® Footwear: Pursuant to +an agreement with Lost Arrow Corporation, the Company has the exclusive footwear marketing and distribution rights under Patagonia ® and other trademarks. The +Patagonia ® footwear line focuses primarily on casual and outdoor performance footwear. Patagonia ® is a registered trademark of Patagonia, Inc. +Chaco ® Footwear: The +Chaco ® footwear line focuses primarily on performance sandals and closed-toe products for the outdoor +enthusiast. +6 +2. +The Heritage Group - The Heritage Group markets footwear, apparel and accessories products under the Wolverine ® brand and footwear under the Cat ® , Bates ® , +Harley-Davidson ® and HyTest ® brands. +Wolverine ® Footwear: +The Wolverine ® brand offers high-quality boots and shoes that incorporate innovative technologies to +deliver comfort and durability. The Wolverine ® brand, in existence for well over 100 years, markets +footwear in three categories: (i) work and industrial; (ii) outdoor sport; and (iii) rugged casual. The development of DuraShocks ® , MultiShox ® , +Wolverine Fusion ® and Wolverine Compressor ® technologies, as well as the development of the Contour Welt ® line, have allowed the +Wolverine ® brand to offer a broad line of work footwear with a focus on comfort. The Wolverine ® work product line, whose target consumers are industrial workers, features work boots and shoes with protective +features such as toe caps, metatarsal guards and electrical hazard protection. The Wolverine ® rugged +casual and outdoor sport product lines incorporate DuraShocks ® , Wolverine iCS ® and other technologies and comfort features into products designed for casual and outdoor sport use. The target +consumers for the rugged casual line products have active lifestyles. The outdoor sport line is designed to meet the needs of hunters, fishermen and other active outdoor sports enthusiasts. +Wolverine ® Apparel and Licensing: The Heritage Group markets a line of work and rugged casual Wolverine ® brand apparel. In addition, the Company licenses its Wolverine ® brand for use on eyewear and gloves. +Cat ® Footwear: Pursuant to a license arrangement with Caterpillar, Inc., the Company has exclusive footwear marketing and distribution rights under +Caterpillar ® , Cat ® , Cat & Design, Walking +Machines ® and other trademarks. The Company believes the association with Cat ® equipment encourages customers to view the footwear as high-quality, rugged and durable. Cat ® brand footwear products include work boots and shoes, sport boots, rugged casual and lifestyle footwear, including +lines of work and casual footwear featuring iTechnology ™ and Hidden Tracks ® comfort features. +Cat ® footwear targets work and industrial users and active lifestyle users. Cat ® , Caterpillar ® , Cat & Design and Walking Machines ® are registered trademarks of Caterpillar Inc. +Bates ® Uniform Footwear: +The Bates ® brand is a leader in supplying footwear to military and civilian uniform wearers. +Bates ® utilizes DuraShocks ® , DuraShocks SR ™, Wolverine +iCS ® and other proprietary comfort technologies in the design of its military-style boots and oxford shoes. +Bates ® contracts with the United States Department of Defense and the military branches of several +foreign countries to supply military footwear. Civilian uniform users include individuals in police, security, postal, restaurant and other industrial occupations. Bates ® products are also distributed through specialty retailers and catalogs. +Harley-Davidson ® Footwear: Pursuant to a license arrangement with the Harley-Davidson Motor Company, the Company has footwear marketing and distribution +rights for Harley-Davidson ® branded footwear. Harley-Davidson ® branded footwear products include motorcycle, casual, fashion, work and western footwear for men, women and +children. Harley-Davidson ® footwear is sold globally through a network of independent +Harley-Davidson ® dealerships and other retail outlets. Harley-Davidson ® is a registered trademark of H-D Michigan, Inc. +HyTest ® Safety Footwear: The HyTest ® product line consists primarily of high-quality work boots and shoes that incorporate various specialty safety features designed to protect against hazards of the +workplace, including steel toe, composite toe, metatarsal guards, and electrical +7 +hazard, static dissipating and conductive footwear. +HyTest ® footwear is distributed primarily through a network of independently-owned Shoemobile ® mobile truck retail outlets providing direct sales of the Company’s occupational and work footwear brands to +workers at industrial facilities and also through direct sales arrangements with large industrial customers. +3. +The Lifestyle Group - The Lifestyle Group consists of Hush Puppies ® footwear and apparel, +Sebago ® footwear and apparel, Cushe ® and Soft Style ® +footwear. +Hush Puppies ® : Since 1958, the Hush +Puppies ® brand has been a leader in casual footwear. The brand offers shoes, sandals and boots for men, +women and children. The brand’s modern styling is complemented by a variety of comfort features and proprietary technologies that have earned the brand its reputation for comfort, style and value. In addition, the Company licenses the Hush +Puppies ® brand for use on certain items, including apparel, eyewear, handbags, socks, watches and plush +toys. +Sebago ® : The Sebago ® +product line has been marketed since 1946 and consists primarily of performance nautical and American-inspired casual footwear for men and women, such as boat shoes and hand sewn loafers. Highly recognized Sebago ® line extensions include Sebago Docksides ® , Drysides ® and +Triwater™. The Sebago ® manufacturing and design tradition of quality components, durability, +comfort and “Americana” heritage is further supported by targeted distribution to better-grade independent, marine and department store retailers throughout the world. +Cushe ® : The +Cushe ® business focuses on relaxed, design-led footwear for active men and women. The Cushe ® Footwear business targets younger adult consumers and better-grade retailers with products ranging from sport casual +footwear to sandals. Cushe ® is marketed under three primary collections: Universal Traveler, Urban Safari +and Coastal Supremacy. +Soft Style ® : The Soft +Style ® product line consists primarily of women’s dress and casual footwear. +4. +The Performance + Lifestyle Group - PLG consists of Keds ® footwear , Saucony ® +footwear and apparel, Sperry Top-Sider ® footwear and apparel, and Stride Rite ® footwear. +Keds ® : The Keds ® +brand is an authentic casual lifestyle brand with a foundation in canvas footwear. This iconic American brand was founded in 1916 when Keds ® redefined footwear with the introduction of the Champion ® sneaker. The simple and chic design ignited a style revolution, capturing the hearts of girls everywhere from fashion icons to the girl next door. Today, +Keds ® is a head-to-toe fashion lifestyle brand fueled by a passion for imagination, inspiring a new +generation of girls to stay authentic, optimistic and brave. The brand targets teen girl consumers through an extensive collection of Champion ® originals, as well as a wide assortment of fashion sneakers and slip-ons. The brand’s product architecture consists of both core offerings and seasonal +iterations featuring updated prints, patterns, materials and constructions. +Saucony ® : The Saucony ® brand is a leading global performance running brand with roots dating back to 1898. Saucony ® targets elite, dedicated and casual running consumers through best-in-class design, innovation and performance technology. The brand is focused on meeting the +biomechanical needs of runners while maximizing comfort and protection, bringing to market innovations such as: PowerGrid™ midsole technology; Sauc-Fit ® , ComfortLite Sock Liner™ and HydraMAX™ upper technologies; and iBR+™ and XT-900™ outsole material innovations. Saucony ® offers five categories of footwear product—technical, natural motion, race, trail and lifestyle originals, +as well as a complete line of +8 +performance running apparel. Through the Find Your Strong™ brand platform, Saucony ® is strengthening connections with consumers and elevating the position of the brand globally. The brand’s products are distributed primarily through leading +run specialty and sporting goods retailers. +Sperry Top-Sider ® : Sperry Top-Sider ® is a leading nautical performance and lifestyle brand offering footwear, apparel and accessories to a broad range of consumers globally. The brand has been an +American favorite since 1935 with the advent of the industry’s first boat shoe. Today, Sperry +Top-Sider ® remains the unquestioned leader in the boat shoe category, but has also expanded its business +into casuals, dress casuals, wet weather, boots and vulcanized product categories. The brand has evolved into a well-balanced, multi-category, year-round business for men, women and children. In addition to its lifestyle products, Sperry +Top-Sider ® also offers sport-specific and athlete-tested performance footwear solutions for sailors, +boaters, anglers and multi-water sports enthusiast. The Advance Water Technologies ™ product collection featuring A SV™ (Anti-Shock and Vibration) , Grip X3 Technology ® and SON-R +Technology ® has allowed Sperry Top-Sider ® to reinforce its position as an innovation leader in these categories. The brand is primarily distributed through leading premium and better lifestyle retailers +as well as through its own company-owned specialty retail stores. +Stride Rite ® : With a history dating back to 1919, Stride Rite ® is the industry leader in kid-focused footwear technology and innovation. Trusted by parents everywhere, and +endorsed by the American Podiatric Medical Association, Stride Rite ® is focused on delivering the best +possible footwear for kids under 9 across a range of categories. All Stride Rite ® product is created from an in-depth knowledge and understanding of how +children walk and grow; every new material and component is rigorously tested to ensure safety, proper fit and durability for kids. Stride Rite’s ® RITE STEPs™ program, featuring the brand’s proprietary Sensory Response Technology™, is a full footwear solution that meets kid’s needs from +pre-walkers to pre-schoolers. Stride Rite ® sells its own namesake brand, as well as kid’s footwear +offerings from Saucony ® , Sperry Top-Sider ® , Keds ® and select +other footwear brands, through a network of mall-based specialty retail stores and a consumer-direct website. Stride +Rite ® also distributes footwear through better department stores, footwear independents, sporting goods, +mall specialty, online retailers and national family footwear stores. +Consumer-Direct +The operating groups for the Company’s consumer direct reportable segment for fiscal 2012 are described below. +1. +Wolverine Retail consists of the Company’s legacy consumer-direct business, operating 87 North American and 12 United Kingdom-based retail +stores at December 29, 2012. These stores are operated under the Hush Puppies ® , Hush Puppies and +Family SM , Track’N Trail ® , Sebago ® , Wolverine Company +Store ® , Rockford Footwear Depot ® and Merrell ® names. +The Wolverine Company Store ® , Track’N +Trail ® , Hush Puppies ® and Hush Puppies and Family SM +retail formats carry a large selection of Company-branded products, featuring such brands as Wolverine ® , Merrell ® , Hush +Puppies ® , Cat ® , Chaco ® , Cushe ® , Patagonia ® , Sebago ® and +Harley-Davidson ® . The Company also operates +Merrell ® specialty stores, Hush Puppies ® specialty stores and +Sebago ® specialty stores, providing a platform to showcase these brands exclusively. In addition, +Wolverine retail operates 38 consumer-direct retail websites, including www.merrell.com, www.wolverine.com, www.cushe.com, www.hushpuppies.com , www.chacos.com, www.catfootwear.com , www.sebago.com and +www.batesfootwear.com . +2. +PLG Retail markets its products directly to consumers through a variety of owned formats: Stride Rite ® specialty and outlet children’s stores, Stride Rite ® store-in-stores, Sperry +Top-Sider ® +9 +specialty and outlet stores, Saucony ® outlet stores +and eCommerce websites. At December 29, 2012, PLG retail included 345 stores, owned or licensed primarily in North America and 25 consumer-direct retail websites. Stride Rite ® children’s stores are located primarily in large regional shopping centers, clustered generally in the major metropolitan areas of the U.S. Stride Rite ® outlet stores, in addition to children’s footwear, also carry a broad range of footwear for adults. Most of +the outlet stores are located in shopping centers consisting only of outlet stores. PLG retail also operates Stride +Rite ® shoe departments within select locations of a large U.S. department store chain. Sperry +Top-Sider ® stores tend to be located in affluent areas that embrace the nautical lifestyle that the brand +projects. +Other Businesses +In addition to its branded wholesale footwear, apparel and licensing and consumer-direct reportable segments, the Company also operates a performance leathers business through its Wolverine Leathers +Division. +The Wolverine Leathers Division The Wolverine Leathers Division markets pigskin leather for use +primarily in the footwear industry. The Company believes pigskin leather offers superior performance and other advantages over cowhide leather. The Company’s waterproof and stain resistant leathers are featured in some of the Company’s +footwear lines and many products offered by the Company’s international licensees and distributors. +Marketing +The Company’s marketing strategy is to develop brand-specific plans and related promotional materials for U.S. and international markets to foster a +consistent message for each of the Company’s core brands. Each brand operating group has dedicated marketing personnel who develop the marketing strategy for brands within that group. Marketing campaigns and strategies vary by brand and are +designed to target accounts and/or end users as the branded operating groups strive to increase awareness of, and affinity for, the Company’s brands. The Company’s advertisements typically emphasize fashion, comfort, quality, durability, +functionality and other performance and lifestyle aspects of the Company’s products. Components of the brand-specific plans vary and may include print, radio and television advertising, search engine optimization, social networking sites, event +sponsorships, in-store point-of-purchase displays, promotional materials, and sales and technical assistance. +The Company’s branded +operating groups provide its licensees and distributors with creative direction, brand images and other materials to convey consistent brand messaging, including (i) direction on the categories of footwear to be promoted, (ii) photography +and layouts, (iii) broadcast advertising, including commercials and film footage, (iv) point-of-purchase presentation specifications, blueprints and packaging, (v) sales materials and (vi) consulting services regarding retail +store layout and design. The Company believes its brand names represent a competitive advantage, and the Company makes significant expenditures on marketing and promotion to support the position of its products and enhance brand awareness. +Domestic Sales and Distribution +The Company targets a wide variety of domestic distribution channels and strategies to distribute its branded products: +• +The Company uses a dedicated sales force and customer service team, advertising and point-of-purchase support and maintains in-stock inventories to +service department stores, national chains, specialty retailers, catalogs, independent retailers, uniform outlets and its own consumer-direct business. +• +Volume direct programs ship products directly to the retail customer without going through a Company distribution center and provide products at +competitive prices with limited marketing support. The Company uses these programs to service major retail, catalog, mass merchant and government customers. +10 +• +A network of independent Shoemobile ® distribution outlets distributes the Company’s work and occupational footwear at industrial facilities. +• +The Company solicits all branches of the U.S. military and submits bids for contracts to supply specific footwear products. Such contracts typically +contain future purchase options that may or may not be exercised. +In addition to its wholesale activities, the Company also +operates a consumer-direct business as described above. The Company continues to develop new programs, both independently and in conjunction with its retail customers, for the distribution of its products. +A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the +Company’s revenue in fiscal 2012. +The Company experiences moderate fluctuations in sales volume during the year as reflected in +quarterly revenue (and taking into consideration the 16 weeks or 17 weeks included in the Company’s fiscal fourth quarter versus the 12 weeks included in each of the first three fiscal quarters). The Company expects current seasonal sales +patterns to continue in future years. The Company also experiences some fluctuation in its levels of working capital, typically including an increase in net working capital requirements near the end of the first and third fiscal quarters. The +Company meets its working capital requirements through internal free cash flow and, as needed, a Revolving Credit Facility. +International +Operations and Global Licensing +The Company’s foreign-sourced revenue is generated from a combination of (i) sales of branded +footwear and apparel through the Company’s owned operations in Canada, the United Kingdom and certain countries in continental Europe, (ii) sales to third-party distributors for certain markets and businesses, and (iii) royalty income +from a network of third-party licensees and distributors, and income from joint ventures that market the Company’s branded products in certain countries in South America and Asia. The Company’s international owned operations are located in +markets where the Company believes it can gain a strategic advantage by directly controlling the sale of its products into retail accounts. License and distribution arrangements enable the Company to develop sales in other markets without the +capital commitment required to maintain related foreign operations, employees, inventories or localized marketing programs. During fiscal 2012, the Company formed joint ventures to market and distribute footwear and apparel in Colombia and India. +The Company believes that these joint ventures will provide it with a more meaningful ownership stake and near-term brand impact in these fast-growing markets than its traditional licensee and distributor arrangements. +The Company continues to develop its network of licensees and distributors to market its branded products. The Company assists its licensees in designing +products that are appropriate to each foreign market, but consistent with the global brand positioning. Pursuant to distribution or license agreements, third-party licensees and distributors either purchase goods directly from the Company and +authorized third-party manufacturers or manufacture branded products themselves, consistent with Company standards. Distributors and licensees are responsible for independently marketing and distributing the Company’s branded products in their +respective territories, with product and marketing support from the Company. +Manufacturing and Sourcing +The Company directly controls the majority of the units of footwear and apparel manufactured or sourced under the Company’s brand names. The +Company’s licensees directly control the balance. A substantial majority of the units sourced or manufactured by the Company are procured from third parties, with the remainder produced at Company-owned facilities. The Company sources a +majority of its footwear from numerous third-party manufacturers in the Asia Pacific region, South America and India. The Company maintains offices in the Asia +11 +Pacific region to facilitate and develop strategies for the sourcing and importation of quality footwear and apparel. The Company has established guidelines for each of its third-party +manufacturers in order to monitor product quality, labor practices and financial viability. The Company has adopted “Engagement Criteria for Partners & Sources,” a policy that requires that the Company’s domestic and foreign +manufacturers, licensees and distributors use ethical business standards; comply with all applicable health and safety laws and regulations; commit to use environmentally safe practices; treat employees fairly with respect to wages, benefits and +working conditions; and not use child or prison labor. Footwear produced by the Company is manufactured at Company-operated facilities located in Michigan and the Dominican Republic. +The Company’s owned manufacturing operations allow the Company to (i) reduce its production lead time, to more quickly respond to market demand and reduce inventory risk, (ii) lower +freight, shipping and duty costs for sales to certain markets, and (iii) more closely monitor product quality. The Company’s third-party sourcing strategy allows the Company to (i) benefit from lower manufacturing costs and +state-of-the-art manufacturing facilities, (ii) source high quality raw materials from around the world, and (iii) avoid capital expenditures necessary for additional owned factories. The Company believes that its overall global +manufacturing strategy provides the flexibility to properly balance the need for timely shipments, high quality products and competitive pricing. +The Company’s principal required raw material is quality leather, which it purchases from a select group of domestic and foreign suppliers. The global availability of common upper materials and +specialty leathers eliminates any reliance by the Company on a sole supplier. +The Company currently purchases all of the raw pigskins used +for its Wolverine Leathers Division from one domestic source, which has been a reliable and consistent supplier to the Company for over 40 years. Alternative sources of raw pigskin are available, but with less advantageous pricing, quality and +compatibility with the Company’s processing method. The Company purchases all of its other raw materials and component parts from a variety of sources and does not believe that any of these sources are a dominant supplier. +The Company is subject to the normal risks of doing business abroad due to its international operations, including the risk of expropriation, acts of war +or terrorism, political disturbances and similar events, the imposition of trade barriers, quotas, tariffs and duties, loss of most favored nation trading status and currency and exchange rate fluctuations. With respect to international sourcing +activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products currently obtained from its foreign suppliers, but that a sustained disruption of such sources of supply could have +an adverse impact on the Company’s results of operations and financial position. +Trademarks, Licenses and Patents +The Company holds a significant portfolio of registered and common law trademarks that identify its branded products and +technologies. The Company’s owned trademarks include Hush Puppies ® , Dog Likeness (registered design +trademark), Wolverine ® , Bates ® , Cushe ® , Chaco ® , Soft Style ® , Wolverine Fusion ® , +DuraShocks ® , MultiShox ® , Wolverine +Compressor ® , Wolverine ICS ® , Hidden Tracks ® , +iTechnology TM , Bounce ® , Comfort Curve ® , HyTest ® , +Merrell ® , M Circle Design (registered design trademark), Continuum ® , Sebago ® , Q Form ® , Sperry +Top-Sider ® , Saucony ® , Stride Rite ® and +Keds ® . The Company’s Wolverine Leathers Division markets its pigskin leathers under the +trademarks Wolverine Warrior Leather ® , Weather Tight ® and All Season Weather Leathers ™. The Company has footwear marketing and distribution rights under +the Cat ® , Harley-Davidson ® and Patagonia ® +trademarks pursuant to license arrangements with the respective trademark owners. The Cat ® , +Harley-Davidson ® , and Patagonia ® licenses extend for three or more years and are subject to early termination for breach. +The Company believes that consumers identify its products by the Company’s trademarks and that its trademarks are valuable assets. The Company is not aware of any third-party infringing uses or any +prior claims of +12 +ownership of its trademarks that could materially affect its current business. The Company has a policy of registering its primary trademarks and vigorously defending its trademarks against +infringement or other threats whenever practicable. The Company also holds many design and utility patents, copyrights and various other proprietary rights. The Company vigorously protects its proprietary rights under applicable laws. +Order Backlog +At the end of fiscal +2012, the Company had an order backlog of approximately $879.4 million compared to an order backlog of approximately $483 million at the end of fiscal 2011. The increase in the fiscal 2012 backlog reflects the fiscal 2012 acquisition of PLG. A +majority of the backlog relates to orders for products expected to be shipped in 2013. Orders in the backlog are subject to cancellation by customers and to changes in planned customer demand or at-once orders. The backlog at any particular time is +affected by a number of factors, including seasonality, retail conditions, expected customer demand, product availability and the schedule for the manufacture and shipment of products. Accordingly, a comparison of backlog from period to period is +not necessarily meaningful and may not be predictive of eventual actual shipments. +Competition +The Company markets its footwear and apparel lines in a highly competitive and fragmented environment. The Company competes with numerous domestic and +international marketers and importers, some of which are larger and have greater resources than the Company. The Company has a significant number of major competitors for its brands of footwear and apparel. Product performance and quality, including +technological improvements, product identity, competitive pricing and ability to control costs, and the ability to adapt to style changes are all important elements of competition in the footwear and apparel markets served by the Company. The +footwear and apparel industries in general are subject to changes in consumer preferences. The Company strives to maintain its competitive position through promotions designed to increase brand awareness, manufacturing and sourcing efficiencies, and +the style, comfort and value of its products. Future sales by the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in consumer preferences. +Because of the lack of reliable published statistics, the Company is unable to state with certainty its competitive position in the overall footwear and +apparel industries. Market shares in the non-athletic footwear and apparel industry are highly fragmented, and no one company has a dominant market position. +Research and Development +In addition to normal and recurring product +development, design and styling activities, the Company engages in research and development activities related to the development of new production techniques and to the improvement of the function, performance, reliability and quality of its +branded footwear and other products. For example, the Company’s continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University has helped validate and refine specific biomechanical design concepts, such as +Bounce ® , DuraShocks ® and Hidden Tracks ® +comfort technologies that have been incorporated into the Company’s footwear. With the acquisition of PLG, the Company now incorporates the research and testing capabilities of the +Saucony ® human performance and innovation lab as well as research funded at University labs including the +University of Colorado and the University of Delaware with a particular focus on quantifying the interaction between footwear and apparel and runners’ strides. While the Company expects to continue to be a leading developer of footwear +innovations, research and development costs do not represent a material portion of operating expenses. +Environmental Matters +Compliance with foreign and domestic federal, state and local requirements regulating the discharge of materials into the environment, or +otherwise relating to the protection of the environment, have not had, nor are they +13 +expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company. The Company uses and generates certain substances and wastes that are regulated +or may be deemed hazardous to the environment under certain federal, state and local regulations. The Company works with domestic and foreign federal, state and local agencies from time to time to resolve cleanup issues at various waste sites and +other regulatory issues. +Employees +As of December 29, 2012, the Company had approximately 8,299 domestic and foreign production, office and sales employees. Approximately 58 employees were covered by a single union contract that +expires on March 31, 2013. The Company presently considers its employee relations to be good. +Available Information +Information about the Company, including the Company’s Code of Conduct & Compliance, Corporate Governance Guidelines, Director Independence +Standards, Accounting and Finance Code of Ethics, Audit Committee Charter, Compensation Committee Charter, and Governance Committee Charter, is available at its website at www.wolverineworldwide.com/investor-relations/corporate-governance . +Printed copies of the documents listed above are available, without charge, by writing to the Company at 9341 Courtland Drive, N.E., Rockford, Michigan 49351, Attention: General Counsel. +The Company also makes available on or through its website, free of charge, the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to +those reports (along with certain other Company filings with the Securities and Exchange Commission (“SEC”)), as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These materials +are also accessible on the SEC’s website at www.sec.gov . \ No newline at end of file diff --git a/raw/filings/0000110471/2012/0001193125-13-079739/item13.txt b/raw/filings/0000110471/2012/0001193125-13-079739/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..67e72db52b7ddf5f2d9cdc278a07aa87358d8685 --- /dev/null +++ b/raw/filings/0000110471/2012/0001193125-13-079739/item13.txt @@ -0,0 +1,6 @@ +Item 13. Certain Relationships and Related Transactions, and Director +Independence +The information contained under the caption “Related Party Matters” under the subheadings “Certain +Relationships and Related Transactions” and “Related Person Transactions Policy” contained in the Definitive Proxy Statement of the Company with respect to the Annual Meeting of Stockholders to be held on April 18, 2013, is +incorporated herein by reference. The information contained under the caption “Corporate Governance” under the subheading “Director Independence” contained in the Definitive Proxy Statement of the Company with respect to the +Annual Meeting of Stockholders to be held on April 18, 2013, is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000110471/2012/0001193125-13-079739/item9a.txt b/raw/filings/0000110471/2012/0001193125-13-079739/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..9bf172696625f7415d17a8fc8af4a850813e64a5 --- /dev/null +++ b/raw/filings/0000110471/2012/0001193125-13-079739/item9a.txt @@ -0,0 +1,21 @@ +Item 9A. Controls and Procedures +Evaluation of Disclosure Controls and Procedures +An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of +the design and +45 +operation of the Company’s disclosure controls and procedures. Based on and as of the time of such evaluation, the Company’s management, including the Chief Executive Officer and Chief +Financial Officer, concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report. +Management’s Report on Internal Control Over Financial Reporting +Management is +responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Under the supervision and with the participation of management, including our Chief +Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of internal control over financial reporting as of December 29, 2012, based on the framework in Internal Control—Integrated Framework issued by +the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on that evaluation, management concluded that internal control over financial reporting was effective as of December 29, 2012. +Based on the Securities and Exchange Commission’s staff interpretation guidance for newly acquired businesses, management’s assessment of and +conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of the Performance + Lifestyle Group Business, which was included in the Company’s fiscal 2012 consolidated financial statements +since the acquisition date of October 9, 2012. PLG constituted 66% of total assets as of December 29, 2012 and 13% of revenues for the year then fiscal year-ended. +The effectiveness of the Company’s internal control over financial reporting as of December 29, 2012 has been audited by Ernst & Young LLP, an independent registered public accounting +firm, as stated in its report, which is included in Appendix A and is incorporated into this Item 9A by reference. +Changes in +Internal Control Over Financial Reporting +There was no change in the Company’s internal control over financial reporting that +occurred during the sixteen-week period ended December 29, 2012 that has materially affected, or that is reasonably likely to materially affect, the Company’s internal control over financial reporting. \ No newline at end of file diff --git a/raw/filings/0000110471/2012/0001193125-13-079739/rp_note.txt b/raw/filings/0000110471/2012/0001193125-13-079739/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000110471/2012/0001193125-13-079739/rpt_disclosure.txt b/raw/filings/0000110471/2012/0001193125-13-079739/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..335985ff734170805465ebbe918a51a082474e96 --- /dev/null +++ b/raw/filings/0000110471/2012/0001193125-13-079739/rpt_disclosure.txt @@ -0,0 +1,25 @@ +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +Wolverine Worldwide has entered into agreements with Grimoldi S.A., an Argentinean corporation of which Mr. Alberto L. Grimoldi, a director of Wolverine Worldwide, is chairman and a 35% shareholder. The agreements grant Grimoldi, S.A. the exclusive rights to distribute and sell footwear products in Argentina under the Hush Puppies®, Caterpillar®, and Patagonia® brand names, and footwear and apparel under the Merrell® brand name. Grimoldi S.A. or its subsidiary purchases products, samples, footwear components, advertising materials and miscellaneous items from Wolverine Worldwide or pays Wolverine Worldwide royalties and certain sublicense fees based on sales or purchases of products in Argentina. Grimoldi S.A. was obligated to pay Wolverine Worldwide purchase prices, royalties, sublicense fees, service fees and interest relating to purchases made or royalties and fees incurred in fiscal year 2013 totaling $5,660,001. All of the transactions described above occurred pursuant to continuing contractual arrangements between Wolverine Worldwide and Grimoldi S.A. Wolverine Worldwide expects similar transactions to occur between Grimoldi S.A. and Wolverine Worldwide and its subsidiaries during fiscal year 2014. The Governance Committee reviewed and approved or ratified each of these transactions in accordance with Wolverine Worldwide’s related person transactions policy, as described below. +RELATED PERSON TRANSACTIONS POLICY +Wolverine Worldwide’s Board adopted written policies and procedures regarding related person transactions. They require the Governance Committee to review and either approve or disapprove the Company entering into any Interested Transactions (defined below). If advance approval is not feasible, then the Governance Committee must review and ratify the Interested Transaction at its next meeting. +Interested Transaction +Any transaction, arrangement or relationship or series of similar transactions, arrangements or relationships (including any indebtedness or guarantee of indebtedness) in which: +(1) +the aggregate amount involved is or is expected to exceed $50,000 since the beginning of Wolverine Worldwide’s last completed fiscal year; +(2) +Wolverine Worldwide is a participant; and +(3) +any Related Person (defined below) has or will have a direct or indirect interest (other than solely as a result of being a director or less than ten percent beneficial owner of another entity or a limited partner in a partnership in which a Related Person, together with all other Related Persons, has an interest of less than ten percent). +Related Person +Any: +(a) +person who is or was at any point during the last fiscal year for which Wolverine Worldwide filed an Annual Report on Form 10-K and proxy statement, an executive officer, director or nominee for election as a director; +(b) +greater than five percent beneficial owner of Wolverine Worldwide’s common stock; or +(c) +immediate family member * of any of the foregoing. +* Immediate family member includes a person’s spouse, parents, stepparents, children, stepchildren, siblings, mothers- and fathers-in-law, sons- and daughters-in-law, and brothers- and sisters-in-law and anyone residing in such person’s home (other than a tenant or employee). +The Governance Committee considers whether the Interested Transaction is on terms no less favorable than terms generally available to an unaffiliated third-party under the same or similar circumstances, the extent of the Related Person’s interest in the transaction, and other factors that it deems relevant. No director participates in any discussion or approval of an Interested Transaction for which he or she is a Related Person, except to provide all material information to the Governance Committee. +Wolverine Worldwide Notice of 2014 Annual Meeting of Stockholders and Proxy Statement +| Page 73 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0000928022/2000/0000950134-01-002893/filing.txt b/raw/filings/0000928022/2000/0000950134-01-002893/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..f3d0ee12bf9e0bf8d92a045d4cd79e3bb15ea9c8 --- /dev/null +++ b/raw/filings/0000928022/2000/0000950134-01-002893/filing.txt @@ -0,0 +1,2830 @@ +10-K405 +1 +d85467e10-k405.txt +FORM 10-K FOR FISCAL YEAR END DECEMBER 31, 2000 +1 +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF +THE SECURITIES EXCHANGE ACT OF 1934 +FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000 +COMMISSION FILE NUMBER 0-25192 +CALLON PETROLEUM COMPANY +(Exact name of Registrant as specified in its charter) +DELAWARE 64-0844345 +------------------------------- ------------------ +(State or other jurisdiction of (I.R.S. Employer +incorporation or organization) Identification No.) +200 NORTH CANAL STREET +NATCHEZ, MISSISSIPPI 39120 (601) 442-1601 +------------------------------- ------------------------------- +(Address of Principal Executive (Registrant's telephone number +Offices)(Zip Code) including area code) +Securities registered pursuant to Section 12(b) of the Act: +TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED +------------------- ------------------------------------ +Convertible Exchangeable Preferred Stock, New York Stock Exchange +Series A, Par Value $.01 Per Share +Common Stock, Par Value $.01 Per Share New York Stock Exchange +Preferred Stock Purchase Rights New York Stock Exchange +10.25% Senior Subordinated Notes due 2004 New York Stock Exchange +11.00% Senior Subordinated Notes due 2005 New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: NONE +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 if disclosure of delinquent filers pursuant to Item 405 +of Regulation S-K is not contained herein, and will not be contained, to the +best of Registrant's knowledge, in definitive proxy or information statements +incorporated by reference in Part III of this Form 10-K or any amendment to this +Form 10-K. [X] +The aggregate market value of the voting stock held by nonaffiliates of the +registrant was approximately $125,850,000 as of March 16, 2001 (based on the +last reported sale price of such stock on the New York Stock Exchange). +As of March 16, 2001, there were 13,353,223 shares of the Registrant's Common +Stock, par value $.01 per share, outstanding. +Document incorporated by reference: Portions of the definitive Proxy Statement +of Callon Petroleum Company (to be filed no later than 120 days after December +31, 2000) relating to the Annual Meeting of Stockholders to be held on May 4, +2001, which is incorporated into Part III of this Form 10-K. +2 +PART I. +ITEM 1. BUSINESS +OVERVIEW +Callon Petroleum Company (the "Company") has been engaged in the exploration, +development, acquisition and production of oil and gas properties since 1950. +The Company's properties are geographically concentrated primarily offshore in +the Gulf of Mexico and onshore in Louisiana and Alabama. The Company was formed +under the laws of the state of Delaware in 1994 through the consolidation of a +publicly traded limited partnership, a joint venture with a consortium of +European institutional investors and an independent energy company owned by +certain members of current management (the "Consolidation"). As used herein, the +"Company" refers to Callon Petroleum Company and its predecessors and +subsidiaries unless the context requires otherwise. +In 1989, the Company began increasing its reserves through the acquisition of +producing properties that were geologically complex, had (or were analogous to +fields with) an established production history from stacked pay zones and were +candidates for exploitation. The Company focused on reducing operating costs and +implementing production enhancements through the application of technologically +advanced production and recompletion techniques. +Over the past five years, the Company has also placed emphasis on the +acquisition of acreage with exploration and development drilling opportunities +in the Gulf of Mexico Shelf area. The Company acquired an infrastructure of +production platforms, gathering systems and pipelines to minimize development +expenditures of these drilling opportunities. The Company also joined with other +industry partners, primarily Murphy Exploration and Production, Inc., ("Murphy") +to explore federal offshore blocks acquired in the Gulf of Mexico. Over the last +several years we have expanded our areas of exploration to include the Gulf of +Mexico Deepwater area (generally 900 to 5,500 feet of water). During this past +five-year period, Callon has drilled 26 productive wells and 16 dry holes for a +total of 42 wells and a success rate of 62%. These 26 productive wells include 3 +onshore, 17 in the Gulf of Mexico Shelf area and 6 in the deepwater region of +the Gulf. +The Company ended the year 2000 with estimated net proved reserves of 334 +billion cubic feet of natural gas equivalent ("Bcfe") and a reserve replacement +rate of 584%. This represents an increase of 28% over 1999 year-end estimated +net proved reserves of 259 Bcfe. +The major focus of the Company's future operations is expected to continue to be +the exploration for and development of oil and gas properties, primarily in the +Gulf of Mexico. +BUSINESS STRATEGY +Our goal is to increase shareholder value by increasing our reserves, +production, cash flow and earnings. We seek to achieve these goals through the +following strategies: +o Focus on Gulf of Mexico exploration with a balance between shelf and +deepwater area using the latest available technology. +o Aggressively explore our existing prospect inventory. +o Replenish our prospect inventory with increasing emphasis on prospect +generation. +2 +3 +o Achieve moderate increases in current production levels through +continued shelf exploration. +o Achieve significant increases in longer-term production levels through +development of deepwater discoveries and ongoing deepwater +exploration. +EXPLORATION AND DEVELOPMENT ACTIVITIES +Capital expenditures for exploration and development costs related to oil and +gas properties totaled approximately $82 million in 2000. The Company incurred +approximately $32.6 million in the Gulf of Mexico Shelf area primarily in the +development of the 1999 discoveries at South Marsh Island 261 and East Cameron +Block 275. Included in these expenditures as exploration costs, is approximately +$7.5 million related to three unsuccessful Gulf of Mexico Shelf prospects +evaluated during 2000. The Gulf of Mexico Deepwater area expenditures accounted +for the remainder of the total capital expended, along with $5.8 million +incurred in leasehold and seismic acquisition costs and $11.9 million of +interest and general and administrative costs allocable directly to exploration +and development projects. The Gulf of Mexico Deepwater area expenditures +included three unsuccessful exploration projects totaling $9.3 million and the +balance was incurred for additional delineation drilling at the Company's Medusa +discovery and the drilling of a test well and delineation drilling at the +Entrada discovery in 2000. The Entrada discovery is located on Garden Banks +Block 782, and reached total depth in April 2000. +As a result of recent successes in the Gulf of Mexico Deepwater area, the +Company is faced with increased costs to develop these significant proved +undeveloped reserves. Substantially all of the future development costs will be +incurred in 2001 and beyond. The Company is currently evaluating various +financing alternatives to address these issues. While management believes there +are a number of financing sources available to the Company, no assurances can be +made that the Company will be able to fund these development costs. +RISK FACTORS +DECREASE IN OIL AND GAS PRICES MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS +AND FINANCIAL CONDITION. Our success is highly dependent on prices for oil and +gas, which are extremely volatile. Any substantial or extended decline in the +price of oil or gas would have a material adverse effect on us. Oil and gas +markets are both seasonal and cyclical. The prices of oil and gas depend on +factors we cannot control such as weather, economic conditions, levels of +production, actions by OPEC and other countries and government actions. Prices +of oil and gas will affect the following aspects of our business: +o our revenues, cash flows and earnings; +o the amount of oil and gas that we are economically able to produce; +o our ability to attract capital to finance our operations and the cost +of the capital; +o the amount we are allowed to borrow under our senior credit facility; +o the value of our oil and gas properties; and +o the profit or loss we incur in exploring for and developing our +reserves. +UNLESS WE ARE ABLE TO REPLACE RESERVES, WHICH WE HAVE PRODUCED, OUR CASH FLOWS +AND PRODUCTION WILL DECREASE OVER TIME. Our future success depends upon our +ability to find, develop and acquire oil and gas reserves that are economically +recoverable. As is generally the case for Gulf Coast properties, our producing +properties usually have high initial production rates, followed by a steep +decline in production. As a result, we must continually locate and develop or +acquire new oil and gas reserves to replace those being depleted by production. +We must do this even during periods of low oil and gas prices when it is +difficult to raise the capital necessary to finance these activities and during +periods of high operating costs +3 +4 +when it is expensive to contract for drilling rigs and other equipment and +personnel necessary to explore for oil and gas. Without successful exploration +or acquisition activities, our reserves, production and revenues will decline +rapidly. We cannot assure you that we will be able to find and develop or +acquire additional reserves at an acceptable cost. +Also, because of the short life of our reserves, our return on the investment we +make in our oil and gas wells and the value of our oil and gas wells will depend +significantly on prices prevailing during relatively short production periods. +A SIGNIFICANT PART OF THE VALUE OF OUR PRODUCTION AND RESERVES IS CONCENTRATED +IN A SMALL NUMBER OF OFFSHORE PROPERTIES, AND ANY PRODUCTION PROBLEMS OR +INACCURACIES IN RESERVE ESTIMATES RELATED TO THOSE PROPERTIES WOULD ADVERSELY +IMPACT OUR BUSINESS. During 2000, about 57% of our daily production came from +three of our properties in the Gulf of Mexico. Moreover, one property accounted +for 35% of our production during this period. If mechanical problems, storms or +other events curtailed a substantial portion of this production, our results of +operations would be adversely affected. In addition, at December 31, 2000 most +of our proved reserves were located in 11 fields in the Gulf of Mexico, with +approximately 90% of our total net proved reserves attributable to five of these +properties. If the actual reserves associated with any one of these five +discoveries are less than our estimated reserves, our results of operations and +financial condition could be adversely affected. +OUR FOCUS ON EXPLORATION PROJECTS INCREASES THE RISKS INHERENT IN OUR OIL AND +GAS ACTIVITIES. Our business strategy focuses on replacing reserves through +exploration, where the risks are greater than in acquisitions and development +drilling. Although we have been successful in exploration in the past, we cannot +assure you that we will continue to increase reserves through exploration or at +an acceptable cost. Additionally, we are often uncertain as to the future costs +and timing of drilling, completing and producing wells. Our drilling operations +may be curtailed, delayed or canceled as a result of a variety of factors, +including: +o unexpected drilling conditions; +o pressure or inequalities in formations; +o equipment failures or accidents; +o adverse weather conditions; +o compliance with governmental requirements; and +o shortages or delays in the availability of drilling rigs and the +delivery of equipment. +BECAUSE WE DO NOT CONTROL ALL OF OUR PROPERTIES, ESPECIALLY OUR DEEP WATER +PROPERTIES, WE HAVE LIMITED INFLUENCE OVER THEIR DEVELOPMENT. We do not operate +all of our properties and have limited influence over the operations of some of +these properties, particularly our deep water projects. Our lack of control +could result in the following: +o the operator may initiate exploration or development on a faster or +slower pace than we prefer; +o the operator may propose to drill more wells or build more facilities +on a project than we have funds for or that we deem appropriate, which +may mean that we are unable to participate in the project or share in +the revenues generated by the project even though we paid our share of +exploration costs; and +o if an operator refuses to initiate a project, we may be unable to +pursue the project. +Any of these events could materially reduce the value of our properties. +4 +5 +OUR DEEP WATER OPERATIONS HAVE SPECIAL OPERATIONAL RISKS THAT MAY NEGATIVELY +AFFECT THE VALUE OF THOSE ASSETS. Drilling operations in the deep water area are +by their nature more difficult and costly than drilling operations in shallow +water. They require the application of more advanced drilling technologies, +involving a higher risk of technological failure and usually resulting in +significantly higher drilling costs. Deep water wells are completed using subsea +completion techniques that require substantial time and the use of advanced +remote installation equipment. These operations involve a high risk of +mechanical difficulties and equipment failures that could result in significant +cost overruns. +In deep water, the time required to commence production following a discovery is +much longer than in shallow water and on-shore. Our deep water discoveries and +prospects will require the construction of expensive production facilities and +pipelines prior to the beginning of production. We cannot estimate the costs and +timing of the construction of these facilities with certainty, and the accuracy +of our estimates will be affected by a number of factors beyond our control, +including the following: +o decisions made by the operators of our deep water wells; +o the availability of materials necessary to construct the facilities; +o proximity of our discoveries to pipelines; and +o the price of oil and natural gas. +Delays and cost overruns in the commencement of production will affect the value +of our deep water prospects and the discounted present value of reserves +attributable to those prospects. +COMPETITIVE INDUSTRY CONDITIONS MAY NEGATIVELY AFFECT OUR ABILITY TO CONDUCT +OPERATIONS. Exploration in the Gulf of Mexico has recently received renewed +interest, especially among major integrated oil companies and large independent +oil companies. The acquisition of exploration prospects, producing properties +and production facilities in the Gulf of Mexico is highly competitive. Factors +which affect our ability to successfully compete are: +o our access to the capital necessary to drill wells and acquire +properties; +o our access to seismic, geological and other information, and our +ability to retain the personnel necessary to properly evaluate such +information; +o the location of, and our ability to access, platforms, pipelines and +other facilities used to produce and transport oil and gas production; +and +o the standards we establish for the minimum projected return on an +investment of our capital. +Our competitors include major integrated oil companies and large independent +energy companies, many of which have greater financial and other resources. +OUR COMPETITORS MAY USE SUPERIOR TECHNOLOGY, WHICH WE MAY BE UNABLE TO AFFORD OR +WHICH WOULD REQUIRE COSTLY INVESTMENT BY US IN ORDER TO COMPETE. Our industry is +subject to rapid and significant advancements in technology, including the +introduction of new products and services using new technologies. As our +competitors use or develop new technologies, we may be placed at a competitive +disadvantage, and competitive pressures may force us to implement new +technologies at a substantial cost. In addition, our competitors may have +greater financial, technical and personnel resources that allow them to enjoy +technological advantages and may in the future allow them to implement new +technologies before we can. We cannot be certain that we will be able to +implement technologies on a timely basis or at a cost that is acceptable to us. +One or more of the technologies that we currently use or that we may implement +in +5 +6 +the future may become obsolete, and we may be adversely affected. For example, +marine seismic acquisition technology has been characterized by rapid +technological advancements in recent years, and further significant +technological developments could substantially impair our 3-D seismic data's +value. +WE MAY NOT BE ABLE TO REPLACE OUR RESERVES OR GENERATE CASH FLOWS IF WE ARE +UNABLE TO RAISE CAPITAL. We will be required to make substantial capital +expenditures to develop our existing reserves, and to discover new oil and gas +reserves. Our current capital budget includes drilling 7 gross (1.1 net) +development wells and 21 gross (9.9 net) exploratory wells through fiscal 2001. +The estimated cost, net to us, to drill and complete these wells is +approximately $73 million. The estimated dry hole costs to drill these wells, +which are the costs we would incur if all of the wells were unsuccessful and we +incurred no completion costs, are approximately $38 million. Historically, we +have financed these expenditures primarily with cash from operations, proceeds +from bank borrowings and proceeds from the sale of debt and equity securities. +See "Management's Discussion and Analysis of Financial Condition and Results of +Operations -- Liquidity and Capital Resources" for a discussion of our capital +budget. We cannot assure you that we will be able to raise capital in the +future. We also make offers to acquire oil and gas properties in the ordinary +course of our business. If these offers are accepted, our capital needs may +increase substantially. +We expect to continue using our senior credit facility to borrow funds to +supplement our available cash. The amount we may borrow under our senior credit +facility may not exceed a borrowing base determined by the lenders based on +their projections of our future production, future production costs, taxes, +commodity prices and any other factors deemed relevant by our lenders. We cannot +control the assumptions the lenders use to calculate our borrowing base. The +lenders may, without our consent, adjust the borrowing base semiannually or in +situations where we purchase or sell assets or issue debt securities. If our +borrowings under the senior credit facility exceed the borrowing base, the +lenders may require that we repay the excess. If this were to occur, we might +have to sell assets or seek financing from other sources. Sales of assets could +reduce the amount of our borrowing base. We cannot assure you that we would be +successful in selling assets or arranging substitute financing. If we were not +able to repay borrowings under our senior credit facility to reduce the +outstanding amount to less than the borrowing base, we will be in default under +our senior credit facility. For a description of our senior credit facility and +its principal terms and conditions, see "Management's Discussion and Analysis of +Financial Condition and Results of Operations --Liquidity and Capital +Resources." +6 +7 +OUR RESERVE INFORMATION REPRESENTS ESTIMATES THAT MAY TURN OUT TO BE INCORRECT +IF THE ASSUMPTIONS UPON WHICH THESE ESTIMATES ARE BASED ARE INACCURATE. +Estimating quantities of proved reserves is inherently imprecise and involves +uncertainties and factors beyond our control. The reserve data in this report +represent only estimates. These estimates are based upon assumptions about +future production levels, future oil and gas prices and future operating costs. +As a result, the quantity of proved reserves may be subject to downward or +upward adjustment as additional information or analysis become available. In +addition, estimates of the economically recoverable oil and gas reserves, +classifications of such reserves, and estimates of future net cash flows, +prepared by different engineers or by the same engineers at different times, may +vary substantially. In particular, the assumptions regarding the timing and +costs to commence production from our deep water wells used in preparing our +reserves are subject to revisions over time as described under " -- Our deep +water operations have special operational risks that may negatively affect the +value of those assets." Information about reserves constitutes forward-looking +information. The discounted present value of our oil and gas reserves is +prepared in accordance with guidelines established by the SEC. A purchaser of +reserves would use numerous other factors to value our reserves. The discounted +present value of reserves, therefore, does not represent the fair market value +of those reserves. +On December 31, 2000, approximately 58.2% of the discounted present value of our +estimated net proved reserves were proved undeveloped. Substantially all of +these proved undeveloped reserves were attributable to our deep water +properties. Development of these properties is subject to additional risks as +described above. +WEATHER, UNEXPECTED SUBSURFACE CONDITIONS, AND OTHER UNFORESEEN OPERATING +HAZARDS MAY ADVERSELY IMPACT OUR ABILITY TO CONDUCT BUSINESS. There are many +operating hazards in exploring for and producing oil and gas, including: +o our drilling operations may encounter unexpected formations or +pressures, which could cause damage to equipment or personal injury; +o we may experience equipment failures which curtail or stop production; +and +o we could experience blowouts or other damages to the productive +formations that may require a well to be re-drilled or other +corrective action to be taken. +In addition, any of the foregoing may result in environmental damages for which +we will be liable. Moreover, a substantial portion of our operations are +offshore and are subject to a variety of risks peculiar to the marine +environment such as hurricanes and other adverse weather conditions. Offshore +operations are also subject to more extensive governmental regulation. +We cannot assure you that we will be able to maintain adequate insurance at +rates we consider reasonable to cover our possible losses from operating +hazards. The occurrence of a significant event not fully insured or indemnified +against could materially and adversely affect our financial condition and +results of operations. +WE MAY NOT HAVE PRODUCTION TO OFFSET HEDGES; BY HEDGING, WE MAY NOT BENEFIT FROM +PRICE INCREASES. Part of our business strategy is to reduce our exposure to the +volatility of oil and gas prices by hedging a portion of our production. In a +typical hedge transaction, we will have the right to receive from the other +parties to the hedge the excess of the fixed price specified in the hedge over a +floating price based on a market index, multiplied by the quantity hedged. If +the floating price exceeds the fixed price, we are required to pay the other +parties this difference multiplied by the quantity hedged. We are required to +pay the difference between the floating price and the fixed price when the +floating price exceeds the fixed price +7 +8 +regardless of whether we have sufficient production to cover the quantities +specified in the hedge. Significant reductions in production at times when the +floating price exceeds the fixed price could require us to make payments under +the hedge agreements even though such payments are not offset by sales of +production. Hedging will also prevent us from receiving the full advantage of +increases in oil or gas prices above the fixed amount specified in the hedge. +See "Quantitative and Qualitative Disclosures About Market Risks" for a +discussion of our hedging practices. +COMPLIANCE WITH ENVIRONMENTAL AND OTHER GOVERNMENT REGULATIONS COULD BE COSTLY +AND COULD NEGATIVELY IMPACT PRODUCTION. Our operations are subject to numerous +laws and regulations governing the discharge of materials into the environment +or otherwise relating to environmental protection. These laws and regulations +may: +o require that we acquire permits before commencing drilling; +o restrict the substances that can be released into the environment in +connection with drilling and production activities; +o limit or prohibit drilling activities on protected areas such as +wetlands or wilderness areas; and +o require remedial measures to mitigate pollution from former +operations, such as dismantling abandoned production facilities. +Under these laws and regulations, we could be liable for personal injury and +clean-up costs and other environmental and property damages, as well as +administrative, civil and criminal penalties. We maintain limited insurance +coverage for sudden and accidental environmental damages. We do not believe that +insurance coverage for environmental damages that occur over time is available +at a reasonable cost. Also, we do not believe that insurance coverage for the +full potential liability that could be caused by sudden and accidental +environmental damages is available at a reasonable cost. Accordingly, we may be +subject to liability or we may be required to cease production from properties +in the event of environmental damages. +FACTORS BEYOND OUR CONTROL AFFECT OUR ABILITY TO MARKET PRODUCTION AND OUR +FINANCIAL RESULTS. The ability to market oil and gas from our wells depends upon +numerous factors beyond our control. These factors include: +o the extent of domestic production and imports of oil and gas; +o the proximity of the gas production to gas pipelines; +o the availability of pipeline capacity; +o the demand for oil and gas by utilities and other end users; +o the availability of alternative fuel sources; +o the effects of inclement weather; +o state and federal regulation of oil and gas marketing; and +o federal regulation of gas sold or transported in interstate commerce. +Because of these factors, we may be unable to market all of the oil or gas we +produce. In addition, we may be unable to obtain favorable prices for the oil +and gas we produce. +IF OIL AND GAS PRICES DECREASE, WE MAY BE REQUIRED TO TAKE WRITEDOWNS. We may be +required to writedown the carrying value of our oil and gas properties when oil +and gas prices are low or if we have substantial downward adjustments to our +estimated net proved reserves, increases in our estimates of development costs +or deterioration in our exploration results. Under the full cost method we use +to account for our oil and gas properties, the net capitalized costs of our oil +and gas properties may not exceed the +8 +9 +present value, discounted at 10%, of future net cash flows from estimated net +proved reserves, using period end oil and gas prices and costs, plus the lower +of cost or fair market value of our unproved properties. If net capitalized +costs of our oil and gas properties exceed this limit, we must charge the amount +of the excess to earnings. This type of charge will not affect our cash flows, +but will reduce the book value of our stockholders' equity. We review the +carrying value of our properties quarterly, based on prices in effect as of the +end of each quarter or at the time of reporting our results. Once incurred, a +writedown of oil and gas properties is not reversible at a later date, even if +prices increase. +FORWARD-LOOKING STATEMENTS +In this report, we have made many forward-looking statements. We cannot assure +you that the plans, intentions or expectations upon which our forward-looking +statements are based will occur. Our forward-looking statements are subject to +risks, uncertainties and assumptions, including those discussed elsewhere in +this report. Forward-looking statements include statements regarding: +o our oil and gas reserve quantities, and the discounted present value +of these reserves; +o the amount and nature of our capital expenditures; +o drilling of wells; +o timing and amount of future production and operating costs; +o business strategies and plans of management; and +o prospect development and property acquisitions. +Some of the risks, which could affect our future results and could cause results +to differ materially from those expressed in our forward-looking statements +include: +o general economic conditions; +o volatility of oil and natural gas prices; +o uncertainty of estimates of oil and natural gas reserves; +o impact of competition; +o availability and cost of seismic, drilling and other equipment; +o operating hazards inherent in the exploration for and production of +oil and natural gas; +o difficulties encountered during the exploration for and production of +oil and natural gas; +o difficulties encountered in delivering oil and natural gas to +commercial markets; +o changes in customer demand; +o uncertainty of our ability to attract capital; +o compliance with, or the effect of changes in, the extensive +governmental regulations regarding the oil and natural gas business; +o actions of operators of our oil and gas properties; and +o climatic conditions. +The information contained in this report, including the information set forth +under the heading "Risk Factors," identifies additional factors that could +affect our operating results and performance. We urge you to carefully consider +these factors and the other cautionary statements in this report. Our +forward-looking statements speak only as of the date made, and we have no +obligation to update these forward-looking statements. +9 +10 +CORPORATE OFFICES +The Company's headquarters are located in Natchez, Mississippi, in approximately +51,500 square feet of owned space. In late 2000, the Company opened a field +office in Houston, Texas, staffed with recently hired technical professionals, +to enhance exploration and development efforts. The Company also maintains owned +or leased field offices in the area of the major fields in which it operates +properties or has a significant interest. Replacement of any of the Company's +leased offices would not result in material expenditures by the Company as +alternative locations to its leased space are anticipated to be readily +available. +EMPLOYEES +The Company had 99 employees as of December 31, 2000, none of who are currently +represented by a union. The Company considers itself to have good relations with +its employees. The Company employs eight petroleum engineers and seven petroleum +geoscientists. +FEDERAL REGULATIONS +SALES OF NATURAL GAS. Effective January 1, 1993, the Natural Gas Wellhead +Decontrol Act deregulated prices for all "first sales" of natural gas. Thus, all +sales of gas by the Company may be made at market prices, subject to applicable +contract provisions. +TRANSPORTATION OF NATURAL GAS. The rates, terms and conditions applicable to the +interstate transportation of natural gas by pipelines are regulated by the +Federal Energy Regulatory Commission ("FERC") under the Natural Gas Act ("NGA"), +as well as under section 311 of the Natural Gas Policy Act ("NGPA"). Since 1985, +the FERC has implemented regulations intended to make natural gas transportation +more accessible to gas buyers and sellers on an open-access, non-discriminatory +basis. +The FERC has announced several important transportation-related policy +statements and rule changes, including a statement of policy and final rule +issued February 25, 2000 concerning alternatives to its traditional +cost-of-service rate-making methodology to establish the rates interstate +pipelines may charge for their services. The final rule revises FERC's pricing +policy and current regulatory framework to improve the efficiency of the market +and further enhance competition in natural gas markets. +With respect to the transportation of natural gas on or across the Outer +Continental Shelf ("OCS"), the FERC requires, as part of its regulation under +the Outer Continental Shelf Lands Act, that all pipelines provide open and +non-discriminatory access to both owner and non-owner shippers. Although to date +the FERC has imposed light-handed regulation on off-shore facilities that meet +its traditional test of gathering status, it has the authority to exercise +jurisdiction under the Outer Continental Shelf Lands Act ("OCSLA") over +gathering facilities, if necessary, to permit non-discriminatory access to +service. For those facilities transporting natural gas across the OCS that are +not considered to be gathering facilities, the rates, terms, and conditions +applicable to this transportation are regulated by FERC under the NGA and NGPA, +as well as the OCSLA. +SALES AND TRANSPORTATION OF CRUDE OIL. Sales of crude oil and condensate can be +made by the Company at market prices not subject at this time to price controls. +The price that the Company receives from the sale of these products will be +affected by the cost of transporting the products to market. The rates, terms, +and conditions applicable to the interstate transportation of oil and related +products by pipelines are regulated by the FERC under the Interstate Commerce +Act. As required by the Energy Policy Act of 1992, the FERC has revised its +regulations governing the rates that may be charged by oil pipelines. The new +rules, which were effective January 1, 1995, provide a simplified, generally +applicable method of regulating such rates by use of an index for setting rate +ceilings. The FERC will also, under defined circumstances, permit alternative +ratemaking methodologies for interstate oil pipelines such as the use of cost of +service rates, settlement rates, +10 +11 +and market-based rates. Market-based rates will be permitted to the extent the +pipeline can demonstrate that it lacks significant market power in the market in +which it proposes to charge market-based rates. The cumulative effect that these +rules may have on moving the Company's production to market cannot yet be +determined. +With respect to the transportation of oil and condensate on or across the OCS, +the FERC requires, as part of its regulation under the OCSLA, that all pipelines +provide open and non-discriminatory access to both owner and non-owner shippers. +Accordingly, the FERC has the authority to exercise jurisdiction under the +OCSLA, if necessary, to permit non-discriminatory access to service. +LEGISLATIVE PROPOSALS. In the past, Congress has been very active in the area of +natural gas regulation. There are legislative proposals pending in Congress and +in various state legislatures which, if enacted, could significantly affect the +petroleum industry. At the present time it is impossible to predict what +proposals, if any, might actually be enacted by Congress or the various state +legislatures and what effect, if any, such proposals might have on the Company's +operations. +FEDERAL, STATE OR INDIAN LEASES. In the event the Company conducts operations on +federal, state or Indian oil and gas leases, such operations must comply with +numerous regulatory restrictions, including various nondiscrimination statutes, +royalty and related valuation requirements, and certain of such operations must +be conducted pursuant to certain on-site security regulations and other +appropriate permits issued by the Bureau of Land Management ("BLM") or Minerals +Management Service ("MMS") or other appropriate federal or state agencies. +The Company's OCS leases in federal waters are administered by the MMS and +require compliance with detailed MMS regulations and orders. The MMS has +promulgated regulations implementing restrictions on various production-related +activities, including restricting the flaring or venting of natural gas. Under +certain circumstances, the MMS may require Company operations on federal leases +to be suspended or terminated. Any such suspension or termination could +materially and adversely affect the Company's financial condition and +operations. On March 15, 2000, the MMS issued a final rule effective June 1, +2000 which amends its regulations governing the calculation of royalties and the +valuation of crude oil produced from federal leases. Among other matters, this +rule amends the valuation procedure for the sale of federal royalty oil by +eliminating posted prices as a measure of value and relying instead on arm's +length sales prices and spot market prices as market value indicators. Because +the Company sells its production in the spot market and therefore pays royalties +on production from federal leases, it is not anticipated that this final rule +will have any substantial impact on the Company. +The Mineral Leasing Act of 1920 ("Mineral Act") prohibits direct or indirect +ownership of any interest in federal onshore oil and gas leases by a foreign +citizen of a country that denies "similar or like privileges" to citizens of the +United States. Such restrictions on citizens of a "non-reciprocal" country +include ownership or holding or controlling stock in a corporation that holds a +federal onshore oil and gas lease. If this restriction is violated, the +corporation's lease can be canceled in a proceeding instituted by the United +States Attorney General. Although the regulations of the BLM (which administers +the Mineral Act) provide for agency designations of non-reciprocal countries, +there are presently no such designations in effect. The Company owns interests +in numerous federal onshore oil and gas leases. It is possible that holders of +equity interests in the Company may be citizens of foreign countries, which at +some time in the future might be determined to be non-reciprocal under the +Mineral Act. +11 +12 +STATE REGULATIONS +Most states regulate the production and sale of oil and natural gas, including +requirements for obtaining drilling permits, the method of developing new +fields, the spacing and operation of wells and the prevention of waste of oil +and gas resources. The rate of production may be regulated and the maximum daily +production allowable from both oil and gas wells may be established on a market +demand or conservation basis or both. +The Company may enter into agreements relating to the construction or operation +of a pipeline system for the transportation of natural gas. To the extent that +such gas is produced, transported and consumed wholly within one state, such +operations may, in certain instances, be subject to the jurisdiction of such +state's administrative authority charged with the responsibility of regulating +intrastate pipelines. In such event, the rates which the Company could charge +for gas, the transportation of gas, and the costs of construction and operation +of such pipeline would be impacted by the rules and regulations governing such +matters, if any, of such administrative authority. Further, such a pipeline +system would be subject to various state and/or federal pipeline safety +regulations and requirements, including those of, among others, the Department +of Transportation. Such regulations can increase the cost of planning, +designing, installation and operation of such facilities. The impact of such +pipeline safety regulations would not be any more adverse to the Company than it +would be to other similar owners or operators of such pipeline facilities. +ENVIRONMENTAL REGULATIONS +GENERAL. The Company's activities are subject to federal, state and local laws +and regulations governing environmental quality and pollution control. Although +no assurances can be made, the Company believes that, absent the occurrence of +an extraordinary event, compliance with existing federal, state and local laws, +rules and regulations regulating the release of materials in the environment or +otherwise relating to the protection of the environment will not have a material +effect upon the capital expenditures, earnings or the competitive position of +the Company with respect to its existing assets and operations. The Company +cannot predict what effect additional regulation or legislation, enforcement +policies thereunder, and claims for damages to property, employees, other +persons and the environment resulting from the Company's operations could have +on its activities. +Activities of the Company with respect to natural gas facilities, including the +operation and construction of pipelines, plants and other facilities for +transporting, processing, treating or storing natural gas and other products, +are subject to stringent environmental regulation by state and federal +authorities including the United States Environmental Protection Agency ("EPA"). +Such regulation can increase the cost of planning, designing, installation and +operation of such facilities. In most instances, the regulatory requirements +relate to water and air pollution control measures. Although the Company +believes that compliance with environmental regulations will not have a material +adverse effect on it, risks of substantial costs and liabilities are inherent in +oil and gas production operations, and there can be no assurance that +significant costs and liabilities will not be incurred. Moreover, it is possible +that other developments, such as stricter environmental laws and regulations, +and claims for damages to property or persons resulting from oil and gas +production, would result in substantial costs and liabilities to the Company. +SOLID AND HAZARDOUS WASTE. The Company owns or leases numerous properties that +have been used for production of oil and gas for many years. Although the +Company has utilized operating and disposal practices standard in the industry +at the time, hydrocarbons or other solid wastes may have been disposed or +released on or under these properties. In addition, many of these properties +have been operated by third parties. The Company had no control over such +entities' treatment of hydrocarbons or other solid wastes and the manner in +which such substances may have been disposed or released. State and federal laws +applicable to oil and gas +12 +13 +wastes and properties have gradually become stricter over time. Under these new +laws, the Company could be required to remove or remediate previously disposed +wastes (including wastes disposed or released by prior owners or operators) or +property contamination (including groundwater contamination by prior owners or +operators) or to perform remedial plugging operations to prevent future +contamination. +The Company generates wastes, including hazardous wastes, that are subject to +the Federal Resource Conservation and Recovery Act ("RCRA") and comparable state +statutes. The EPA has limited the disposal options for certain hazardous wastes +and is considering the adoption of stricter disposal standards for nonhazardous +wastes. Furthermore, it is possible that certain wastes currently exempt from +treatment as "hazardous wastes" generated by the Company's oil and gas +operations may in the future be designated as "hazardous wastes" under RCRA or +other applicable statutes, and therefore may be subject to more rigorous and +costly disposal requirements. +SUPERFUND. The Comprehensive Environmental Response, Compensation and Liability +Act ("CERCLA"), also known as the "Superfund" law, imposes liability, without +regard to fault or the legality of the original conduct, on certain classes of +persons with respect to the release of a "hazardous substance" into the +environment. These persons include the owner and operator of a site and persons +that disposed or arranged for the disposal of the hazardous substances found at +a site. CERCLA also authorizes the EPA and, in some cases, third parties to take +actions in response to threats to the public health or the environment and to +seek to recover from the responsible classes of persons the costs of such +action. Neither the Company nor its predecessors has been designated as a +potentially responsible party by the EPA under CERCLA with respect to any such +site. +OIL POLLUTION ACT. The Oil Pollution Act of 1990 (the "OPA") and regulations +thereunder impose a variety of regulations on "responsible parties" related to +the prevention of oil spills and liability for damages resulting from such +spills in United States waters. A "responsible party" includes the owner or +operator of a facility or vessel, or the lessee or permittee of the area in +which an offshore facility is located. The OPA assigns liability to each +responsible party for oil removal costs and a variety of public and private +damages. While liability limits apply in some circumstances, a party cannot take +advantage of liability limits if the spill was caused by gross negligence or +willful misconduct or resulted from violation of a federal safety, construction +or operating regulation. If the party fails to report a spill or to cooperate +fully in the cleanup, liability limits likewise do not apply. Few defenses exist +to the liability imposed by the OPA. +The OPA also imposes ongoing requirements on a responsible party, including +proof of financial responsibility to cover at least some costs in a potential +spill. Certain amendments to the OPA that were enacted in 1996 require owners +and operators of offshore facilities that have a worst case oil spill potential +of more than 1,000 barrels to demonstrate financial responsibility in amounts +ranging from $10 million in specified state waters and $35 million in federal +OCS waters, with higher amounts, up to $150 million based upon worst case +oil-spill discharge volume calculations. The Company believes that it currently +has established adequate proof of financial responsibility for its offshore +facilities. +AIR EMISSIONS. The operations of the Company are subject to local, state and +federal regulations for the control of emissions from sources of air pollution. +Administrative enforcement actions for failure to comply strictly with air +regulations or permits are generally resolved by payment of monetary fines and +correction of any identified deficiencies. Alternatively, regulatory agencies +could require the Company to forego construction or operation of certain air +emission sources, although the Company believes that in such case it would have +enough permitted or permittable capacity to continue its operations without a +material adverse effect on any particular producing field. +13 +14 +OSHA. The Company is subject to the requirements of the Federal Occupational +Safety and Health Act ("OSHA") and comparable state statutes. The OSHA hazard +communication standard, the EPA community right-to-know regulations under Title +III of the Federal Superfund Amendment and Reauthorization Act and similar state +statutes require the Company to organize and/or disclose information about +hazardous materials used or produced in its operations. Certain of this +information must be provided to employees, state and local governmental +authorities and local citizens. +Management believes that the Company is in substantial compliance with current +applicable environmental laws and regulations and that continued compliance with +existing requirements would not have a material adverse impact on the Company. +ITEM 2. PROPERTIES +The Company is engaged in the exploration, development, acquisition and +production of oil and gas properties and natural gas transmission and provides +oil and gas property management services for other investors. The Company's +properties are concentrated offshore in the Gulf of Mexico and onshore, +primarily, in Louisiana and Alabama. We have historically grown our reserves and +production by focusing primarily on low to moderate risk exploration and +acquisition opportunities in the Gulf of Mexico Shelf area. Over the last +several years, we have expanded our area of exploration to include the Gulf of +Mexico Deepwater area. As of December 31, 2000, the Company's estimated net +proved reserves totaled 33.4 million barrels of oil ("MBbl") and 133.4 billion +cubic feet of natural gas ("Bcf"), with a pre-tax present value, discounted at +10%, of the estimated future net revenues based on constant prices in effect at +year-end ("Discounted Cash Flow") of $939.3 million. Gas constitutes +approximately 40% of the Company's total estimated proved reserves and +approximately 20% of the Company's reserves are proved producing reserves. +14 +15 +SIGNIFICANT PROPERTIES +The following table shows discounted cash flows and estimated net proved oil and +gas reserves by major field for the Company's twelve largest fields and for all +other properties combined at December 31, 2000. +ESTIMATED NET PROVED RESERVES PRE-TAX +PROVED RESERVES AND PRODUCTION BY 2000 ------------------------------ DISCOUNTED +---------------------------------- PRIMARY PRODUCTION OIL GAS TOTAL PRESENT VALUE +FOCUS AREA: OPERATOR (MMcfe) (MBbls) (MMcf) (MMcfe) ($000) +-------------- -------- ------- ------- ------ ------- ------------- +(b) (b) (a)(b) +GULF OF MEXICO SHELF: +Mobile Block 864 Area Callon 5,474 -- 47,582 47,582 $264,436 +Main Pass Block 26 SL 15827 Callon 385 116 2,855 3,551 20,248 +South Marsh Island 261 Callon 1,960 962 2,995 8,767 18,920 +East Cameron Block 275 Callon 1,185 13 2,616 2,694 17,766 +High Island Block A-494 +"Snapper" Petrosec 668 -- 1,637 1,637 10,852 +Main Pass 163 Area Callon 1,317 -- 2,431 2,431 10,404 +Chandeleur Block 40 Callon 399 -- 1,470 1,470 9,758 +Other Various 2,166 79 2,537 3,011 15,294 +-------- -------- -------- -------- -------- +TOTAL SHELF AREA 13,554 1,170 64,123 71,143 367,678 +-------- -------- -------- -------- -------- +GULF OF MEXICO DEEPWATER: +Garden Banks Blocks 738/782/826/827 +"Entrada" BP Amoco -- 7,983 29,940 77,838 191,234 +Mississippi Canyon 538/582 +"Medusa" Murphy -- 9,585 9,288 66,798 130,982 +Garden Banks Block 341 +"Habanero" Shell -- 6,393 12,547 50,905 112,967 +Ewing Bank Block 994 +"Boomslang" Murphy -- 7,230 13,015 56,395 102,206 +-------- -------- -------- -------- -------- +TOTAL DEEPWATER AREA -- 31,191 64,790 251,936 537,389 +-------- -------- -------- -------- -------- +ONSHORE AND OTHER: +Big Escambia Creek Exxon 421 639 1,523 5,357 12,304 +Other Various 1,359 382 2,967 5,259 21,954 +-------- -------- -------- -------- -------- +TOTAL ONSHORE AND OTHER 1,780 1,021 4,490 10,616 34,258 +-------- -------- -------- -------- -------- +TOTAL PROVED RESERVES 15,334 33,382 133,403 333,695 $939,325 +======== ======== ======== ======== ======== +---------------- +(a) Represents the present value of future net cash flows before deduction of +federal income taxes, discounted at 10%, attributable to estimated net +proved reserves as of December 31, 2000, as set forth in the Company's +reserve reports prepared by its independent petroleum reserve engineers, +Huddleston & Co., Inc. of Houston, Texas. +(b) The estimates include reserve volumes of approximately 3.5 Bcf and $29.5 +million of pre-tax discounted present value and 2,300 MMcf of 2000 +production dedicated to a volumetric production payment. +15 +16 +GULF OF MEXICO DEEPWATER +Entrada, Garden Banks Blocks 738/782/826/827 +The Entrada discovery is located in approximately 4,500 feet of water in the +Gulf of Mexico. Two wells and seven sidetracks have been drilled to date on +Garden Banks 782 on a northwest plunging salt ridge along the southern edge of +the Entrada Basin. Multiple stacked amplitudes trapped against a salt or fault +interface characterize the Entrada Area. Callon owns a 20% working interest in +this discovery with BP Amoco holding the remaining working interest. +The operator is evaluating information obtained in a data swap with another +exploration company that has announced a similar discovery adjacent to Entrada +and is incorporating it into the Entrada development plans. +Medusa, Mississippi Canyon Block 538/582 +The initial well encountered two intervals with over 120 feet of total pay after +being drilled to a measured depth of 16,241 feet. The test well encountered 59 +true vertical feet of pay in the T1 objective in Fault Block A and 61 true +vertical feet of pay in the T4 sand. A sidetrack well, testing the extent of the +discovery, encountered 110 true vertical feet of pay in the T1 objective sand in +Fault Block B. An additional sidetrack well was drilled to test the downdip +limits of the T1 pay sand in Fault Block B and encountered 90 feet (true +vertical depth) of oil pay. A delineation well was drilled in January 2000, and +16 +17 +tested the updip limits of the T1 pay sand in Fault Block A. This latest well +was drilled deeper to further delineate the T4 objective, which was discovered +by the original well. Medusa lies in approximately 2,100 feet of water and the +Company owns a 15% working interest with Murphy, the operator owning 60% and +British-Borneo Petroleum, Inc. owning the remaining 25%. +The operator has submitted an Authorization For Expenditure for a floating +production system at Medusa and the integrated project team has been active on +this development project since late third quarter of 2000. The drilling of four +development wells and the completion of one existing wellbore are scheduled to +begin in April 2001. This will provide five initial takepoints for the +production facility. First production is anticipated in late 2002 or early 2003. +Habanero, Garden Banks Block 341 +During February 1999 the initial test well on the Company's Habanero prospect +encountered over 200 feet of net pay. Located in 2,000 feet of water, the well +was drilled to a measured depth of 21,158 feet. This discovery was the second +deepwater success for Callon. Callon owns an 11.25% working interest in the +well. It is operated by Shell Deepwater Development Inc., which owns a 55% +working interest, with the remaining working interest being owned by Murphy. +A field delineation program including sidetracking the existing well with two +additional sidetracks is scheduled to begin by midyear 2001. Development plans +include sub sea completion and tie back to an existing production facility in +the area. The operator has submitted to the co-owners a development schedule +with estimated initial production in November 2003. +Boomslang, Ewing Bank Block 994 +Located in 900 feet of water, the Boomslang prospect was drilled to a total +depth of 12,955 feet and encountered 185 net feet of oil pay in three separate +zones. In December 1999, Callon purchased from Santos USA Corporation an +additional 20% working interest in the Boomslang deepwater discovery on Ewing +Bank Block 994 for $7.3 million. This brought Callon's total working interest in +the well to 55%. +A complete field study has been initiated with a goal of generating a +delineation and development proposal in 2001. Prior to designing production +facilities for Boomslang the Company plans to drill the Sidewinder prospect, +located immediately to the southeast of Boomslang on Ewing Bank Block 995 and +Green Canyon Blocks 24 and 25. Callon owns a 15% working interest in these +leases. +17 +18 +GULF OF MEXICO SHELF +Mobile Block 864 Area +The Mobile Block 864 Area is located offshore Alabama in the federal waters of +the Outer Continental Shelf. The Company consummated five acquisitions in this +area for a total of $63.8 million. In total, the Company has acquired an average +81.6% working interest in seven blocks, a 66.4% working interest in the Mobile +Block 864 Area unit and the unit production facilities, and a 100% working +interest in three producing wells. The Company was appointed operator of the +Mobile Block 864 unit and three other wells. Net average daily production during +2000 was 15 MMcf per day. +South Marsh Island Block 261 +In November 1999, we announced a discovery on this block, which encountered 110 +feet of net natural gas pay. We began drilling a second test well in December +1999 and encountered 100 feet of net natural gas pay in five pay sands before it +blew out. We brought the well under control, plugged it and drilled a +replacement well in the first quarter of 2000. Our insurance policy covered the +costs associated with the blowout, the plugging of the well and the drilling of +the replacement well. The #1 well commenced production in May 2000 and was +shut-in during January 2001 after depleting. An evaluation of new seismic +indicated the productive sand is compartmentalized by faulting and the well is +currently scheduled for sidetrack drilling to a separate fault block. The #3 +well commenced production in May 2000. Upon depletion, the well is scheduled to +be recompleted in a behind pipe oil sand. We drilled a fourth well in the second +quarter of 2000 and encountered 165 net feet of pay in four pay sands. The +fourth well commenced production on February 10, 2001. We own a 100% working +interest in these wells. +East Cameron Block 275 +In December 1999, we announced a discovery, which encountered net natural gas +pay of 160 feet in five intervals between 5,800 feet and 10,500 feet. The well +commenced production in April 2000. The well was recompleted in October 2000 and +subsequently shut-in for work on the host production platform. The well came +back online January 12, 2001. We own a 100% working interest. +Main Pass 26 / SL 15827 #1 +We negotiated a farm-in agreement in 1998 for a 97% working interest after +identifying a prospect on Main Pass Block 26 based upon a seismic survey we +completed in 1996. In August 1998, we drilled the SL 15827 well to a depth of +10,450 feet. The well depleted this productive zone in January 2001 and was +recompleted to a behind pipe gas zone in February 2001. We operate this well. +Snapper, High Island Block A-494 +In January 1999, we announced a discovery on our Snapper prospect, which we +drilled to a total depth of 8,800 feet. We own a 50% working interest in this +well, which is operated by PetroQuest Energy. The well began production in July +1999. +18 +19 +ONSHORE +We own various small royalty and working interests in several onshore areas, +which as of December 31, 2000 had total net proved reserves of 10.6 Bcfe with a +discounted present value of $34.2 million. Over (50%) of these reserves and +their related discounted present value were attributable to our interest in the +Big Escambia Creek gas field located in south Alabama. +OIL AND GAS RESERVES +The following table sets forth certain information about the estimated proved +reserves of the Company as of the dates set forth below. +YEARS ENDED DECEMBER 31, +---------------------------------------- +2000(a) 1999(a) 1998 +------- ------- ---- +(IN THOUSANDS) +Proved developed: +Oil (Bbls) 2,192 1,376 2,079 +Gas (Mcf) 67,463 82,109 76,895 +Proved undeveloped: +Oil (Bbls) 31,190 22,458 4,819 +Gas (Mcf) 65,940 34,326 11,135 +Total proved: +Oil (Bbls) 33,382 23,834 6,898 +Gas (Mcf) 133,403 116,435 88,030 +Estimated pre-tax future net cash flows $1,610,320 $528,659 $152,552 +========== ======== ======== +Pre-tax discounted present value $ 939,325 $296,513 $99,751 +========== ======== ======== +Standardized measure of discounted future +net cash flows $ 671,197 $256,322 $99,751 +========== ======== ======== +(a) The estimates include volumes of approximately 5.8 Bcf, $12.1 million of +pre-tax future net cash flows and $10.7 million of pre-tax discounted +present value in 1999 and 3.5 Bcf, $31.8 million of pre- tax future net +cash flows and $29.5 million of pre-tax discounted present value flows in +2000 attributable to a volumetric production payment. Standardized measure +of discounted future net cash flows does not include any volumes or cash +flows associated with the volumetric production payment. +The Company's independent reserve engineers (Huddleston & Co., Inc.) prepared +the estimates of the proved reserves and the future net cash flows (and present +value thereof) attributable to such proved reserves. Reserves were estimated +using oil and gas prices and production and development costs in effect on +December 31 of each such year, without escalation, and were otherwise prepared +in accordance with the Commission regulations regarding disclosure of oil and +gas reserve information. +There are numerous uncertainties inherent in estimating quantities of proved +reserves, including many factors beyond the control of the Company and the +reserve engineers. Reserve engineering is a subjective process of estimating +underground accumulations of oil and gas that cannot be measured in an exact +manner, and the accuracy of any reserve or cash flow estimate is a function of +the quality of available data and of engineering +19 +20 +and geological interpretation and judgment. Estimates by different engineers +often vary, sometimes significantly. In addition, physical factors, such as the +results of drilling, testing and production subsequent to the date of an +estimate, as well as economic factors, such as an increase or decrease in +product prices that renders production of such reserves more or less economic, +may justify revision of such estimates. Accordingly, reserve estimates are +different from the quantities of oil and gas that are ultimately recovered. +The Company has not filed any reports with other federal agencies, which contain +an estimate of total proved net oil and gas reserves. +PRODUCTIVE WELLS +The following table sets forth the wells drilled and completed by the Company +during the periods indicated. All such wells were drilled in the continental +United States including federal and state waters in the Gulf of Mexico. +YEARS ENDED DECEMBER 31, +------------------------ +2000 1999 1998 +---- ---- ---- +GROSS NET GROSS NET GROSS NET +----- --- ----- --- ----- --- +Development: +Oil 2 .35 -- -- 2 .40 +Gas -- -- -- -- -- -- +Non-productive -- -- -- -- -- -- +---- ---- ---- ---- ---- ---- +Total 2 .35 -- -- 2 .40 +==== ==== ==== ==== ==== ==== +Exploration: +Oil 1 .20 2 0.26 1 .35 +Gas 2 2.00 5 3.79 3 2.14 +Non-productive 6 2.29 2 1.20 2 1.25 +---- ---- ---- ---- ---- ---- +Total 9 4.49 9 5.25 6 3.74 +==== ==== ==== ==== ==== ==== +The Company owned working and royalty interests in approximately 254 gross (7.0 +net) producing oil and 289 gross (30.0 net) producing gas wells as of December +31, 2000. A well is categorized as an oil well or a natural gas well based upon +the ratio of oil to gas reserves on a Mcfe basis. However, some of the Company's +wells produce both oil and gas. At December 31, 2000, the Company had one gross +(0.1 net) exploratory oil well in progress. +LEASEHOLD ACREAGE +The following table shows the approximate developed and undeveloped (gross and +net) leasehold acreage of the Company as of December 31, 2000. +LEASEHOLD ACREAGE +----------------- +DEVELOPED UNDEVELOPED +LOCATION GROSS NET GROSS NET +-------- ----- --- ----- --- +Alabama 13,394 13,246 256 29 +Louisiana 8,925 6,309 2,375 700 +Other States 912 440 1,471 1,142 +Federal Waters 135,612 88,071 356,990 112,322 +------- ------- ------- ------- +Total 158,843 108,066 361,092 114,193 +======= ======= ======= ======= +20 +21 +As of December 31, 2000, the Company owned various royalty and overriding +royalty interests in 1,336 net developed acres and 6,862 undeveloped acres. In +addition, the Company owned 6,247 developed and 119,753 undeveloped mineral +acres. +MAJOR CUSTOMERS +Our production is sold on month-to-month contracts at prevailing prices. The +following table identifies customers to whom we sold a significant percentage of +our total oil and gas production during each of the twelve-month periods ended: +DECEMBER 31, +------------ +2000 1999 1998 +---- ---- ---- +Adams Resources Marketing, Ltd. 14% 16% -- +Columbia Energy Services -- 29% 22% +Dynegy Marketing & Trade -- 12% 23% +PG&E Energy Trading Corporation -- -- 26% +Reliant Energy Services 37% -- -- +Unocal Exploration Corporation 8% -- -- +Because alternative purchasers of oil and gas are readily available, we believe +that the loss of any of these purchasers would not result in a material adverse +effect on our ability to market future oil and gas production. +TITLE TO PROPERTIES +The Company believes that the title to its oil and gas properties is good and +defensible in accordance with standards generally accepted in the oil and gas +industry, subject to such exceptions which, in the opinion of the Company, are +not so material as to detract substantially from the use or value of such +properties. The Company's properties are typically subject, in one degree or +another, to one or more of the following: royalties and other burdens and +obligations, express or implied, under oil and gas leases; overriding royalties +and other burdens created by the Company or its predecessors in title; a variety +of contractual obligations (including, in some cases, development obligations) +arising under operating agreements, farmout agreements, production sales +contracts and other agreements that may affect the properties or their titles; +back-ins and reversionary interests existing under purchase agreements and +leasehold assignments; liens that arise in the normal course of operations, such +as those for unpaid taxes, statutory liens securing obligations to unpaid +suppliers and contractors and contractual liens under operating agreements; +pooling, unitization and communitization agreements, declarations and orders; +and easements, restrictions, rights-of-way and other matters that commonly +affect property. To the extent that such burdens and obligations affect the +Company's rights to production revenues, they have been taken into account in +calculating the Company's net revenue interests and +21 +22 +in estimating the size and value of the Company's reserves. The Company believes +that the burdens and obligations affecting its properties are conventional in +the industry for properties of the kind owned by the Company. +ITEM 3. LEGAL PROCEEDINGS +The Company is a defendant in various legal proceedings and claims, which arise +in the ordinary course of Callon's business. Callon does not believe the +ultimate resolution of any such actions will have a material affect on the +Company's financial position or results of operations. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +There were no matters submitted to a vote of security holders during the fourth +quarter of 2000. +PART II. +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED +STOCKHOLDER MATTERS +The Company's Common Stock trades on the New York Stock Exchange under the +symbol "CPE". The following table sets forth the high and low sale prices per +share as reported for the periods indicated. +QUARTER ENDED HIGH LOW +------------- ---- --- +1999: +First quarter $ 11.875 $ 8.875 +Second quarter 11.250 9.875 +Third quarter 15.375 10.000 +Fourth quarter 15.375 11.625 +2000: +First quarter $ 15.625 $ 9.625 +Second quarter 16.500 10.625 +Third quarter 17.625 12.500 +Fourth quarter 17.188 12.938 +22 +23 +As of March 16, 2001, there were approximately 5,283 common stockholders of +record. +The Company has not paid dividends on the Common Stock and intends to retain its +cash flow from operations, net of preferred stock dividends, for the future +operation and development of its business. In addition, the Company's primary +credit facility and the terms of the Company's outstanding subordinated debt +restrict payments of dividends on its Common Stock. +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth, as of the dates and for the periods indicated, +selected financial information for the Company. The financial information for +each of the five years in the period ended December 31, 2000 have been derived +from the audited Consolidated Financial Statements of the Company for such +periods. The information should be read in conjunction with "Management's +Discussion and Analysis of Financial Condition and Results of Operations" and +the Consolidated Financial Statements and notes thereto. The following +information is not necessarily indicative of future results for the Company. +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) +YEARS ENDED DECEMBER 31, +---------------------------------------------------------- +2000 1999 1998 1997 1996 +--------- --------- --------- --------- --------- +STATEMENT OF OPERATIONS DATA: +Revenues: +Oil and gas sales $ 56,310 $ 37,140 $ 35,624 $ 42,130 $ 25,764 +Interest and other 1,767 1,853 2,094 1,508 946 +--------- --------- --------- --------- --------- +Total revenues 58,077 38,993 37,718 43,638 26,710 +--------- --------- --------- --------- --------- +Costs and expenses: +Lease operating expenses 9,339 7,536 7,817 8,123 7,562 +Depreciation, depletion and amortization 17,153 16,727 19,284 16,488 9,832 +General and administrative 4,155 4,575 5,285 4,433 3,495 +Interest 8,420 6,175 1,925 1,957 313 +Accelerated vesting and retirement benefits -- -- 5,761 -- -- +Impairment of oil and gas properties -- -- 43,500 -- -- +--------- --------- --------- --------- --------- +Total costs and expenses 39,067 35,013 83,572 31,001 21,202 +--------- --------- --------- --------- --------- +Income (loss) from operations 19,010 3,980 (45,854) 12,637 5,508 +Income tax expense (benefit) 6,463 1,353 (15,100) 4,200 50 +--------- --------- --------- --------- --------- +Net income (loss) 12,547 2,627 (30,754) 8,437 5,458 +Preferred stock dividends 2,403 2,497 2,779 2,795 2,795 +--------- --------- --------- --------- --------- +Net income (loss) available to common shares $ 10,144 $ 130 $ (33,533) $ 5,642 $ 2,663 +========= ========= ========= ========= ========= +Net income (loss) per common share: +Basic $ .82 $ .01 $ (4.17) $ .91 $ .46 +Diluted $ .80 $ .01 $ (4.17) $ .88 $ .45 +Shares used in computing net income (loss) per common share: +Basic 12,420 8,976 8,034 6,194 5,835 +Diluted 12,745 9,075 8,034 6,422 5,952 +BALANCE SHEET DATA (END OF PERIOD): +Oil and gas properties, net $ 258,613 $ 194,365 $ 141,905 $ 150,494 $ 82,489 +Total assets $ 301,569 $ 259,877 $ 181,652 $ 190,421 $ 118,520 +Long-term debt, less current portion $ 134,000 $ 100,250 $ 78,250 $ 60,250 $ 24,250 +Stockholders' equity $ 136,328 $ 124,380 $ 84,484 $ 113,701 $ 77,864 +--------------- +23 +24 +We use the full-cost method of accounting. Under this method of accounting, our +net capitalized costs to acquire, explore and develop oil and gas properties may +not exceed the standardized measure of our proved reserves. If these capitalized +costs exceed the standardized measure, the excess is charged to expense. As a +result of the significant decline in oil and gas prices, we recorded a non-cash +impairment expense related to our oil and gas properties in the amount of $43.5 +million ($28.7 million after-tax) during the fourth quarter of 1998. +ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS +OF OPERATIONS +The following discussion is intended to assist in an understanding of the +Company's financial condition and results of operations. The Company's Financial +Statements and Notes thereto contain detailed information that should be +referred to in conjunction with the following discussion. See Item 8. "Financial +Statements and Supplementary Data." +GENERAL +Callon Petroleum Company has been engaged in the exploration, development, +acquisition and production of oil and gas properties since 1950. The Company's +revenues, profitability and future growth and the carrying value of its oil and +gas properties are substantially dependent on prevailing prices of oil and gas +and its ability to find, develop and acquire additional oil and gas reserves +that are economically recoverable. The Company's ability to maintain or increase +its borrowing capacity and to obtain additional capital on attractive terms is +also influenced by oil and gas prices. +Our estimated net proved oil and gas reserves increased significantly at +December 31, 2000 to 334 billion cubic feet of natural gas equivalent (Bcfe). +This represents an increase of 28% over previous year-end 1999 estimated proved +reserves of 259 Bcfe. This increase in 2000 is primarily due to results of +drilling activity in the deepwater areas of the Gulf of Mexico, along with +drilling successes on the Gulf of Mexico Shelf area. +24 +25 +These reserve estimates include 3.5 Bcfe at December 31, 2000 and 5.8 Bcfe at +December 31, 1999 dedicated to a volumetric production payment. +Prices for oil and gas are subject to large fluctuations in response to +relatively minor changes in the supply of and demand for oil and gas, market +uncertainty and a variety of additional factors beyond the control of the +Company. These factors include weather conditions in the United States, the +condition of the United States economy, the actions of the Organization of +Petroleum Exporting Countries, governmental regulation, political stability in +the Middle East and elsewhere, the foreign supply of crude oil and natural gas, +the price of foreign imports and the availability of alternate fuel sources. Any +substantial and extended decline in the price of crude oil or natural gas would +have an adverse effect on the Company's carrying value of its proved reserves, +borrowing capacity, revenues, profitability and cash flows from operations. The +Company uses derivative financial instruments (see Note 6 and Item 7A. +"Quantitative and Qualitative Disclosures About Market Risks") for price +protection purposes on a limited amount of its future production and does not +use them for trading purposes. On a Mcfe basis, natural gas represents 86% of +the budgeted 2001 production and 40% of proved reserves at year-end. +Inflation has not had a material impact on the Company and is not expected to +have a material impact on the Company in the future. +LIQUIDITY AND CAPITAL RESOURCES +The Company's primary sources of capital are its cash flows from operations, +borrowings under our bank Credit Facility and sales of debt and equity +securities. Net cash and cash equivalents decreased during 2000 by $22.8 +million. Cash provided from operating activities during 2000 totaled $28.7 +million. The Company completed the sale of its Senior Subordinated Notes due +2005 in October 2000 for net proceeds of approximately $31.5 million. An +additional $24.9 million (net) was borrowed under our bank Credit Facility. +Dividends paid on preferred stock were $2.2 million. Average debt outstanding +was $118.3 million during 2000 compared to $96.9 million in 1999. At December +31, 2000, the Company had working capital of $1.1 million. +Effective October 31, 2000, the Company entered into a $75.0 million Credit +Facility with First Union National Bank. Borrowings under the Credit Facility +are secured by mortgages covering substantially all of the Company's producing +oil and gas properties and guaranteed by our subsidiaries. The Credit Facility +currently provides for a $50 million borrowing base ("Borrowing Base") which is +adjusted periodically on the basis of a discounted present value of future net +cash flows attributable to the Company's proved producing oil and gas reserves +as determined by the bank. The Company may borrow, pay, reborrow and repay under +the Credit Facility until July 31, 2002, on which date, the Company must repay +in full all amounts then outstanding. At December 31, 2000, availability under +the Credit Facility was $25 million. +On July 15, 1999 the Company completed the sale of $40 million of Senior +Subordinated Notes due 2004 at 10.25%. The net proceeds of $38.2 million were +used to pay down the Credit Facility and finance the capital budget. These notes +are not entitled to any mandatory sinking fund payments and are subject to +redemption at the Company's option at par plus unpaid interest at any time after +March 15, 2001. The notes are subject to a change of control clause that +obligates the Company to repurchase the notes for 101% of par should a change of +control occur. Interest is paid quarterly. +The Company completed the sale of $33 million Senior Subordinated Notes due +2005, on October 26, 2000 for net proceeds of $31.5 million from the offering +after deducting the underwriters' discount and offering expenses. Approximately +$20.8 million of the net proceeds from the offering were used to purchase the +25 +26 +Company's outstanding 10% Senior Subordinated Notes due 2001 in conjunction with +a tender offer. The Company also redeemed the remaining $3.4 million of its 10% +Senior Subordinated Notes due 2001 not tendered in the offer. +The Credit Facility and the subordinated debt contain various covenants +including restrictions on additional indebtedness and payment of cash dividends +as well as maintenance of certain financial ratios. The Company is in compliance +with these covenants at December 31, 2000. +In November of 1999, the Company sold 3,680,000 shares of Common Stock in a +public offering at a price to the public of $11.875 per share. Cash proceeds +received by the Company were $41.1 million net of underwriting discount and +offering costs. The proceeds from the stock offering were used to pay the +outstanding balance of the Company's Credit Facility and to fund, together with +internally generated cash flows from operations, the remaining portion of the +Company's 1999 and part of the 2000 capital expenditure budget. +The Company's plans for 2001 include capital expenditures budgeted at $90 +million. The Company currently expects to spend $21 million to drill up to 14 +wells in the shelf area of the Gulf of Mexico. An estimated $18 million, net to +the Company, will be required to complete and develop the successful wells. This +estimate is dependent on exploration success. Plans also call for $36 million to +be invested in the deepwater area of the Gulf of Mexico with $18 million of the +investment allocated to development of the Company's four deepwater discoveries. +The Company will continue to build its portfolio of drilling prospects and is +budgeted to spend approximately $9 million on seismic and new Gulf of Mexico +lease acquisitions. +Projected cash flows from operations, cash on hand and borrowings under the +Credit Facility are anticipated to be sufficient to fund the Company's shelf +drilling program and seismic and lease acquisitions. Conventional debt or equity +offerings may be used to finance the Company's capital expenditure program, but +other options are being considered for the Company's deepwater development +projects. One such option is to develop a discovery as a production hub, with +some or all of the financing provided by a partner, and charge other companies +with discoveries in the area for access to the processing equipment on the +platform. +RESULTS OF OPERATIONS +The following table sets forth certain operating information with respect to the +oil and gas operations of the Company for each of the three years in the period +ended December 31, 2000. +DECEMBER 31, +------------------------------------- +2000(a)(b) 1999(a)(b) 1998(a) +---------- --------- ----------- +Production: +Oil (MBbls) 232 330 310 +Gas (MMcf) 13,943 14,606 14,036 +Total production (MMcfe) 15,334 16,589 15,894 +Average daily production (MMcfe) 41.9 45.5 43.5 +Average sales price: +Oil (per Bbl) $ 27.88 $ 12.16 $ 12.41 +Gas (per Mcf) $ 3.57 $ 2.27 $ 2.26 +Total production (per Mcfe) $ 3.67 $ 2.24 $ 2.24 +Average costs (per Mcfe): +Lease operating expenses (excluding severance taxes) $ .55 $ .39 $ .44 +Severance taxes $ .06 $ .07 $ .06 +Depletion $ 1.10 $ .99 $ 1.19 +General and administrative (net of management fees) $ .27 $ .28 $ .33 +------------ +(a) Includes hedging gains and losses +(b) Includes volumes of 2,300 MMcf and 1,300 MMcf for 2000 and 1999, +respectively, at an average price of $2.08 per Mcf associated with a +volumetric production payment. +26 +27 +COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2000 AND +1999 +OIL AND GAS REVENUES +Oil and gas revenues for 2000 were $56.3 million, a 52% increase from the 1999 +amount of $37.1 million. However, 2000 oil and gas production of 15,334 MMcfe +decreased by 8% from the 1999 amount of 16,589 MMcfe. Oil production decreased +from 330,000 barrels in 1999 to 232,000 barrels in 2000 but the average sales +price increased from $12.16 in 1999 to $27.88 in 2000. As a result, oil revenues +went from $4.0 million in 1999 to $6.5 million in 2000. The decrease in oil +production was primarily from older properties' normal and expected decline in +production and the depletion of Main Pass 31. The significant increase in oil +revenue was due to the price of oil received for 2000 oil production more than +doubling over 1999 average prices. +Gas revenues for 2000 were $49.8 million based on sales of 13.9 Bcf at an +average sales price of $3.57 per Mcf. For 1999, gas revenues were $33.1 million +based on production of 14.6 Bcf sold at an average sales price of $2.27 per Mcf. +When compared to 1999, production decreased due to a combination of older +properties' normal and expected decline in production and the depletion of Main +Pass 31. This decrease was offset by production gains at East Cameron Block 275 +and South Marsh Island 261 as they began production in early 2000. East Cameron +Block 275 experienced a significant drop in the fourth quarter of 2000 due to +work on the host platform, which caused the well to be shut in for the entire +quarter. This property was back online in January 2001 and currently is +producing at or near levels prior to the shut-in. +27 +28 +Gas revenue increased due to higher prices received for production in 2000, +especially in the fourth quarter, compared to 1999 offset by the 5% decline in +gas production. +LEASE OPERATING EXPENSES AND SEVERANCE TAXES +Lease operating expenses, including severance taxes, increased from $7.5 million +($.46 per Mcfe) in 1999 to $9.3 million ($.61 per Mcfe) in 2000. The increase +per Mcfe is primarily attributable to production declines in 2000 related to +older properties that have relatively fixed operating costs which contributed to +the higher per Mcf costs. +DEPRECIATION, DEPLETION AND AMORTIZATION +Depreciation, depletion and amortization increased by almost 3% due to a +combination of an increase in the amortization base by 56% (primarily increased +future development costs over 1999) offset by a 28% increase in reserves and by +a decrease in production. +Total charges increased from $16.7 million, or $1.01 per Mcfe in 1999 to $17.2 +million, or $1.12 per Mcfe in 2000. +GENERAL AND ADMINISTRATIVE +General and administrative expenses for 2000 were $4.2 million, or $.27 per +Mcfe, compared to $4.6 million, or $.28 per Mcfe, in 1999. This 9% decrease is +primarily due to an increase in direct overhead capitalized allocable to +employees engaged in the acquisition, exploration and development of oil and gas +properties in 2000. +INTEREST EXPENSE +Interest expense for 2000 and 1999 was $8.4 million and $6.2 million, +respectively. This increase is a result of the increase in interest rates and in +average debt outstanding in 2000 versus 1999. This average debt outstanding +increase is directly related to the Senior Subordinated Notes issued in October +2000 and borrowings under the Credit Facility during the year. +INCOME TAXES +The Company's 2000 results include a deferred income tax expense of $6.5 +million. The Company has evaluated the deferred income tax asset in light of its +reserve quantity estimates, its long-term outlook for oil and gas prices and its +expected level of future revenues and expenses. The Company believes it is more +likely than not, based upon this evaluation, that it will realize the recorded +deferred income tax asset. However, there is no assurance that such asset will +ultimately be realized. +COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1999 AND +1998 +OIL AND GAS REVENUES +Oil and gas revenues for 1999 were $37.1 million, a 4% increase from the 1998 +amount of $35.6 million. Similarly, 1999 oil and gas production of 16,589 MMcfe +increased by 4% over the 1998 amount of 15,894 MMcfe. +28 +29 +Oil production increased from 310,000 barrels in 1998 to 330,000 barrels in 1999 +but the average sales price declined from $12.41 in 1998 to $12.16 in 1999. As a +result, oil revenues went from $3.8 million in 1998 to $4.0 million in 1999. The +increase in oil production was primarily from Main Pass 26 and Eugene Island 335 +offset by the loss of production in 1999 from the Black Bay Field, which was +sold in 1998. +Gas revenues for 1999 were $33.1 million based on sales of 14.6 Bcf at an +average sales price of $2.27 per Mcf. For 1998, gas revenues were $31.8 million +based on production of 14 Bcf sold at an average sales price of $2.26 per Mcf. +When compared to 1998, the Company in 1999 added gas production from new +discoveries at Main Pass 26 and Eugene Island 335 but has experienced reduced +production from several Shallow Miocene properties, which normally have steep +decline curves. Except for the increase at Main Pass 31, which was the result of +a recompletion, other properties continue to experience normal and expected +declines. +LEASE OPERATING EXPENSES AND SEVERANCE TAXES +Lease operating expenses, including severance taxes, decreased from $7.8 million +in 1998 to $7.5 million in 1999 as a result of a decrease in operating expenses +in the Main Pass 163 Area and the North Dauphin Island Field as well as the sale +of the Black Bay Field in 1998. This decline was offset by the Snapper, Main +Pass 36, Main Pass 26 and Kemah properties, which began operations in 1999. +DEPRECIATION, DEPLETION AND AMORTIZATION +Depreciation, depletion and amortization decreased due to the combined effect of +the net increase in proved reserves during 1999 (primarily in the fourth quarter +of 1999), the level of finding costs attributable to reserves added in 1999 and +the reduction of the full cost pool due to an impairment of oil and gas +properties at December 31, 1998. Total charges decreased from $19.3 million, or +$1.21 per Mcfe in 1998, to $16.7 million, or $1.01 per Mcfe in 1999. +GENERAL AND ADMINISTRATIVE +General and administrative expenses for 1999 were $4.6 million, or $.28 per +Mcfe, compared to $5.3 million, or $.33 per Mcfe, in 1998. This 13% decrease is +primarily due to a reduction of staff in 1999 along with an increase in overhead +allocable to employees directly engaged in the acquisition, exploration and +development of oil and gas properties in 1999. +INTEREST EXPENSE +Interest expense for 1999 and 1998 was $6.2 million and $1.9 million, +respectively. This increase is a result of a decrease in interest capitalized on +unevaluated oil and gas properties and the increase in interest rates and in +average debt outstanding in 1999 versus 1998. This average debt outstanding +increase is directly related to the Senior Subordinated Notes issued in July +1999 and the Credit Facility borrowings during the year. The Common Stock +offering completed in November 1999 reduced Credit Facility debt at the end of +1999. +INCOME TAXES +The Company's 1999 results include a deferred income tax expense of $1.4 +million. The Company has evaluated the deferred income tax asset in light of its +reserve quantity estimates, its long-term outlook for oil and gas prices and its +expected level of future revenues and expenses. The Company believes it is more +likely than not, based upon this evaluation, that it will realize the recorded +deferred income tax asset. However, there is no assurance that such asset will +ultimately be realized. +29 +30 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS +The Company's revenues are derived from the sale of its crude oil and natural +gas production. From time to time, the Company has entered into hedging +transactions that lock in for specified periods the prices the Company will +receive for the production volumes to which the hedge relates. The hedges reduce +the Company's exposure on the hedged volumes to decreases in commodities prices +and limit the benefit the Company might otherwise have received from any +increases in commodities prices on the hedged volumes. +As of December 31, 2000, the Company had open collar contracts with third +parties whereby minimum floor prices and maximum ceiling prices are contracted +and applied to related contract volumes. These agreements in effect for 2001 are +for average gas volumes of 390,000 Mcf per month beginning in January 2001 +through October 2001 at (on average) a ceiling price of $5.86 and floor price of +$4.69. The Company had no open oil hedging contracts at December 31, 2000. +The calculation of the fair market value of the outstanding hedging contracts as +of December 31, 2000 indicated a $5.8 million market value liability based on +market prices at that date. Natural gas prices have declined significantly since +year-end. As a result, and if the price decline for natural gas is sustained +throughout the contract periods, the market value liability of the derivatives +described above have decreased significantly also. +In June 1998, the Financial Accounting Standards Board issued Statement of +Financial Accounting Standards No. 133 ("SFAS 133"), Accounting for Derivative +Instruments and Hedging Activities. The Company adopted SFAS 133 effective +January 1, 2001. +This statement establishes accounting and reporting standards that differ from +those used in prior years. SFAS 133 requires that every derivative instrument be +recorded in the balance sheet as either an asset or liability measured at its +fair value at the date of adoption and requires that future changes in the +derivatives fair value be recognized currently in earnings unless specific hedge +accounting criteria are met. Special accounting for qualifying hedges allows a +derivative instrument's gain or loss to offset related results on the hedged +item in the income statement, to the extent effective, and requires that the +Company must formally document, designate, and assess effectiveness of +transactions that receive hedge accounting. The Company believes that its hedges +described above, to the extent of intrinsic value, will qualify as cash flow +hedges under SFAS 133. +The Company has not yet quantified all effects of adopting SFAS 133 on its +future financial statements. However, the Statement will increase volatility in +earnings and other comprehensive income as market prices for the natural gas +hedged changes. +Based on projected annual sales volumes for 2001 (excluding forecast production +increases over 2000), a 10% decline in the prices the Company receives for its +crude oil and natural gas production would have an approximate $7.1 million +impact on the Company's revenues. The hypothetical impact on the decline in oil +and gas prices does not include the incremental gain that would be realized upon +a decline in prices by the oil and gas hedging contracts in place as of December +31, 2000. +30 +31 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +---- +Report of Independent Public Accountants 32 +Consolidated Balance Sheets as of December 31, 2000 33 +and 1999 +Consolidated Statements of Operations for Each of the Three Years +in the Period Ended December 31, 2000 34 +Consolidated Statements of Stockholders' Equity +for Each of the Three Years in the Period Ended December 31, 2000 35 +Consolidated Statements of Cash Flows for Each of the Three Years +in the Period Ended December 31, 2000 36 +Notes to Consolidated Financial Statements 37 +31 +32 +REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS +To the Stockholders and Board of Directors of Callon Petroleum Company: +We have audited the accompanying consolidated balance sheets of Callon +Petroleum Company (a Delaware corporation) and subsidiaries as of December 31, +2000 and 1999, and the related consolidated statements of operations, +stockholders' equity and cash flows for each of the three years in the period +ended December 31, 2000. These financial statements are the responsibility of +the Company's management. Our responsibility is to express an opinion on these +financial statements based on our audits. +We conducted our audits in accordance with auditing standards generally +accepted in the United States. Those standards require that we plan and perform +the audit to obtain reasonable assurance about whether the financial statements +are free of material misstatement. An audit includes examining, on a test basis, +evidence supporting the amounts and disclosures in the financial statements. An +audit also includes assessing the accounting principles used and significant +estimates made by management, as well as evaluating the overall financial +statement presentation. We believe that our audits provide a reasonable basis +for our opinion. +In our opinion, the financial statements referred to above present fairly, +in all material respects, the financial position of Callon Petroleum Company and +subsidiaries, as of December 31, 2000 and 1999, and the results of their +operations and their cash flows for each of the three years in the period ended +December 31, 2000, in conformity with accounting principles generally accepted +in the United States. +ARTHUR ANDERSEN LLP +New Orleans, Louisiana, +February 22, 2001 +32 +33 +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(IN THOUSANDS, EXCEPT SHARE DATA) +DECEMBER 31, +------------------------------- +2000 1999 +------------ ------------ +ASSETS +Current assets: +Cash and cash equivalents $ 11,876 $ 34,671 +Accounts receivable 9,244 5,362 +Advance to operators 1,131 -- +Other current assets 207 189 +------------ ------------ +Total current assets 22,458 40,222 +------------ ------------ +Oil and gas properties, full-cost accounting method: +Evaluated properties 589,549 511,689 +Less accumulated depreciation, depletion and amortization (378,589) (361,758) +------------ ------------ +210,960 149,931 +Unevaluated properties excluded from amortization 47,653 44,434 +------------ ------------ +Total oil and gas properties 258,613 194,365 +------------ ------------ +Pipeline and other facilities, net 5,537 5,860 +Other property and equipment, net 1,790 1,450 +Deferred tax asset 8,573 14,995 +Long-term gas balancing receivable 643 243 +Other assets, net 3,955 2,742 +------------ ------------ +Total assets $ 301,569 $ 259,877 +============ ============ +LIABILITIES AND STOCKHOLDERS' EQUITY +Current liabilities: +Accounts payable and accrued liabilities $ 17,842 $ 16,786 +Undistributed oil and gas revenues 1,411 2,082 +Accrued net profits interest payable 2,146 1,676 +------------ ------------ +Total current liabilities 21,399 20,544 +------------ ------------ +Long-term debt 134,000 100,250 +Deferred revenue on sale of production payment 7,236 12,080 +Accrued retirement benefits 1,886 2,107 +Long-term gas balancing payable 720 516 +------------ ------------ +Total liabilities 165,241 135,497 +------------ ------------ +Stockholders' equity: +Preferred Stock, $.01 par value; 2,500,000 shares +authorized; 600,861 shares of Convertible +Exchangeable Preferred Stock, Series A issued +and outstanding at December 31, 2000 and +1,045,461 outstanding at December 31, 1999 with +a liquidation +preference of $15,021,525 at December 31, 2000 6 11 +Common Stock, $.01 par value; 20,000,000 +shares authorized; 13,327,675 and 12,239,238 shares +outstanding at December 31, 2000 and 1999, respectively 133 122 +Treasury stock (99,078 shares at cost) (1,183) (1,183) +Capital in excess of par value 151,223 149,425 +Retained earnings (deficit) (13,851) (23,995) +------------ ------------ +Total stockholders' equity 136,328 124,380 +------------ ------------ +Total liabilities and stockholders' equity $ 301,569 $ 259,877 +============ ============ +The accompanying notes are an integral part of these financial statements. +33 +34 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF OPERATIONS +FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 +(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) +2000 1999 1998 +------------ ------------ ------------ +Revenues: +Oil and gas sales $ 56,310 $ 37,140 $ 35,624 +Interest and other 1,767 1,853 2,094 +------------ ------------ ------------ +Total revenues 58,077 38,993 37,718 +------------ ------------ ------------ +Costs and expenses: +Lease operating expenses 9,339 7,536 7,817 +Depreciation, depletion and amortization 17,153 16,727 19,284 +General and administrative 4,155 4,575 5,285 +Interest 8,420 6,175 1,925 +Accelerated vesting and retirement benefits -- -- 5,761 +Impairment of oil and gas properties -- -- 43,500 +------------ ------------ ------------ +Total costs and expenses 39,067 35,013 83,572 +------------ ------------ ------------ +Income (loss) from operations 19,010 3,980 (45,854) +Income tax expense (benefit) 6,463 1,353 (15,100) +------------ ------------ ------------ +Net income (loss) 12,547 2,627 (30,754) +Preferred stock dividends 2,403 2,497 2,779 +------------ ------------ ------------ +Net income (loss) available to common shares $ 10,144 $ 130 $ (33,533) +============ ============ ============ +Net income (loss) per common share: +Basic $ .82 $ .01 $ (4.17) +============ ============ ============ +Diluted $ .80 $ .01 $ (4.17) +============ ============ ============ +Shares used in computing net income (loss) per common share: +Basic 12,420 8,976 8,034 +============ ============ ============ +Diluted 12,745 9,075 8,034 +============ ============ ============ +The accompanying notes are an integral part of these financial statements. +34 +35 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY +(IN THOUSANDS) +UNEARNED +COMPENSATION CAPITAL IN RETAINED +PREFERRED COMMON TREASURY RESTRICTED EXCESS OF EARNINGS +STOCK STOCK STOCK STOCK PAR VALUE (DEFICIT) +---------- ---------- ---------- ------------- ----------- ---------- +Balances, December 31, 1997 $ 13 $ 79 $ -- $ (2,232) $ 106,433 $ 9,408 +Net income (loss) -- -- -- -- -- (30,754) +Preferred stock dividends -- -- -- -- 15 (2,779) +Shares issued pursuant to employee +benefit and option plan -- -- -- -- 235 -- +Employee stock purchase plan -- -- -- -- 163 -- +Restricted stock plan -- 2 -- (2,731) 2,584 -- +Earned portion of restricted stock -- -- -- 4,963 -- -- +Conversion of preferred shares to common -- 1 -- -- (1) -- +Stock buyback plan -- -- (915) -- -- -- +---------- ---------- ---------- ---------- ---------- ---------- +Balances, December 31, 1998 13 82 (915) -- 109,429 (24,125) +Net income (loss) -- -- -- -- -- 2,627 +Sale of common stock -- 37 -- -- 40,994 -- +Preferred stock dividends -- -- -- -- -- (2,222) +Shares issued pursuant to employee +benefit and option plan -- -- -- -- 274 -- +Employee stock purchase plan -- -- -- -- 67 -- +Restricted stock plan -- (2) -- -- (1,613) -- +Conversion of preferred shares to common (2) 5 -- -- 274 (275) +Stock buyback plan -- -- (268) -- -- -- +---------- ---------- ---------- ---------- ---------- ---------- +Balances, December 31, 1999 11 122 (1,183) -- 149,425 (23,995) +Net income (loss) -- -- -- -- -- 12,547 +Preferred stock dividends -- -- -- -- -- (1,978) +Shares issued pursuant to employee +benefit and option plan -- -- -- -- 1,069 -- +Employee stock purchase plan -- -- -- -- 269 -- +Tax benefits related to stock compensation plans -- -- -- -- 41 -- +Conversion of preferred shares to common (5) 11 -- -- 419 (425) +---------- ---------- ---------- ---------- ---------- ---------- +Balances, December 31, 2000 $ 6 $ 133 $ (1,183) $ -- $ 151,223 $ (13,851) +========== ========== ========== ========== ========== ========== +The accompanying notes are an integral part of these financial statements. +35 +36 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 +(IN THOUSANDS) +2000 1999 1998 +------------ ------------ ------------ +Cash flows from operating activities: +Net income (loss) $ 12,547 $ 2,627 $ (30,754) +Adjustments to reconcile net income (loss) to +cash provided by operating activities: +Depreciation, depletion and amortization 17,598 17,232 19,791 +Impairment of oil and gas properties -- -- 43,500 +Amortization of deferred costs 1,034 707 619 +Amortization of deferred production payment revenue (4,844) (2,710) -- +Deferred income tax expense (benefit) 6,463 1,353 (15,100) +Noncash charge related to compensation plans 1,069 275 7,583 +Changes in current assets and liabilities: +Accounts receivable (3,882) 662 6,144 +Advance to operators (1,131) 1,271 (1,271) +Other current assets (18) (11) 57 +Current liabilities 1,077 1,981 (876) +Change in gas balancing receivable (400) (44) 43 +Change in gas balancing payable 204 27 85 +Change in other long-term liabilities (221) (216) -- +Change in other assets, net (751) (134) (116) +------------ ------------ ------------ +Cash provided (used) by operating activities 28,745 23,020 29,705 +------------ ------------ ------------ +Cash flows from investing activities: +Capital expenditures (81,849) (51,709) (63,501) +Cash proceeds from sale of mineral interests -- -- 9,909 +------------ ------------ ------------ +Cash provided (used) by investing activities (81,849) (51,709) (53,592) +------------ ------------ ------------ +Cash flows from financing activities: +Equity issued related to employee stock plans 269 68 414 +Purchase of treasury shares -- (268) (915) +Payment on debt (29,250) (42,500) -- +Increase in debt 63,000 64,500 18,000 +Deferred financing costs (1,496) (1,823) -- +Restricted stock plan -- (1,615) (130) +Sale of common stock -- 41,031 -- +Cash dividends on preferred stock (2,214) (2,333) (2,779) +------------ ------------ ------------ +Cash provided (used) by financing activities 30,309 57,060 14,590 +------------ ------------ ------------ +Net increase (decrease) in cash and cash equivalents (22,795) 28,371 (9,297) +Cash and cash equivalents: +Balance, beginning of period 34,671 6,300 15,597 +------------ ------------ ------------ +Balance, end of period $ 11,876 $ 34,671 $ 6,300 +============ ============ ============ +The accompanying notes are an integral part of these financial statements. +36 +37 +CALLON PETROLEUM COMPANY +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +Callon Petroleum Company (the "Company") was organized under the laws of the +state of Delaware in March 1994 to serve as the surviving entity in the +consolidation and combination of several related entities (referred to herein +collectively as the "Constituent Entities"). The combination of the businesses +and properties of the Constituent Entities with the Company was completed on +September 16, 1994 (the "Consolidation"). +As a result of the Consolidation, all of the businesses and properties of the +Constituent Entities are owned (directly or indirectly) by the Company. Certain +registration rights were granted to the stockholders of certain of the +Constituent Entities. See Note 7. +The Company and its predecessors have been engaged in the acquisition, +development and exploration of crude oil and natural gas since 1950. The +Company's properties are geographically concentrated in Louisiana, Alabama, +Texas and offshore Gulf of Mexico. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +PRINCIPLES OF CONSOLIDATION AND REPORTING +The Consolidated Financial Statements include the accounts of the Company, and +its subsidiary, Callon Petroleum Operating Company ("CPOC"). CPOC also has +subsidiaries, namely Callon Offshore Production, Inc. and Mississippi Marketing, +Inc. All intercompany accounts and transactions have been eliminated. Certain +prior year amounts have been reclassified to conform to presentation in the +current year. +USE OF ESTIMATES +The preparation of financial statements in conformity with generally accepted +accounting principles requires management to make estimates and assumptions that +affect the reported amounts of assets and liabilities and disclosure of +contingent assets and liabilities at the date of the financial statements and +the reported amounts of revenues and expenses during the reporting period. +Actual results could differ from those estimates. +ACCOUNTING PRONOUNCEMENTS +In June 1998, the Financial Accounting Standards Board issued Statement of +Financial Accounting Standards No. 133 ("SFAS 133"), Accounting for Derivative +Instruments and Hedging Activities. The Statement establishes accounting and +reporting standards requiring that every derivative instrument, including +certain derivative instruments embedded in other contracts, be recorded in the +balance sheet as either an asset or liability measured at its fair value. SFAS +133 is effective for fiscal years beginning after June 15, 2000, with earlier +application permitted. The Company adopted SFAS 133 effective January 1, 2001. +37 +38 +SFAS 133 requires the Company to report changes in the fair value of our +derivative financial instruments that qualify as cash flow hedges in other +comprehensive income, a component of stockholders' equity, until realized. See +Note 6 for a comprehensive discussion of our derivative financial instruments. +PROPERTY AND EQUIPMENT +The Company follows the full-cost method of accounting for oil and gas +properties whereby all costs incurred in connection with the acquisition, +exploration and development of oil and gas reserves, including certain overhead +costs, are capitalized. Such amounts include the cost of drilling and equipping +productive wells, dry hole costs, lease acquisition costs, delay rentals, +interest capitalized on unevaluated leases and other costs related to +exploration and development activities. Payroll and general and administrative +costs capitalized include salaries and related fringe benefits paid to employees +directly engaged in the acquisition, exploration and/or development of oil and +gas properties as well as other directly identifiable general and administrative +costs associated with such activities. Such capitalized costs do not include any +costs related to production or general corporate overhead. Costs associated with +unevaluated properties are excluded from amortization. Unevaluated property +costs are transferred to evaluated property costs at such time as wells are +completed on the properties, the properties are sold or management determines +these costs have been impaired. +Costs of properties, including future development and net future site +restoration, dismantlement and abandonment costs, which have proved reserves and +those which have been determined to be worthless, are depleted using the +unit-of-production method based on proved reserves. If the total capitalized +costs of oil and gas properties, net of amortization, exceed the sum of (1) the +estimated future net revenues from proved reserves at current prices and +discounted at 10% and (2) the lower of cost or market of unevaluated properties +(the full-cost ceiling amount), net of tax effects, then such excess is charged +to expense during the period in which the excess occurs. See Note 8. +Upon the acquisition or discovery of oil and gas properties, management +estimates the future net costs to be incurred to dismantle, abandon and restore +the property using geological, engineering and regulatory data available. Such +cost estimates are periodically updated for changes in conditions and +requirements. Such estimated amounts are considered as part of the full cost +pool subject to amortization upon acquisition or discovery. Such costs are +capitalized as oil and gas properties as the actual restoration, dismantlement +and abandonment activities take place. +Depreciation of other property and equipment is provided using the straight-line +method over estimated lives of three to 20 years. Depreciation of pipeline and +other facilities is provided using the straight-line method over estimated lives +of 15 to 27 years. +NATURAL GAS IMBALANCES +The Company follows an entitlement method of accounting for its proportionate +share of gas production on a well-by-well basis, recording a receivable to the +extent that a well is in an "undertake" position and conversely recording a +liability to the extent that a well is in an "overtake" position. +38 +39 +DERIVATIVES +The Company uses derivative financial instruments for price protection purposes +on a limited amount of its future production and does not use them for trading +purposes. Such derivatives were accounted for in years prior to and including +2000 as hedges and have been recognized as an adjustment to oil and gas sales in +the period in which they are related. Future accounting treatment will be under +SFAS 133 (see Note 6). +ACCOUNTS RECEIVABLE +Accounts receivable consists primarily of accrued oil and gas production +receivables. The balance in the reserve for doubtful accounts included in +accounts receivable was $78,000 and $38,000 at December 31, 2000 and 1999, +respectively. Net recoveries were $40,000 in 2000. There were no provisions to +expense in the three-year period ended December 31, 2000. +MAJOR CUSTOMERS +Our production is sold on month-to-month contracts at prevailing prices. The +following table identifies customers to whom we sold a significant percentage of +our total oil and gas production during each of the twelve-month periods ended: +DECEMBER 31, +---------------------------- +2000 1999 1998 +------ ------ ------ +Adams Resources Marketing, Ltd. 14% 16% -- +Columbia Energy Services -- 29% 22% +Dynegy Marketing & Trade -- 12% 23% +PG&E Energy Trading Corporation -- -- 26% +Reliant Energy Services 37% -- -- +Unocal Exploration Corporation 8% -- -- +Because alternative purchasers of oil and gas are readily available, we believe +that the loss of any of these purchasers would not result in a material adverse +effect on our ability to market future oil and gas production. +STATEMENTS OF CASH FLOWS +For purposes of the Consolidated Financial Statements, the Company considers all +highly liquid investments purchased with an original maturity of three months or +less to be cash equivalents. +The Company paid no federal income taxes for the three years ended December 31, +2000. During the years ended December 31, 2000, 1999 and 1998, the Company made +cash payments of $11,449,000, $9,013,000 and $6,229,000 respectively, for +interest. +PER SHARE AMOUNTS +Basic income or loss per common share were computed by dividing net income or +loss by the weighted average number of shares of common stock outstanding during +the year. Diluted income per common share for 2000 and 1999 were determined on a +weighted average basis using common shares issued and outstanding adjusted for +the effect of stock options considered common stock equivalents computed using +39 +40 +the treasury stock method. In 1998, all options were excluded from the +computation of diluted loss per share because they were antidilutive. The +conversion of the preferred stock was not included in any annual calculation due +to its antidilutive effect on diluted income or loss per common share. +A reconciliation of the basic and diluted per share computation is as follows +(in thousands, except per share amounts): +2000 1999 1998 +------------ ------------ ------------ +(a) Net income (loss) available for common stock $ 10,144 $ 130 $ (33,533) +Preferred dividends assuming conversion of +preferred stock (if dilutive) -- -- -- +(b) Income available for common stock assuming +conversion of preferred stock (if dilutive) $ 10,144 $ 130 $ (33,533) +(c) Weighted average shares outstanding 12,420 8,976 8,034 +Dilutive impact of stock options 325 99 -- +Convertible preferred stock (if dilutive) -- -- -- +(d) Total diluted shares 12,745 9,075 8,034 +Stock options excluded due to antidilutive impact -- -- 163 +Basic income (loss) per share (a/c) $ .82 $ .01 $ (4.17) +Diluted income (loss) per share (b/d) $ .80 $ .01 $ (4.17) +FAIR VALUE OF FINANCIAL INSTRUMENTS +Fair value of cash, cash equivalents, accounts receivable, accounts payable and +long-term debt approximates book value at December 31, 2000 and 1999. Fair value +of long-term debt (specifically, the 10%, the 10.125%, the 10.25% and the 11% +Senior Subordinated Notes) was based on quoted market value. +The calculation of the fair market value of the outstanding hedging contracts +(see Note 6) as of December 31, 2000 indicated a $5.8 million market value +liability based on market prices at that date. See Note 6 for further discussion +related to the derivative activity of the Company. +3. INCOME TAXES +The Company follows the asset and liability method of accounting for deferred +income taxes prescribed by Statement of Financial Accounting Standards No. 109 +("SFAS 109") "Accounting for Income Taxes". The statement provides for the +recognition of a deferred tax asset for deductible temporary timing differences, +capital and operating loss carryforwards, statutory depletion carryforward and +tax credit carryforwards, net of a "valuation allowance". The valuation +allowance is provided for that portion of the asset, for which it is deemed more +likely than not, that it will not be realized. The Company's management +determined that no valuation allowance was required in 2000 and 1999. +Accordingly, the Company has recorded a deferred tax asset at December 31, 2000 +and 1999 as follows: +40 +41 +DECEMBER 31, +------------------------------- +2000 1999 +------------ ------------ +(IN THOUSANDS) +Federal net operating loss carryforwards $ 14,352 $ 13,143 +Statutory depletion carryforward 4,152 4,087 +Temporary differences: +Oil and gas properties (8,937) (2,200) +Pipeline and other facilities (1,938) (2,051) +Non-oil and gas property (81) (102) +Other 1,025 2,118 +------------ ------------ +Total tax asset 8,573 14,995 +Valuation allowance -- -- +------------ ------------ +Net tax asset $ 8,573 $ 14,995 +============ ============ +At December 31, 2000, the Company had, for federal tax reporting purposes, net +operating loss carryforwards of $41.0 million, which expire in 2001 through +2015. Additionally, the Company had available for tax reporting purposes $11.9 +million in statutory depletion deductions, which can be carried forward for an +indefinite period. +The Company has significant state net operating loss carryforwards that are not +included in the deferred tax asset above, as the Company does not anticipate +generating taxable state income in the states in which these loss carryforwards +apply. The Company has very limited state taxable income as primarily all of its +revenue is generated in federal waters not subject to state income taxes. +The provision for income taxes at the Company's effective tax rate differed from +the provision for income taxes at the statutory rate as follows: +2000 1999 1998 +------------ ------------ ------------ +(IN THOUSANDS) +Computed expense (benefit) at the expected +statutory rate $ 6,463 $ 1,353 $ (15,590) +Other -- -- 490 +------------ ------------ ------------ +Deferred income tax expense (benefit) $ 6,463 $ 1,353 $ (15,100) +============ ============ ============ +4. SALE OF PRODUCTION PAYMENT INTEREST +In June 1999, the Company acquired a working interest in the Mobile Block 864 +Area where the Company already owned an interest. Concurrent with this +acquisition, the seller received a volumetric production payment, valued at +approximately $14.8 million, from production attributable to a portion of the +Company's interest in the area over a 39-month period. The Company recorded a +liability associated with the sale of this production payment interest because a +substantial obligation for future performance exists. Under the terms of the +sale, the Company is obligated to deliver the production volumes free and clear +of royalties, lease operating expenses, production taxes and all capital costs. +The production payment was recorded at the present value of the volumetric +production committed to the seller at market value and, beginning in June 1999, +is amortized to oil and gas sales on the units-of-production method as +associated hydrocarbons are delivered. +41 +42 +5. LONG-TERM DEBT +Long-term debt consisted of the following at: +DECEMBER 31, +------------------------------ +2000 1999 +------------ ------------ +(IN THOUSANDS) +Credit Facility $ 25,000 $ 100 +10% Senior Subordinated Notes -- 24,150 +10.125% Senior Subordinated Notes (due 2002) 36,000 36,000 +10.25% Senior Subordinated Notes (due 2004) 40,000 40,000 +11% Senior Subordinated Notes (due 2005) 33,000 -- +------------ ------------ +134,000 100,250 +Less: current portion -- -- +------------ ------------ +$ 134,000 $ 100,250 +============ ============ +The Company negotiated a new Credit Facility effective October 31, 2000 with +First Union National Bank. Borrowings under the Credit Facility are secured by +mortgages covering substantially all of the Company's producing oil and gas +properties. Currently, the Credit Facility is for $75 million with an initial +$50 million borrowing base ("Borrowing Base"), which is adjusted periodically on +the basis of a discounted present value of future net cash flows attributable to +the Company's proved producing oil and gas reserves. Pursuant to the Credit +Facility, the interest rate is equal to the lender's prime rate plus 0.25%. The +Company, at its option, may fix the interest rate on all or a portion of the +outstanding principal balance at 1.75% above a defined "Eurodollar" rate for +periods up to six months. The weighted average interest rate for the Credit +Facility debt outstanding at December 31, 2000 and 1999 was 8.53% and 9.00%, +respectively. Under the Credit Facility, a commitment fee of 0.25% or 0.375% per +annum, depending on the amount of the unused portion of the borrowing base, is +payable quarterly. The Company may borrow, pay, reborrow and repay under the +Credit Facility until July 31, 2002 up to the borrowing base amount, on which +date, the Company must repay in full all amounts then outstanding. +On July 31, 1997, the Company issued $36 million of its 10.125% Series A Senior +Subordinated Notes due September 15, 2002. Interest on the 10.125% Notes is +payable quarterly, on March 15, June 15, September 15, and December 15 of each +year. The 10.125% Notes are redeemable at the option of the Company in whole or +in part, at any time on or after September 15, 2000. The 10.125% Notes are +general unsecured obligations of the Company, subordinated in right of payment +to all existing and future indebtedness of the Company. +On July 15, 1999, the Company completed the sale of $40 million of Senior +Subordinated Notes due 2004 at 10.25%. The net proceeds of approximately $38.2 +million were used to pay down the Credit Facility at that time. These notes are +not entitled to any mandatory sinking fund payments and are subject to +redemption at the Company's option at par plus unpaid interest at any time after +March 15, 2001. The notes are listed on the New York Stock Exchange under the +symbol "CPE 04" and are subject to a change +42 +43 +of control clause that obligates the Company to repurchase the notes for 101% of +par should a change of control occur. Interest is paid quarterly. +The Company completed the sale of $33 million of 11% Senior Subordinated Notes +due 2005, on October 26, 2000. The Company netted $31.5 million from the +offering after deducting the underwriters' discount and offering expenses. +Approximately $20.8 million of the net proceeds from the offering were used to +purchase the Company's outstanding 10% Senior Subordinated Notes due 2001 in +conjunction with a tender offer. The Company also redeemed the remaining $3.4 +million of its 10% Senior Subordinated Notes due 2001 not tendered in the offer. +The Credit Facility and the subordinated debt contain various covenants +including restrictions on additional indebtedness and payment of cash dividends +as well as maintenance of certain financial ratios. The Company is in compliance +with these covenants at December 31, 2000. +6. HEDGING CONTRACTS +The Company periodically uses derivative financial instruments to manage oil and +gas price risk. Settlements of gains and losses on commodity price contracts are +generally based upon the difference between the contract price or prices +specified in the derivative instrument and a NYMEX price or other cash or +futures index price, and are reported in 2000 and prior years as a component of +oil and gas revenues. Gains or losses attributable to the termination of a +contract are deferred and recognized in revenue when the oil and gas production +is sold. Approximately $3,290,000 and $1,559,000 were recognized as a reduction +of oil and gas revenue in 2000 and 1999 respectively, and $1,886,000 was +recognized as additional oil and gas revenue in 1998 as a result of such +agreements. +As of December 31, 2000, the Company had open collar contracts with third +parties whereby minimum floor prices and maximum ceiling prices are contracted +and applied to related contract volumes. These agreements in effect for 2001 are +for average gas volumes of 390,000 Mcf per month beginning in January 2001 +through October 2001 at (based on a weighted average of the contracts) a ceiling +price of $5.86 and floor price of $4.69. The Company had no open oil hedging +contracts at December 31, 2000. +As discussed in Note 2, the Company adopted SFAS 133 effective January 1, 2001. +This statement establishes accounting and reporting standards that differ from +those used in prior years. SFAS 133 requires that every derivative instrument be +recorded in the balance sheet as either an asset or liability measured at its +fair value at the date of adoption. The statement requires that future changes +in the derivatives fair value be recognized currently in earnings unless +specific hedge accounting criteria are met. Special accounting for qualifying +hedges allows a derivative instrument's gain or loss to offset related results +on the hedged item in the income statement, to the extent effective, and +requires that the Company must formally document, designate, and assess +effectiveness of transactions that receive hedge accounting. The Company +believes that its hedges described above, to the extent of intrinsic value, will +qualify as cash flow hedges under SFAS 133. +The Company has not yet quantified all effects of adopting SFAS 133 on its +future financial statements. However as discussed in the following paragraphs, +the Statement will increase volatility in earnings and other comprehensive +income. +43 +44 +The Company will record a market value liability in 2001 of $5.8 million related +to the fair value of the derivatives outstanding at January 1, 2001 with a +corresponding charge, net of tax, to other comprehensive income. This transition +adjustment will be reclassified into earnings in the same period or periods +during which the hedged forecasted transactions affects earnings, adjusted for +any future changes in fair value. +Oil and gas prices have declined significantly since January 1, 2001(the date of +the transition entry to record the derivatives at fair value) causing +substantially all of the liability recorded on the balance sheet at that date to +be reversed in the first quarter of 2001. +7. COMMITMENTS AND CONTINGENCIES +As described in Note 9, abandonment trusts (the "Trusts") have been established +for future abandonment obligations of those oil and gas properties of the +Company burdened by a net profits interest. The management of the Company +believes the Trusts will be sufficient to offset those future abandonment +liabilities; however, the Company is responsible for any abandonment expenses in +excess of the Trusts' balances. As of December 31, 2000 total estimated site +restoration, dismantlement and abandonment costs were approximately $6,227,000, +net of expected salvage value. Substantially all such costs are expected to be +funded through the Trusts' funds, all of which will be accessible to the Company +when abandonment work begins. In addition, as a working interest owner and/or +operator of oil and gas properties, the Company is responsible for the cost of +abandonment of such properties. See Note 2. +The Company, as part of the Consolidation, entered into Registration Rights +Agreements whereby the former stockholders of certain of the Constituent +Entities are entitled to require the Company to register Common Stock of the +Company owned by them with the Securities and Exchange Commission for sale to +the public in a firm commitment public offering and generally to include shares +owned by them, at no cost, in registration statements filed by the Company. +Costs of the offering will not include discounts and commissions, which will be +paid by the respective sellers of the Common Stock. +44 +45 +8. OIL AND GAS PROPERTIES +The following table discloses certain financial data relating to the Company's +oil and gas activities, all of which are located in the United States. +YEARS ENDED DECEMBER 31, +----------------------------------------- +2000 1999 1998 +--------- --------- --------- +(IN THOUSANDS) +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance $ 511,689 $ 444,579 $ 398,046 +Property acquisition costs 3,211 24,153 9,464 +Exploration costs 51,837 37,427 42,617 +Development costs 25,242 5,530 4,361 +Sale of mineral interests (2,430) -- (9,909) +--------- --------- --------- +End of period balance $ 589,549 $ 511,689 $ 444,579 +========= ========= ========= +Unevaluated Properties (excluded from +amortization) - +Beginning of period balance $ 44,434 $ 42,679 $ 35,339 +Additions 4,381 4,890 11,156 +Capitalized interest 4,548 3,497 4,440 +General and administrative costs 5,036 3,623 4,515 +Transfers to evaluated (10,746) (10,255) (12,771) +--------- --------- --------- +End of period balance $ 47,653 $ 44,434 $ 42,679 +========= ========= ========= +Accumulated depreciation, depletion +and amortization +Beginning of period balance $ 361,758 $ 345,353 $ 282,891 +Provision charged to expense 16,831 16,405 18,962 +Impairment of oil and gas properties -- -- 43,500 +--------- --------- --------- +End of period balance $ 378,589 $ 361,758 $ 345,353 +========= ========= ========= +Unevaluated property costs, primarily lease acquisition costs incurred at +federal lease sales, unevaluated drilling costs, capitalized interest and +general and administrative costs being excluded from the amortizable evaluated +property base consisted of $12.3 million incurred in 2000, $7.5 million incurred +in 1999 and $27.9 million incurred in 1998 and prior. These costs are directly +related to the acquisition and evaluation of unproved properties and major +development projects. The excluded costs and related reserves are included in +the amortization base as the properties are evaluated and proved reserves are +established or impairment is determined. The majority of these costs will be +evaluated over the next five-year period. +Depletion per unit-of-production (thousand cubic feet of gas equivalent) +amounted to $1.10, $.99 and $1.19 for the years ended December 31, 2000, 1999, +and 1998, respectively. +IMPAIRMENT OF OIL AND GAS PROPERTIES-1998 +Under full-cost accounting rules, the capitalized costs of proved oil and gas +properties are subject to a "ceiling test", which limits such costs to the +estimated present value net of related tax effects, discounted at a 10 percent +interest rate, of future net cash flows from proved reserves, based on current +economic and operating conditions (PV10). If capitalized costs exceed this +limit, the excess is charged to expense. During the fourth quarter of 1998, the +Company recorded a noncash impairment provision related to oil and gas +45 +46 +properties in the amount of $43.5 million ($28.7 million after-tax) primarily +due to the significant decline in oil and gas prices at December 31, 1998. +9. NET PROFITS INTEREST +From 1989 through 1994, the Constituent Entities entered into separate +agreements to purchase certain oil and gas properties with gross contract +acquisition prices of $170,000,000 ($150,000,000 net as of closing dates) and in +simultaneous transactions, entered into agreements to sell overriding royalty +interests ("ORRI") in the acquired properties. These ORRI are in the form of net +profits interests ("NPI") equal to a significant percentage of the excess of +gross proceeds over production costs, as defined, from the acquired oil and gas +properties. A net deficit incurred in any month can be carried forward to +subsequent months until such deficit is fully recovered. The Company has the +right to abandon the purchased oil and gas properties if it deems the properties +to be uneconomical. +The Company has, pursuant to the purchase agreements, created abandonment trusts +whereby funds are provided out of gross production proceeds from the properties +for the estimated amount of future abandonment obligations related to the +working interests owned by the Company. The Trusts are administered by unrelated +third party trustees for the benefit of the Company's working interest in each +property. The Trust agreements limit their funds to be disbursed for the +satisfaction of abandonment obligations. Any funds remaining in the Trusts after +all restoration, dismantlement and abandonment obligations have been met will be +distributed to the owners of the properties in the same ratio as contributions +to the Trusts. The Trusts' assets are excluded from the Consolidated Balance +Sheets of the Company because the Company does not control the Trusts. Estimated +future revenues and costs associated with the NPI and the Trusts are also +excluded from the oil and gas reserve disclosures at Note 12. As of December 31, +2000 and 1999, the Trusts' assets (all cash and investments) totaled $6,227,000 +and $5,690,000 respectively, all of which will be available to the Company to +pay its portion, as working interest owner, of the restoration, dismantlement +and abandonment costs discussed at Note 7. +At the time of acquisition of properties by the Company, the property owners +estimated the future costs to be incurred for site restoration, dismantlement +and abandonment, net of salvage value. A portion of the amounts necessary to pay +such estimated costs was deposited in the Trusts upon acquisition of the +properties, and the remainder is deposited from time to time out of the proceeds +from production. The determination of the amount deposited upon the acquisition +of the properties and the amount to be deposited as proceeds from production was +based on numerous factors, including the estimated reserves of the properties. +The amounts deposited in the Trusts upon acquisition of the properties were +capitalized by the Company as oil and gas properties. +As operator, the Company receives all of the revenues and incurs all of the +production costs for the purchased oil and gas properties but retains only that +portion applicable to its net ownership share. As a result, the payables and +receivables associated with operating the properties included in the Company's +Consolidated Balance Sheets include both the Company's and all other outside +owners' shares. However, revenues and production costs associated with the +acquired properties reflected in the accompanying Consolidated Statements of +Operations represent only the Company's share, after reduction for the NPI. +46 +47 +10. EMPLOYEE BENEFIT PLANS +The Company has adopted a series of incentive compensation plans designed to +align the interest of the executives and employees with those of its +stockholders. The following is a brief description of each plan: +- The Savings and Protection Plan provides employees with the option to +defer receipt of a portion of their compensation and the Company may, +at its discretion, match a portion of the employee's deferral with cash +and Company Common Stock. The Company may also elect, at its +discretion, to contribute a non-matching amount in cash and Company +Common Stock to employees. The amounts held under the Savings and +Protection Plan are invested in various funds maintained by a third +party in accordance with the directions of each employee. An employee +is fully vested, including Company discretionary contributions, +immediately upon participation in the Savings and Protection Plan. The +total amounts contributed by the Company, including the value of the +common stock contributed, were $500,000, $466,000, and $468,000 in the +years 2000, 1999 and 1998, respectively. +- The 1994 Stock Incentive Plan (the "1994 Plan") provides for 600,000 +shares of Common Stock to be reserved for issuance pursuant to such +plan. Under the 1994 Plan the Company may grant both stock options +qualifying under Section 422 of the Internal Revenue Code and options +that are not qualified as incentive stock options, as well as +performance shares. These options have an expiration date 10 years from +date of grant. +- On August 23, 1996, the Board of Directors of the Company approved and +adopted the Callon Petroleum Company 1996 Stock Incentive Plan (the +"1996 Plan"). The 1996 Plan provides for the same types of awards as +the 1994 Plan and is limited to a maximum of 1,200,000 shares (as +amended from the original 900,000 shares) of common stock that may be +subject to outstanding awards. Unvested options are subject to +forfeiture upon certain termination of employment events and expire 10 +years from date of grant. +- The Company granted 533,000 stock options to employees on March 23, +2000 and 120,000 stock options to directors on July 25, 2000 at $10.50 +per share. The March 23, 2000 grant was subject to shareholder approval +of an amendment to the 1996 Stock Incentive Plan. The amendment, which +was approved on May 9, 2000 at the Annual Meeting of Shareholders, +increased the number of shares reserved for issuance under the 1996 +plan. The excess of the market price over the exercise price on the +approval date of the amendment is amortized over the three-year vesting +period of the options. Compensation costs of $800,973 were recognized +in income in 2000 related to these options. +The Company accounts for the options issued pursuant to the stock incentive +plans under APB Opinion No. 25, under which no compensation cost has been +recognized unless the exercise price is less than the market price at the +measurement date. Had compensation cost for these plans been determined +consistent with Statement of Financial Accounting Standards No. 123 ("SFAS +123"), "Accounting for Stock-Based Compensation", the Company's net income and +earnings per common share would have been reduced to the following pro forma +amounts: +47 +48 +2000 1999 1998 +---------- ---------- ---------- +(IN THOUSANDS, EXCEPT PER SHARE DATA) +Net income (loss) available for +common shares: As Reported $ 10,144 $ 130 $ (33,533) +Pro Forma 8,418 (1,212) (34,421) +Basic earnings (loss) per share: As Reported .82 .01 (4.17) +Pro Forma .68 (.14) (4.28) +Diluted earnings (loss) per share: As Reported .80 .01 (4.17) +Pro Forma .66 (.14) (4.28) +A summary of the status of the Company's two stock option plans at December 31, +2000, 1999 and 1998 and changes during the years then ended is presented in the +table and narrative below: +2000 1999 1998 +---------------------------- --------------------------- -------------------------- +WTD AVG WTD AVG WTD AVG +SHARES EX PRICE SHARES EX PRICE SHARES EX PRICE +------------ ------------ ------------ ------------ ------------ ------------ +Outstanding, beginning of year 1,536,500 $ 10.60 1,266,000 $ 11.00 1,041,000 $ 11.19 +Granted (at market) 135,000 14.73 270,500 9.27 225,000 10.08 +Granted (below market) 653,000 10.50 -- -- -- -- +Exercised (20,333) 9.00 -- -- -- -- +Forfeited -- -- -- -- -- -- +Expired -- -- -- -- -- -- +------------ ------------ ------------ ------------ ------------ ------------ +Outstanding, end of year 2,304,167 $ 10.83 1,536,500 $ 10.60 1,266,000 $ 11.00 +============ ============ ============ ============ ============ ============ +Exercisable, end of year 1,647,657 $ 10.71 1,247,600 $ 10.47 802,250 $ 10.90 +============ ============ ============ ============ ============ ============ +Weighted average fair value of +options granted (at market) $ 7.68 $ 4.94 $ 4.31 +============ ============ ============ +Weighted average fair value of +options granted (below market) $ 7.90 N/A N/A +============ +At December 31, 2000, 2,129,167 of the 2,304,167 options outstanding have +exercise prices between $9 and $13.50 with a weighted average exercise price of +$10.51 and a weighted average remaining contractual life of 6.85 years. Of these +options, 1,546,357 are exercisable at a weighted average exercise price of +$10.46. The remaining 175,000 options have exercise prices between $13.50 and +$15.31 with a weighted average exercise price of $14.69 and a weighted average +remaining contractual life of 8.98 years. Of these options, 101,300 are +exercisable at a weighted average exercise price of $14.46. +The fair value of each option grant is estimated on the date of grant using the +Black-Scholes option pricing model with the following weighted average +assumptions used for options granted during 2000, 1999 and 1998. +2000 1999 1998 +---------- ---------- ---------- +Risk free interest rate 6.3% 6.3% 5.1% +Expected life (years) 5.0 7.0 7.0 +Expected volatility 52.1% 46.0% 28.8% +Expected dividends -- -- -- +The Company awarded 225,000 performance shares under the 1996 Plan to the +Company's Executive officers on August 23, 1996. All of the performance shares +granted were scheduled to vest in whole on January 1, 2001. The unearned portion +was being amortized as compensation expense on a straight-line basis over the +vesting period. An additional 25,000 shares were issued under the 1994 Plan in +1997 and 165,500 shares were issued to certain key employees other than the +Company's Executive officers in 1998. +48 +49 +Approximately $4,963,000 in 1998 and $714,000 in 1997 of compensation cost were +charged to expense related to the restricted shares granted. In December 1998, +the Company approved the accelerated vesting of all performance shares. As a +result, an additional charge of $3,469,000 which represents the future +unamortized expense related to unvested shares at the date the acceleration of +vesting occurred, was expensed in 1998. +In addition, the Company recorded a provision of approximately $2.3 million for +retirement benefits approved by the compensation committee of the Board of +Directors in December of 1998. +11. EQUITY TRANSACTIONS +In November 1995, the Company sold 1,315,500 shares of $2.125 Convertible +Exchangeable Preferred Stock, Series A (the "Preferred Stock") for net proceeds +of $30.9 million. Annual dividends are $2.125 per share and are cumulative. The +net proceeds of the $.01 par value stock after underwriters discount and expense +was $30,899,000. Each share has a liquidation preference of $25.00, plus accrued +and unpaid dividends. Dividends on the Preferred Stock are cumulative from the +date of issuance and are payable quarterly, commencing January 15, 1996. The +Preferred Stock is convertible at any time, at the option of the holders +thereof, unless previously redeemed, into shares of Common Stock of the Company +at an initial conversion price of $11 per share of Common Stock, subject to +adjustments under certain conditions. +The Preferred Stock is redeemable at any time on or after December 31, 1998, in +whole or in part at the option of the Company at a redemption price of $26.488 +per share beginning at December 31, 1998 and at premiums declining to the $25.00 +liquidation preference by the year 2005 and thereafter, plus accrued and unpaid +dividends. The Preferred Stock is also exchangeable, in whole, but not in part, +at the option of the Company on or after January 15, 1998 for the Company's 8.5% +Convertible Subordinated Debentures due 2010 (the "Debentures") at a rate of +$25.00 principal amount of Debentures for each share of Preferred Stock. The +Debentures will be convertible into Common Stock of the Company on the same +terms as the Preferred Stock and will pay interest semi-annually. +In a December 1998 private transaction, a preferred stockholder elected to +convert 59,689 shares of Preferred Stock into 136,867 shares of the Company's +Common Stock. In 1999 certain other preferred stockholders, through private +transactions, agreed to convert 210,350 shares of Preferred Stock into 502,637 +shares of the Company's Common Stock under similar terms. Likewise in 2000, +444,600 shares of Preferred Stock were converted into 1,036,098 shares of the +Company's Common Stock. Any noncash premium negotiated in excess of the +conversion rate was recorded as additional preferred stock dividends and +excluded from the Consolidated Statements of Cash Flows. +In November of 1999, the Company sold 3,680,000 shares of Common Stock in a +public offering at a price to the public of $11.875 per share. Cash proceeds +received by the Company were $41.1 million net of underwriting discount and +offering costs. +The Company adopted a stockholder rights plan on March 30, 2000, designed to +assure that the Company's stockholders receive fair and equal treatment in the +event of any proposed takeover of the Company and to guard against partial +tender offers, squeeze-outs, open market accumulations, and other abusive +tactics to gain control without paying all stockholders a fair price. The rights +plan was not adopted in response to any specific takeover proposal. Under the +rights plan, the Company declared a dividend of one right ("Right") +49 +50 +on each share of the Company's Common Stock. Each Right will entitle the holder +to purchase one one-thousandth of a share of a Series B Preferred Stock, par +value $0.01 per share, at an exercise price of $90 per one one-thousandth of a +share. The Rights are not currently exercisable and will become exercisable only +in the event a person or group acquires, or engages in a tender or exchange +offer to acquire, beneficial ownership of 15 percent or more (one existing +stockholder was granted an exception for up to 21 percent) of the Company's +Common Stock. After the Rights become exercisable, each Right will also entitle +its holder to purchase a number of common shares of the Company having a market +value of twice the exercise price. The dividend distribution was made to +stockholders of record at the close of business on April 10, 2000. The Rights +will expire on March 30, 2010. +12. SUPPLEMENTAL OIL AND GAS RESERVE DATA (UNAUDITED) +The Company's proved oil and gas reserves at December 31, 2000, 1999 and 1998 +have been estimated by independent petroleum consultants in accordance with +guidelines established by the Securities and Exchange Commission ("SEC"). +Accordingly, the following reserve estimates are based upon existing economic +and operating conditions. +The 2000 estimates have been adjusted (per SEC guidelines) to exclude (i) +volumes (approximately 3.5 billion cubic feet of natural gas) and (ii) future +revenues of approximately $31.8 million associated with the volumetric +production payment described in Note 4. The adjustments resulted in a reduction +of approximately $29.5 million in standardized measure of discounted net cash +flows, before tax, associated with this volumetric production payment. +There are numerous uncertainties inherent in establishing quantities of proved +reserves. The following reserve data represent estimates only and should not be +construed as being exact. In addition, the present values should not be +construed as the current market value of the Company's oil and gas properties or +the cost that would be incurred to obtain equivalent reserves. +50 +51 +ESTIMATED RESERVES +Changes in the estimated net quantities of crude oil and natural gas reserves, +all of which are located onshore and offshore in the continental United States, +are as follows: +RESERVE QUANTITIES +YEARS ENDED DECEMBER 31, +-------------------------------------------- +2000 1999 1998 +---------- ---------- ---------- +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period 23,834 6,898 3,402 +Revisions to previous estimates 85 (686) (99) +Purchase of reserves in place -- 2,629 162 +Sales of reserves in place -- -- (1,531) +Extensions and discoveries 9,695 15,323 5,274 +Production (232) (330) (310) +---------- ---------- ---------- +End of period 33,382 23,834 6,898 +========== ========== ========== +Natural Gas (MMcf): +Beginning of period 110,621 88,030 88,738 +Revisions to previous estimates (4,817) (11,492) (8,631) +Purchase of reserves in place 347 4,733 4,414 +Sales of reserves in place -- -- (684) +Extensions and discoveries 35,387 42,662 18,229 +Production (11,616) (13,312) (14,036) +---------- ---------- ---------- +End of period 129,922 110,621 88,030 +========== ========== ========== +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period 1,376 1,774 2,976 +========== ========== ========== +End of period 2,192 1,376 1,774 +========== ========== ========== +Natural Gas (MMcf): +Beginning of period 76,295 76,895 88,010 +========== ========== ========== +End of period 63,982 76,295 76,895 +========== ========== ========== +51 +52 +STANDARDIZED MEASURE +The following tables present the Company's standardized measure of discounted +future net cash flows and changes therein relating to proved oil and gas +reserves and were computed using reserve valuations based on regulations +prescribed by the SEC. These regulations provide that the oil, condensate and +gas price structure utilized to project future net cash flows reflects current +prices ($9.14 for natural gas and $26.71 for oil for the 2000 disclosures) at +each date presented and have been escalated only when known and determinable +price changes are provided by contract and law. Future production, development +and net abandonment costs are based on current costs without escalation. The +resulting net future cash flows have been discounted to their present values +based on a 10% annual discount factor. +STANDARDIZED MEASURE +YEARS ENDED DECEMBER 31, +----------------------------------------------- +2000 1999 1998 +----------- ----------- ----------- +(IN THOUSANDS) +Future cash inflows $ 2,080,680 $ 847,930 $ 256,325 +Future costs - +Production (284,667) (207,615) (67,192) +Development and net abandonment (217,507) (123,749) (36,581) +----------- ----------- ----------- +Future net inflows before income taxes 1,578,506 516,567 152,552 +Future income taxes (472,637) (109,238) -- +----------- ----------- ----------- +Future net cash flows 1,105,869 407,329 152,552 +10% discount factor (434,672) (151,007) (52,801) +----------- ----------- ----------- +Standardized measure of discounted +future net cash flows $ 671,197 $ 256,322 $ 99,751 +=========== =========== =========== +CHANGES IN STANDARDIZED MEASURE +YEARS ENDED DECEMBER 31, +-------------------------------------------------- +2000 1999 1998 +------------ ------------ ------------ +(IN THOUSANDS) +Standardized measure - beginning of period $ 256,322 $ 99,751 $ 128,079 +Sales and transfers, net of production costs (42,132) (27,076) (27,807) +Net change in sales and transfer prices, +Net of production costs 361,179 57,246 (33,029) +Exchange and sale of in place reserves -- -- (4,445) +Purchases, extensions, discoveries, and improved +recovery, net of future production and +development costs 276,770 181,185 24,294 +Revisions of quantity estimates (12,399) (22,438) (9,409) +Accretion of discount 28,581 9,975 13,645 +Net change in income taxes (209,090) (29,492) 7,926 +Changes in production rates, timing and other 11,966 (12,829) 497 +------------ ------------ ------------ +Standardized measure - end of period $ 671,197 $ 256,322 $ 99,751 +============ ============ ============ +52 +53 +13. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) +FIRST SECOND THIRD FOURTH +QUARTER QUARTER QUARTER QUARTER +---------- ---------- ---------- ---------- +(IN THOUSANDS, EXCEPT PER SHARE DATA) +2000 +---- +Total revenues $ 10,118 $ 14,716 $ 16,422 $ 16,821 +Total costs and expenses 8,354 9,935 9,958 10,820 +Income tax expense 600 1,626 2,197 2,040 +Net income 1,164 3,155 4,267 3,961 +Net income per share-basic 0.05 0.21 0.30 0.25 +Net income per share-diluted 0.05 0.21 0.29 0.24 +1999 +---- +Total revenues $ 8,374 $ 9,031 $ 10,584 $ 11,004 +Total costs and expenses 7,659 8,690 8,986 9,678 +Income tax expense 243 116 543 451 +Net income 472 225 1,055 875 +Net income (loss) per share-basic (0.04) (0.04) 0.06 0.03 +Net income (loss) per share-diluted (0.04) (0.04) 0.06 0.03 +53 +54 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND +FINANCIAL DISCLOSURE +None. +PART III. +ITEMS 10, 11, 12 &13 +For information concerning Item 10 - Directors and Executive Officers of the +Registrant, Item 11 - Executive Compensation, Item 12 - Security Ownership of +Certain Beneficial Owners and Management and Item 13 - Certain Relationships and +Related Transactions, see the definitive Proxy Statement of Callon Petroleum +Company relating to the Annual Meeting of Stockholders on May 4, 2001 which will +be filed with the Securities and Exchange Commission and is incorporated herein +by reference. +54 +55 +PART IV. +ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K +(a) 1. The following is an index to the financial statements and financial +statement schedules that are filed as part of this Form 10-K on pages 32 +through 53. +Report of Independent Public Accountants +Consolidated Balance Sheets as of the Years Ended December 31, 2000 and +1999 +Consolidated Statements of Operations for the Three Years in the Period +Ended December 31, 2000 +Consolidated Statements of Stockholders' Equity for the Three Years in the +Period Ended December 31, 2000 +Consolidated Statements of Cash Flows for the Three Years in the Period +Ended December 31, 2000 +Notes to Consolidated Financial Statements +(a) 2. Schedules other than those listed above are omitted because they are not +required, not applicable or the required information is included in the +financial statements or notes thereto. +(a) 3. Exhibits: +2. Plan of acquisition, reorganization, arrangement, liquidation or +succession* +3. Articles of Incorporation and Bylaws +3.1 Certificate of Incorporation of the Company, as amended +(incorporated by reference from Exhibit 3.1 of the Company's +Registration Statement on Form S-4, filed August 4, 1994, Reg. +No. 33-82408) +3.2 Certificate of Merger of Callon Consolidated Partners, L. P. +with and into the Company dated September 16, 1994 +(incorporated by reference from Exhibit 3.2 of the Company's +Report on Form 10-K for the fiscal year ended December 31, +1994) +3.3 Bylaws of the Company (incorporated by reference from Exhibit +3.2 of the Company's Registration Statement on Form S-4, filed +August 4, 1994, Reg. No. 33-82408) +4. Instruments defining the rights of security holders, including +indentures +4.1 Specimen Common Stock Certificate (incorporated by reference +from Exhibit 4.1 of the Company's Registration Statement on +Form S-4, filed August 4, 1994, Reg. No. 33-82408) +55 +56 +4.2 Specimen Preferred Stock Certificate (incorporated by +reference from Exhibit 4.2 of the Company's Registration +Statement on Form S-1, filed November 13, 1995, Reg. No. +33-96700) +4.3 Designation for Convertible, Exchangeable Preferred Stock, +Series A (incorporated by reference from Exhibit 4.3 of the +Company's Registration Statement on Form S-1, filed November +13, 1995, Reg. No. 33-96700) +4.4 Indenture for Convertible Debentures (incorporated by +reference from Exhibit 4.4 of the Company's Registration +Statement on Form S-1, filed November 13, 1995, Reg. No. +33-96700) +4.5 Certificate of Correction on Designation of Series A Preferred +Stock (incorporated by reference from Exhibit 4.4 of the +Company's Registration Statement on Form S-1, filed November +22, 1996, Reg. No. 333-15501) +4.6 Form of Note Indenture for the Company's 10.25% Senior +Subordinated Notes due 2004 (incorporated by reference from +Exhibit 4.10 of the Company's Registration Statement on Form +S-2, filed June 25, 1999, Reg. No. 333-80579) +4.7 Rights Agreement between Callon Petroleum Company and American +Stock Transfer & Trust Company, Rights Agent, dated March 30, +2000 (incorporated by reference from Exhibit 4 of the +Company's 8-K filed April 6, 2000) +4.8 Subordinated Indenture for the Company dated October 26, 2000 +(incorporated by reference from Exhibit 4.1 of the Company's +Current Report on Form 8-K dated October 24, 2000) +4.9 Supplemental Indenture for the Company's 11% Senior +Subordinated Notes due 2005 (incorporated by reference from +Exhibit 4.2 of the Company's Current Report on Form 8-K dated +October 24, 2000) +9. Voting trust agreement +None. +10. Material contracts +10.1 Registration Rights Agreement dated September 16, 1994 between +the Company and NOCO Enterprises, L. P. (incorporated by +reference from Exhibit 10.2 of the Company's Registration +Statement on Form 8-B filed October 3, 1994) +10.2 Counterpart to Registration Rights Agreement by and between +the Company, Ganger Rolf ASA and Bonheur ASA. +56 +57 +10.3 Registration Rights Agreement dated September 16, 1994 between +the Company and Callon Stockholders (incorporated by reference +from Exhibit 10.3 of the Company's Registration Statement on +Form 8-B filed October 3, 1994) +10.4 Callon Petroleum Company 1994 Stock Incentive Plan +(incorporated by reference from Exhibit 10.5 of the Company's +Registration Statement on Form 8-B filed October 3, 1994) +10.5 Consulting Agreement between the Company and John S. Callon +dated June 19, 1996 (incorporated by reference from Exhibit +10.10 of the Company's Registration Statement on Form S-1, +filed November 5, 1996, Reg. No. 333-15501) +10.6 Callon Petroleum Company Amended 1996 Stock Incentive Plan +(incorporated by reference from Exhibit 4.4 of the +Post-Effective Amendment No. 1 to the Company's Registration +Statement on Form S-8, filed February 5, 1999, Reg No. +333-29537) +10.7 Purchase and Sale Agreement between Callon Petroleum Operating +Company and Murphy Exploration Company, dated May 26, 1999 +(incorporated by reference from Exhibit 10.11 on Form S-2, +filed June 14, 1999, Reg. No. 333-80579) +10.8 Callon Petroleum Company 1996 Stock Incentive Plan as amended +on May 9, 2000 (incorporated by reference from Appendix I of +the Company's Definitive Proxy Statement of Schedule 14A filed +March 28, 2000) +10.9 Credit Agreement dated as of October 30, 2000 between the +Company and First Union National Bank, as administrative agent +for the lenders (incorporated by reference from Exhibit 10.2 +of the Company's September 30, 2000 Form 10-Q filed November +13, 2000) +11. Statement re computation of per share earnings* +12. Statements re computation of ratios* +13. Annual Report to security holders, Form 10-Q or quarterly reports* +16. Letter re change in certifying accountant* +18. Letter re change in accounting principles* +21. Subsidiaries of the Company +21.1 Subsidiaries of the Company (incorporated by reference from +Exhibit 21.1 of the Company's Registration Statement on Form +8-B filed October 3, 1994) +22. Published report regarding matters submitted to vote of security +holders* +23. Consents of experts and counsel +23.1 Consent of Arthur Andersen LLP +57 +58 +24. Power of attorney* +99. Additional Exhibits* +---------- +*Inapplicable to this filing. +(b) Reports on Form 8-K. +The Company filed a Report on Form 8-K on October 27, 2000 under "Item 5 - +Other Events" filing certain exhibits in connection with the offer and +sale of the Company's 11% Senior Subordinated Notes due 2005. +The Company filed a Report on Form 8-K on December 4, 2000 under "Item 5 - +Other Events" which contained the news release regarding the completion of +the redemption of its 10% Senior Subordinated Notes due 2001. +58 +59 +SIGNATURES +Pursuant to the requirements of the Securities Exchange Act of 1934, this report +has been signed below by the following persons on behalf of the registrant and +in the capacities and on the dates indicated. +CALLON PETROLEUM COMPANY +Date: March 30, 2001 /s/ Fred L. Callon +---------------- ------------------------------------------------------- +Fred L. Callon (principal executive officer, director) +Date: March 30, 2001 /s/ John S. Weatherly +---------------- ------------------------------------------------------- +John S. Weatherly (principal financial officer) +Date: March 30, 2001 /s/ James O. Bassi +---------------- ------------------------------------------------------- +James O. Bassi (principal accounting officer) +Date: March 30, 2001 /s/ John S. Callon +---------------- ------------------------------------------------------- +John S. Callon (director) +Date: March 30, 2001 /s/ Dennis W. Christian +---------------- ------------------------------------------------------- +Dennis W. Christian (director) +Date: March 30, 2001 /s/ B. F. Weatherly +---------------- ------------------------------------------------------- +B. F. Weatherly (director) +Date: March 30, 2001 /s/ John C. Wallace +---------------- ------------------------------------------------------- +John C. Wallace (director) +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange +Act of 1934, the registrant has duly caused this report to be signed on its +behalf by the undersigned, thereunto duly authorized. +CALLON PETROLEUM COMPANY +Date: March 30, 2001 By: /s/ John S. Weatherly +---------------- ------------------------------------------------------- +John S. Weatherly, Senior Vice President and +Chief Financial Officer +59 +60 +INDEX TO EXHIBITS +EXHIBIT +NUMBER DESCRIPTION +------ ----------- +(a) 3. Exhibits: +2. Plan of acquisition, reorganization, arrangement, liquidation or +succession* +3. Articles of Incorporation and Bylaws +3.1 Certificate of Incorporation of the Company, as amended +(incorporated by reference from Exhibit 3.1 of the Company's +Registration Statement on Form S-4, filed August 4, 1994, Reg. +No. 33-82408) +3.2 Certificate of Merger of Callon Consolidated Partners, L. P. +with and into the Company dated September 16, 1994 +(incorporated by reference from Exhibit 3.2 of the Company's +Report on Form 10-K for the fiscal year ended December 31, +1994) +3.3 Bylaws of the Company (incorporated by reference from Exhibit +3.2 of the Company's Registration Statement on Form S-4, filed +August 4, 1994, Reg. No. 33-82408) +4. Instruments defining the rights of security holders, including +indentures +4.1 Specimen Common Stock Certificate (incorporated by reference +from Exhibit 4.1 of the Company's Registration Statement on +Form S-4, filed August 4, 1994, Reg. No. 33-82408) +61 +4.2 Specimen Preferred Stock Certificate (incorporated by +reference from Exhibit 4.2 of the Company's Registration +Statement on Form S-1, filed November 13, 1995, Reg. No. +33-96700) +4.3 Designation for Convertible, Exchangeable Preferred Stock, +Series A (incorporated by reference from Exhibit 4.3 of the +Company's Registration Statement on Form S-1, filed November +13, 1995, Reg. No. 33-96700) +4.4 Indenture for Convertible Debentures (incorporated by +reference from Exhibit 4.4 of the Company's Registration +Statement on Form S-1, filed November 13, 1995, Reg. No. +33-96700) +4.5 Certificate of Correction on Designation of Series A Preferred +Stock (incorporated by reference from Exhibit 4.4 of the +Company's Registration Statement on Form S-1, filed November +22, 1996, Reg. No. 333-15501) +4.6 Form of Note Indenture for the Company's 10.25% Senior +Subordinated Notes due 2004 (incorporated by reference from +Exhibit 4.10 of the Company's Registration Statement on Form +S-2, filed June 25, 1999, Reg. No. 333-80579) +4.7 Rights Agreement between Callon Petroleum Company and American +Stock Transfer & Trust Company, Rights Agent, dated March 30, +2000 (incorporated by reference from Exhibit 4 of the +Company's 8-K filed April 6, 2000) +4.8 Subordinated Indenture for the Company dated October 26, 2000 +(incorporated by reference from Exhibit 4.1 of the Company's +Current Report on Form 8-K dated October 24, 2000) +4.9 Supplemental Indenture for the Company's 11% Senior +Subordinated Notes due 2005 (incorporated by reference from +Exhibit 4.2 of the Company's Current Report on Form 8-K dated +October 24, 2000) +9. Voting trust agreement +None. +10. Material contracts +10.1 Registration Rights Agreement dated September 16, 1994 between +the Company and NOCO Enterprises, L. P. (incorporated by +reference from Exhibit 10.2 of the Company's Registration +Statement on Form 8-B filed October 3, 1994) +10.2 Counterpart to Registration Rights Agreement by and between +the Company, Ganger Rolf ASA and Bonheur ASA. +62 +10.3 Registration Rights Agreement dated September 16, 1994 between +the Company and Callon Stockholders (incorporated by reference +from Exhibit 10.3 of the Company's Registration Statement on +Form 8-B filed October 3, 1994) +10.4 Callon Petroleum Company 1994 Stock Incentive Plan +(incorporated by reference from Exhibit 10.5 of the Company's +Registration Statement on Form 8-B filed October 3, 1994) +10.5 Consulting Agreement between the Company and John S. Callon +dated June 19, 1996 (incorporated by reference from Exhibit +10.10 of the Company's Registration Statement on Form S-1, +filed November 5, 1996, Reg. No. 333-15501) +10.6 Callon Petroleum Company Amended 1996 Stock Incentive Plan +(incorporated by reference from Exhibit 4.4 of the +Post-Effective Amendment No. 1 to the Company's Registration +Statement on Form S-8, filed February 5, 1999, Reg No. +333-29537) +10.7 Purchase and Sale Agreement between Callon Petroleum Operating +Company and Murphy Exploration Company, dated May 26, 1999 +(incorporated by reference from Exhibit 10.11 on Form S-2, +filed June 14, 1999, Reg. No. 333-80579) +10.8 Callon Petroleum Company 1996 Stock Incentive Plan as amended +on May 9, 2000 (incorporated by reference from Appendix I of +the Company's Definitive Proxy Statement of Schedule 14A filed +March 28, 2000) +10.9 Credit Agreement dated as of October 30, 2000 between the +Company and First Union National Bank, as administrative agent +for the lenders (incorporated by reference from Exhibit 10.2 +of the Company's September 30, 2000 Form 10-Q filed November +13, 2000) +11. Statement re computation of per sharing earnings* +12. Statements re computation of ratios* +13. Annual Report to security holders, Form 10-Q or quarterly reports* +16. Letter re change in certifying accountant* +18. Letter re change in accounting principles* +21. Subsidiaries of the Company +21.1 Subsidiaries of the Company (incorporated by reference from +Exhibit 21.1 of the Company's Registration Statement on Form +8-B filed October 3, 1994) +22. Published report regarding matters submitted to vote of security +holders* +23. Consents of experts and counsel +23.1 Consent of Arthur Andersen LLP +63 +24. Power of attorney* +99. Additional Exhibits* +---------- +*Inapplicable to this filing. \ No newline at end of file diff --git a/raw/filings/0000928022/2000/0000950134-01-002893/filing_metadata.csv b/raw/filings/0000928022/2000/0000950134-01-002893/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..1dcc9337c80f1d7ebff457ec007489c0d8a23d5d --- /dev/null +++ b/raw/filings/0000928022/2000/0000950134-01-002893/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000928022,CPE,Callon Petroleum Co,10-K405,2001-03-30,2000-12-31,2001-03-30T05:00:00.000Z,0000950134-01-002893,d85467e10-k405.txt,"FORM 10-K FOR FISCAL YEAR END DECEMBER 31, 2000",211742,0,0,https://www.sec.gov/Archives/edgar/data/928022/000095013401002893/d85467e10-k405.txt,https://www.sec.gov/Archives/edgar/data/928022/000095013401002893/,2000,2000,1 diff --git a/raw/filings/0000928022/2000/0000950134-01-002893/item1.txt b/raw/filings/0000928022/2000/0000950134-01-002893/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..55667e18b45818afd6e7119ab220c09d2ded4ace --- /dev/null +++ b/raw/filings/0000928022/2000/0000950134-01-002893/item1.txt @@ -0,0 +1,673 @@ +ITEM 1. BUSINESS +OVERVIEW +Callon Petroleum Company (the "Company") has been engaged in the exploration, +development, acquisition and production of oil and gas properties since 1950. +The Company's properties are geographically concentrated primarily offshore in +the Gulf of Mexico and onshore in Louisiana and Alabama. The Company was formed +under the laws of the state of Delaware in 1994 through the consolidation of a +publicly traded limited partnership, a joint venture with a consortium of +European institutional investors and an independent energy company owned by +certain members of current management (the "Consolidation"). As used herein, the +"Company" refers to Callon Petroleum Company and its predecessors and +subsidiaries unless the context requires otherwise. +In 1989, the Company began increasing its reserves through the acquisition of +producing properties that were geologically complex, had (or were analogous to +fields with) an established production history from stacked pay zones and were +candidates for exploitation. The Company focused on reducing operating costs and +implementing production enhancements through the application of technologically +advanced production and recompletion techniques. +Over the past five years, the Company has also placed emphasis on the +acquisition of acreage with exploration and development drilling opportunities +in the Gulf of Mexico Shelf area. The Company acquired an infrastructure of +production platforms, gathering systems and pipelines to minimize development +expenditures of these drilling opportunities. The Company also joined with other +industry partners, primarily Murphy Exploration and Production, Inc., ("Murphy") +to explore federal offshore blocks acquired in the Gulf of Mexico. Over the last +several years we have expanded our areas of exploration to include the Gulf of +Mexico Deepwater area (generally 900 to 5,500 feet of water). During this past +five-year period, Callon has drilled 26 productive wells and 16 dry holes for a +total of 42 wells and a success rate of 62%. These 26 productive wells include 3 +onshore, 17 in the Gulf of Mexico Shelf area and 6 in the deepwater region of +the Gulf. +The Company ended the year 2000 with estimated net proved reserves of 334 +billion cubic feet of natural gas equivalent ("Bcfe") and a reserve replacement +rate of 584%. This represents an increase of 28% over 1999 year-end estimated +net proved reserves of 259 Bcfe. +The major focus of the Company's future operations is expected to continue to be +the exploration for and development of oil and gas properties, primarily in the +Gulf of Mexico. +BUSINESS STRATEGY +Our goal is to increase shareholder value by increasing our reserves, +production, cash flow and earnings. We seek to achieve these goals through the +following strategies: +o Focus on Gulf of Mexico exploration with a balance between shelf and +deepwater area using the latest available technology. +o Aggressively explore our existing prospect inventory. +o Replenish our prospect inventory with increasing emphasis on prospect +generation. +2 +3 +o Achieve moderate increases in current production levels through +continued shelf exploration. +o Achieve significant increases in longer-term production levels through +development of deepwater discoveries and ongoing deepwater +exploration. +EXPLORATION AND DEVELOPMENT ACTIVITIES +Capital expenditures for exploration and development costs related to oil and +gas properties totaled approximately $82 million in 2000. The Company incurred +approximately $32.6 million in the Gulf of Mexico Shelf area primarily in the +development of the 1999 discoveries at South Marsh Island 261 and East Cameron +Block 275. Included in these expenditures as exploration costs, is approximately +$7.5 million related to three unsuccessful Gulf of Mexico Shelf prospects +evaluated during 2000. The Gulf of Mexico Deepwater area expenditures accounted +for the remainder of the total capital expended, along with $5.8 million +incurred in leasehold and seismic acquisition costs and $11.9 million of +interest and general and administrative costs allocable directly to exploration +and development projects. The Gulf of Mexico Deepwater area expenditures +included three unsuccessful exploration projects totaling $9.3 million and the +balance was incurred for additional delineation drilling at the Company's Medusa +discovery and the drilling of a test well and delineation drilling at the +Entrada discovery in 2000. The Entrada discovery is located on Garden Banks +Block 782, and reached total depth in April 2000. +As a result of recent successes in the Gulf of Mexico Deepwater area, the +Company is faced with increased costs to develop these significant proved +undeveloped reserves. Substantially all of the future development costs will be +incurred in 2001 and beyond. The Company is currently evaluating various +financing alternatives to address these issues. While management believes there +are a number of financing sources available to the Company, no assurances can be +made that the Company will be able to fund these development costs. +RISK FACTORS +DECREASE IN OIL AND GAS PRICES MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS +AND FINANCIAL CONDITION. Our success is highly dependent on prices for oil and +gas, which are extremely volatile. Any substantial or extended decline in the +price of oil or gas would have a material adverse effect on us. Oil and gas +markets are both seasonal and cyclical. The prices of oil and gas depend on +factors we cannot control such as weather, economic conditions, levels of +production, actions by OPEC and other countries and government actions. Prices +of oil and gas will affect the following aspects of our business: +o our revenues, cash flows and earnings; +o the amount of oil and gas that we are economically able to produce; +o our ability to attract capital to finance our operations and the cost +of the capital; +o the amount we are allowed to borrow under our senior credit facility; +o the value of our oil and gas properties; and +o the profit or loss we incur in exploring for and developing our +reserves. +UNLESS WE ARE ABLE TO REPLACE RESERVES, WHICH WE HAVE PRODUCED, OUR CASH FLOWS +AND PRODUCTION WILL DECREASE OVER TIME. Our future success depends upon our +ability to find, develop and acquire oil and gas reserves that are economically +recoverable. As is generally the case for Gulf Coast properties, our producing +properties usually have high initial production rates, followed by a steep +decline in production. As a result, we must continually locate and develop or +acquire new oil and gas reserves to replace those being depleted by production. +We must do this even during periods of low oil and gas prices when it is +difficult to raise the capital necessary to finance these activities and during +periods of high operating costs +3 +4 +when it is expensive to contract for drilling rigs and other equipment and +personnel necessary to explore for oil and gas. Without successful exploration +or acquisition activities, our reserves, production and revenues will decline +rapidly. We cannot assure you that we will be able to find and develop or +acquire additional reserves at an acceptable cost. +Also, because of the short life of our reserves, our return on the investment we +make in our oil and gas wells and the value of our oil and gas wells will depend +significantly on prices prevailing during relatively short production periods. +A SIGNIFICANT PART OF THE VALUE OF OUR PRODUCTION AND RESERVES IS CONCENTRATED +IN A SMALL NUMBER OF OFFSHORE PROPERTIES, AND ANY PRODUCTION PROBLEMS OR +INACCURACIES IN RESERVE ESTIMATES RELATED TO THOSE PROPERTIES WOULD ADVERSELY +IMPACT OUR BUSINESS. During 2000, about 57% of our daily production came from +three of our properties in the Gulf of Mexico. Moreover, one property accounted +for 35% of our production during this period. If mechanical problems, storms or +other events curtailed a substantial portion of this production, our results of +operations would be adversely affected. In addition, at December 31, 2000 most +of our proved reserves were located in 11 fields in the Gulf of Mexico, with +approximately 90% of our total net proved reserves attributable to five of these +properties. If the actual reserves associated with any one of these five +discoveries are less than our estimated reserves, our results of operations and +financial condition could be adversely affected. +OUR FOCUS ON EXPLORATION PROJECTS INCREASES THE RISKS INHERENT IN OUR OIL AND +GAS ACTIVITIES. Our business strategy focuses on replacing reserves through +exploration, where the risks are greater than in acquisitions and development +drilling. Although we have been successful in exploration in the past, we cannot +assure you that we will continue to increase reserves through exploration or at +an acceptable cost. Additionally, we are often uncertain as to the future costs +and timing of drilling, completing and producing wells. Our drilling operations +may be curtailed, delayed or canceled as a result of a variety of factors, +including: +o unexpected drilling conditions; +o pressure or inequalities in formations; +o equipment failures or accidents; +o adverse weather conditions; +o compliance with governmental requirements; and +o shortages or delays in the availability of drilling rigs and the +delivery of equipment. +BECAUSE WE DO NOT CONTROL ALL OF OUR PROPERTIES, ESPECIALLY OUR DEEP WATER +PROPERTIES, WE HAVE LIMITED INFLUENCE OVER THEIR DEVELOPMENT. We do not operate +all of our properties and have limited influence over the operations of some of +these properties, particularly our deep water projects. Our lack of control +could result in the following: +o the operator may initiate exploration or development on a faster or +slower pace than we prefer; +o the operator may propose to drill more wells or build more facilities +on a project than we have funds for or that we deem appropriate, which +may mean that we are unable to participate in the project or share in +the revenues generated by the project even though we paid our share of +exploration costs; and +o if an operator refuses to initiate a project, we may be unable to +pursue the project. +Any of these events could materially reduce the value of our properties. +4 +5 +OUR DEEP WATER OPERATIONS HAVE SPECIAL OPERATIONAL RISKS THAT MAY NEGATIVELY +AFFECT THE VALUE OF THOSE ASSETS. Drilling operations in the deep water area are +by their nature more difficult and costly than drilling operations in shallow +water. They require the application of more advanced drilling technologies, +involving a higher risk of technological failure and usually resulting in +significantly higher drilling costs. Deep water wells are completed using subsea +completion techniques that require substantial time and the use of advanced +remote installation equipment. These operations involve a high risk of +mechanical difficulties and equipment failures that could result in significant +cost overruns. +In deep water, the time required to commence production following a discovery is +much longer than in shallow water and on-shore. Our deep water discoveries and +prospects will require the construction of expensive production facilities and +pipelines prior to the beginning of production. We cannot estimate the costs and +timing of the construction of these facilities with certainty, and the accuracy +of our estimates will be affected by a number of factors beyond our control, +including the following: +o decisions made by the operators of our deep water wells; +o the availability of materials necessary to construct the facilities; +o proximity of our discoveries to pipelines; and +o the price of oil and natural gas. +Delays and cost overruns in the commencement of production will affect the value +of our deep water prospects and the discounted present value of reserves +attributable to those prospects. +COMPETITIVE INDUSTRY CONDITIONS MAY NEGATIVELY AFFECT OUR ABILITY TO CONDUCT +OPERATIONS. Exploration in the Gulf of Mexico has recently received renewed +interest, especially among major integrated oil companies and large independent +oil companies. The acquisition of exploration prospects, producing properties +and production facilities in the Gulf of Mexico is highly competitive. Factors +which affect our ability to successfully compete are: +o our access to the capital necessary to drill wells and acquire +properties; +o our access to seismic, geological and other information, and our +ability to retain the personnel necessary to properly evaluate such +information; +o the location of, and our ability to access, platforms, pipelines and +other facilities used to produce and transport oil and gas production; +and +o the standards we establish for the minimum projected return on an +investment of our capital. +Our competitors include major integrated oil companies and large independent +energy companies, many of which have greater financial and other resources. +OUR COMPETITORS MAY USE SUPERIOR TECHNOLOGY, WHICH WE MAY BE UNABLE TO AFFORD OR +WHICH WOULD REQUIRE COSTLY INVESTMENT BY US IN ORDER TO COMPETE. Our industry is +subject to rapid and significant advancements in technology, including the +introduction of new products and services using new technologies. As our +competitors use or develop new technologies, we may be placed at a competitive +disadvantage, and competitive pressures may force us to implement new +technologies at a substantial cost. In addition, our competitors may have +greater financial, technical and personnel resources that allow them to enjoy +technological advantages and may in the future allow them to implement new +technologies before we can. We cannot be certain that we will be able to +implement technologies on a timely basis or at a cost that is acceptable to us. +One or more of the technologies that we currently use or that we may implement +in +5 +6 +the future may become obsolete, and we may be adversely affected. For example, +marine seismic acquisition technology has been characterized by rapid +technological advancements in recent years, and further significant +technological developments could substantially impair our 3-D seismic data's +value. +WE MAY NOT BE ABLE TO REPLACE OUR RESERVES OR GENERATE CASH FLOWS IF WE ARE +UNABLE TO RAISE CAPITAL. We will be required to make substantial capital +expenditures to develop our existing reserves, and to discover new oil and gas +reserves. Our current capital budget includes drilling 7 gross (1.1 net) +development wells and 21 gross (9.9 net) exploratory wells through fiscal 2001. +The estimated cost, net to us, to drill and complete these wells is +approximately $73 million. The estimated dry hole costs to drill these wells, +which are the costs we would incur if all of the wells were unsuccessful and we +incurred no completion costs, are approximately $38 million. Historically, we +have financed these expenditures primarily with cash from operations, proceeds +from bank borrowings and proceeds from the sale of debt and equity securities. +See "Management's Discussion and Analysis of Financial Condition and Results of +Operations -- Liquidity and Capital Resources" for a discussion of our capital +budget. We cannot assure you that we will be able to raise capital in the +future. We also make offers to acquire oil and gas properties in the ordinary +course of our business. If these offers are accepted, our capital needs may +increase substantially. +We expect to continue using our senior credit facility to borrow funds to +supplement our available cash. The amount we may borrow under our senior credit +facility may not exceed a borrowing base determined by the lenders based on +their projections of our future production, future production costs, taxes, +commodity prices and any other factors deemed relevant by our lenders. We cannot +control the assumptions the lenders use to calculate our borrowing base. The +lenders may, without our consent, adjust the borrowing base semiannually or in +situations where we purchase or sell assets or issue debt securities. If our +borrowings under the senior credit facility exceed the borrowing base, the +lenders may require that we repay the excess. If this were to occur, we might +have to sell assets or seek financing from other sources. Sales of assets could +reduce the amount of our borrowing base. We cannot assure you that we would be +successful in selling assets or arranging substitute financing. If we were not +able to repay borrowings under our senior credit facility to reduce the +outstanding amount to less than the borrowing base, we will be in default under +our senior credit facility. For a description of our senior credit facility and +its principal terms and conditions, see "Management's Discussion and Analysis of +Financial Condition and Results of Operations --Liquidity and Capital +Resources." +6 +7 +OUR RESERVE INFORMATION REPRESENTS ESTIMATES THAT MAY TURN OUT TO BE INCORRECT +IF THE ASSUMPTIONS UPON WHICH THESE ESTIMATES ARE BASED ARE INACCURATE. +Estimating quantities of proved reserves is inherently imprecise and involves +uncertainties and factors beyond our control. The reserve data in this report +represent only estimates. These estimates are based upon assumptions about +future production levels, future oil and gas prices and future operating costs. +As a result, the quantity of proved reserves may be subject to downward or +upward adjustment as additional information or analysis become available. In +addition, estimates of the economically recoverable oil and gas reserves, +classifications of such reserves, and estimates of future net cash flows, +prepared by different engineers or by the same engineers at different times, may +vary substantially. In particular, the assumptions regarding the timing and +costs to commence production from our deep water wells used in preparing our +reserves are subject to revisions over time as described under " -- Our deep +water operations have special operational risks that may negatively affect the +value of those assets." Information about reserves constitutes forward-looking +information. The discounted present value of our oil and gas reserves is +prepared in accordance with guidelines established by the SEC. A purchaser of +reserves would use numerous other factors to value our reserves. The discounted +present value of reserves, therefore, does not represent the fair market value +of those reserves. +On December 31, 2000, approximately 58.2% of the discounted present value of our +estimated net proved reserves were proved undeveloped. Substantially all of +these proved undeveloped reserves were attributable to our deep water +properties. Development of these properties is subject to additional risks as +described above. +WEATHER, UNEXPECTED SUBSURFACE CONDITIONS, AND OTHER UNFORESEEN OPERATING +HAZARDS MAY ADVERSELY IMPACT OUR ABILITY TO CONDUCT BUSINESS. There are many +operating hazards in exploring for and producing oil and gas, including: +o our drilling operations may encounter unexpected formations or +pressures, which could cause damage to equipment or personal injury; +o we may experience equipment failures which curtail or stop production; +and +o we could experience blowouts or other damages to the productive +formations that may require a well to be re-drilled or other +corrective action to be taken. +In addition, any of the foregoing may result in environmental damages for which +we will be liable. Moreover, a substantial portion of our operations are +offshore and are subject to a variety of risks peculiar to the marine +environment such as hurricanes and other adverse weather conditions. Offshore +operations are also subject to more extensive governmental regulation. +We cannot assure you that we will be able to maintain adequate insurance at +rates we consider reasonable to cover our possible losses from operating +hazards. The occurrence of a significant event not fully insured or indemnified +against could materially and adversely affect our financial condition and +results of operations. +WE MAY NOT HAVE PRODUCTION TO OFFSET HEDGES; BY HEDGING, WE MAY NOT BENEFIT FROM +PRICE INCREASES. Part of our business strategy is to reduce our exposure to the +volatility of oil and gas prices by hedging a portion of our production. In a +typical hedge transaction, we will have the right to receive from the other +parties to the hedge the excess of the fixed price specified in the hedge over a +floating price based on a market index, multiplied by the quantity hedged. If +the floating price exceeds the fixed price, we are required to pay the other +parties this difference multiplied by the quantity hedged. We are required to +pay the difference between the floating price and the fixed price when the +floating price exceeds the fixed price +7 +8 +regardless of whether we have sufficient production to cover the quantities +specified in the hedge. Significant reductions in production at times when the +floating price exceeds the fixed price could require us to make payments under +the hedge agreements even though such payments are not offset by sales of +production. Hedging will also prevent us from receiving the full advantage of +increases in oil or gas prices above the fixed amount specified in the hedge. +See "Quantitative and Qualitative Disclosures About Market Risks" for a +discussion of our hedging practices. +COMPLIANCE WITH ENVIRONMENTAL AND OTHER GOVERNMENT REGULATIONS COULD BE COSTLY +AND COULD NEGATIVELY IMPACT PRODUCTION. Our operations are subject to numerous +laws and regulations governing the discharge of materials into the environment +or otherwise relating to environmental protection. These laws and regulations +may: +o require that we acquire permits before commencing drilling; +o restrict the substances that can be released into the environment in +connection with drilling and production activities; +o limit or prohibit drilling activities on protected areas such as +wetlands or wilderness areas; and +o require remedial measures to mitigate pollution from former +operations, such as dismantling abandoned production facilities. +Under these laws and regulations, we could be liable for personal injury and +clean-up costs and other environmental and property damages, as well as +administrative, civil and criminal penalties. We maintain limited insurance +coverage for sudden and accidental environmental damages. We do not believe that +insurance coverage for environmental damages that occur over time is available +at a reasonable cost. Also, we do not believe that insurance coverage for the +full potential liability that could be caused by sudden and accidental +environmental damages is available at a reasonable cost. Accordingly, we may be +subject to liability or we may be required to cease production from properties +in the event of environmental damages. +FACTORS BEYOND OUR CONTROL AFFECT OUR ABILITY TO MARKET PRODUCTION AND OUR +FINANCIAL RESULTS. The ability to market oil and gas from our wells depends upon +numerous factors beyond our control. These factors include: +o the extent of domestic production and imports of oil and gas; +o the proximity of the gas production to gas pipelines; +o the availability of pipeline capacity; +o the demand for oil and gas by utilities and other end users; +o the availability of alternative fuel sources; +o the effects of inclement weather; +o state and federal regulation of oil and gas marketing; and +o federal regulation of gas sold or transported in interstate commerce. +Because of these factors, we may be unable to market all of the oil or gas we +produce. In addition, we may be unable to obtain favorable prices for the oil +and gas we produce. +IF OIL AND GAS PRICES DECREASE, WE MAY BE REQUIRED TO TAKE WRITEDOWNS. We may be +required to writedown the carrying value of our oil and gas properties when oil +and gas prices are low or if we have substantial downward adjustments to our +estimated net proved reserves, increases in our estimates of development costs +or deterioration in our exploration results. Under the full cost method we use +to account for our oil and gas properties, the net capitalized costs of our oil +and gas properties may not exceed the +8 +9 +present value, discounted at 10%, of future net cash flows from estimated net +proved reserves, using period end oil and gas prices and costs, plus the lower +of cost or fair market value of our unproved properties. If net capitalized +costs of our oil and gas properties exceed this limit, we must charge the amount +of the excess to earnings. This type of charge will not affect our cash flows, +but will reduce the book value of our stockholders' equity. We review the +carrying value of our properties quarterly, based on prices in effect as of the +end of each quarter or at the time of reporting our results. Once incurred, a +writedown of oil and gas properties is not reversible at a later date, even if +prices increase. +FORWARD-LOOKING STATEMENTS +In this report, we have made many forward-looking statements. We cannot assure +you that the plans, intentions or expectations upon which our forward-looking +statements are based will occur. Our forward-looking statements are subject to +risks, uncertainties and assumptions, including those discussed elsewhere in +this report. Forward-looking statements include statements regarding: +o our oil and gas reserve quantities, and the discounted present value +of these reserves; +o the amount and nature of our capital expenditures; +o drilling of wells; +o timing and amount of future production and operating costs; +o business strategies and plans of management; and +o prospect development and property acquisitions. +Some of the risks, which could affect our future results and could cause results +to differ materially from those expressed in our forward-looking statements +include: +o general economic conditions; +o volatility of oil and natural gas prices; +o uncertainty of estimates of oil and natural gas reserves; +o impact of competition; +o availability and cost of seismic, drilling and other equipment; +o operating hazards inherent in the exploration for and production of +oil and natural gas; +o difficulties encountered during the exploration for and production of +oil and natural gas; +o difficulties encountered in delivering oil and natural gas to +commercial markets; +o changes in customer demand; +o uncertainty of our ability to attract capital; +o compliance with, or the effect of changes in, the extensive +governmental regulations regarding the oil and natural gas business; +o actions of operators of our oil and gas properties; and +o climatic conditions. +The information contained in this report, including the information set forth +under the heading "Risk Factors," identifies additional factors that could +affect our operating results and performance. We urge you to carefully consider +these factors and the other cautionary statements in this report. Our +forward-looking statements speak only as of the date made, and we have no +obligation to update these forward-looking statements. +9 +10 +CORPORATE OFFICES +The Company's headquarters are located in Natchez, Mississippi, in approximately +51,500 square feet of owned space. In late 2000, the Company opened a field +office in Houston, Texas, staffed with recently hired technical professionals, +to enhance exploration and development efforts. The Company also maintains owned +or leased field offices in the area of the major fields in which it operates +properties or has a significant interest. Replacement of any of the Company's +leased offices would not result in material expenditures by the Company as +alternative locations to its leased space are anticipated to be readily +available. +EMPLOYEES +The Company had 99 employees as of December 31, 2000, none of who are currently +represented by a union. The Company considers itself to have good relations with +its employees. The Company employs eight petroleum engineers and seven petroleum +geoscientists. +FEDERAL REGULATIONS +SALES OF NATURAL GAS. Effective January 1, 1993, the Natural Gas Wellhead +Decontrol Act deregulated prices for all "first sales" of natural gas. Thus, all +sales of gas by the Company may be made at market prices, subject to applicable +contract provisions. +TRANSPORTATION OF NATURAL GAS. The rates, terms and conditions applicable to the +interstate transportation of natural gas by pipelines are regulated by the +Federal Energy Regulatory Commission ("FERC") under the Natural Gas Act ("NGA"), +as well as under section 311 of the Natural Gas Policy Act ("NGPA"). Since 1985, +the FERC has implemented regulations intended to make natural gas transportation +more accessible to gas buyers and sellers on an open-access, non-discriminatory +basis. +The FERC has announced several important transportation-related policy +statements and rule changes, including a statement of policy and final rule +issued February 25, 2000 concerning alternatives to its traditional +cost-of-service rate-making methodology to establish the rates interstate +pipelines may charge for their services. The final rule revises FERC's pricing +policy and current regulatory framework to improve the efficiency of the market +and further enhance competition in natural gas markets. +With respect to the transportation of natural gas on or across the Outer +Continental Shelf ("OCS"), the FERC requires, as part of its regulation under +the Outer Continental Shelf Lands Act, that all pipelines provide open and +non-discriminatory access to both owner and non-owner shippers. Although to date +the FERC has imposed light-handed regulation on off-shore facilities that meet +its traditional test of gathering status, it has the authority to exercise +jurisdiction under the Outer Continental Shelf Lands Act ("OCSLA") over +gathering facilities, if necessary, to permit non-discriminatory access to +service. For those facilities transporting natural gas across the OCS that are +not considered to be gathering facilities, the rates, terms, and conditions +applicable to this transportation are regulated by FERC under the NGA and NGPA, +as well as the OCSLA. +SALES AND TRANSPORTATION OF CRUDE OIL. Sales of crude oil and condensate can be +made by the Company at market prices not subject at this time to price controls. +The price that the Company receives from the sale of these products will be +affected by the cost of transporting the products to market. The rates, terms, +and conditions applicable to the interstate transportation of oil and related +products by pipelines are regulated by the FERC under the Interstate Commerce +Act. As required by the Energy Policy Act of 1992, the FERC has revised its +regulations governing the rates that may be charged by oil pipelines. The new +rules, which were effective January 1, 1995, provide a simplified, generally +applicable method of regulating such rates by use of an index for setting rate +ceilings. The FERC will also, under defined circumstances, permit alternative +ratemaking methodologies for interstate oil pipelines such as the use of cost of +service rates, settlement rates, +10 +11 +and market-based rates. Market-based rates will be permitted to the extent the +pipeline can demonstrate that it lacks significant market power in the market in +which it proposes to charge market-based rates. The cumulative effect that these +rules may have on moving the Company's production to market cannot yet be +determined. +With respect to the transportation of oil and condensate on or across the OCS, +the FERC requires, as part of its regulation under the OCSLA, that all pipelines +provide open and non-discriminatory access to both owner and non-owner shippers. +Accordingly, the FERC has the authority to exercise jurisdiction under the +OCSLA, if necessary, to permit non-discriminatory access to service. +LEGISLATIVE PROPOSALS. In the past, Congress has been very active in the area of +natural gas regulation. There are legislative proposals pending in Congress and +in various state legislatures which, if enacted, could significantly affect the +petroleum industry. At the present time it is impossible to predict what +proposals, if any, might actually be enacted by Congress or the various state +legislatures and what effect, if any, such proposals might have on the Company's +operations. +FEDERAL, STATE OR INDIAN LEASES. In the event the Company conducts operations on +federal, state or Indian oil and gas leases, such operations must comply with +numerous regulatory restrictions, including various nondiscrimination statutes, +royalty and related valuation requirements, and certain of such operations must +be conducted pursuant to certain on-site security regulations and other +appropriate permits issued by the Bureau of Land Management ("BLM") or Minerals +Management Service ("MMS") or other appropriate federal or state agencies. +The Company's OCS leases in federal waters are administered by the MMS and +require compliance with detailed MMS regulations and orders. The MMS has +promulgated regulations implementing restrictions on various production-related +activities, including restricting the flaring or venting of natural gas. Under +certain circumstances, the MMS may require Company operations on federal leases +to be suspended or terminated. Any such suspension or termination could +materially and adversely affect the Company's financial condition and +operations. On March 15, 2000, the MMS issued a final rule effective June 1, +2000 which amends its regulations governing the calculation of royalties and the +valuation of crude oil produced from federal leases. Among other matters, this +rule amends the valuation procedure for the sale of federal royalty oil by +eliminating posted prices as a measure of value and relying instead on arm's +length sales prices and spot market prices as market value indicators. Because +the Company sells its production in the spot market and therefore pays royalties +on production from federal leases, it is not anticipated that this final rule +will have any substantial impact on the Company. +The Mineral Leasing Act of 1920 ("Mineral Act") prohibits direct or indirect +ownership of any interest in federal onshore oil and gas leases by a foreign +citizen of a country that denies "similar or like privileges" to citizens of the +United States. Such restrictions on citizens of a "non-reciprocal" country +include ownership or holding or controlling stock in a corporation that holds a +federal onshore oil and gas lease. If this restriction is violated, the +corporation's lease can be canceled in a proceeding instituted by the United +States Attorney General. Although the regulations of the BLM (which administers +the Mineral Act) provide for agency designations of non-reciprocal countries, +there are presently no such designations in effect. The Company owns interests +in numerous federal onshore oil and gas leases. It is possible that holders of +equity interests in the Company may be citizens of foreign countries, which at +some time in the future might be determined to be non-reciprocal under the +Mineral Act. +11 +12 +STATE REGULATIONS +Most states regulate the production and sale of oil and natural gas, including +requirements for obtaining drilling permits, the method of developing new +fields, the spacing and operation of wells and the prevention of waste of oil +and gas resources. The rate of production may be regulated and the maximum daily +production allowable from both oil and gas wells may be established on a market +demand or conservation basis or both. +The Company may enter into agreements relating to the construction or operation +of a pipeline system for the transportation of natural gas. To the extent that +such gas is produced, transported and consumed wholly within one state, such +operations may, in certain instances, be subject to the jurisdiction of such +state's administrative authority charged with the responsibility of regulating +intrastate pipelines. In such event, the rates which the Company could charge +for gas, the transportation of gas, and the costs of construction and operation +of such pipeline would be impacted by the rules and regulations governing such +matters, if any, of such administrative authority. Further, such a pipeline +system would be subject to various state and/or federal pipeline safety +regulations and requirements, including those of, among others, the Department +of Transportation. Such regulations can increase the cost of planning, +designing, installation and operation of such facilities. The impact of such +pipeline safety regulations would not be any more adverse to the Company than it +would be to other similar owners or operators of such pipeline facilities. +ENVIRONMENTAL REGULATIONS +GENERAL. The Company's activities are subject to federal, state and local laws +and regulations governing environmental quality and pollution control. Although +no assurances can be made, the Company believes that, absent the occurrence of +an extraordinary event, compliance with existing federal, state and local laws, +rules and regulations regulating the release of materials in the environment or +otherwise relating to the protection of the environment will not have a material +effect upon the capital expenditures, earnings or the competitive position of +the Company with respect to its existing assets and operations. The Company +cannot predict what effect additional regulation or legislation, enforcement +policies thereunder, and claims for damages to property, employees, other +persons and the environment resulting from the Company's operations could have +on its activities. +Activities of the Company with respect to natural gas facilities, including the +operation and construction of pipelines, plants and other facilities for +transporting, processing, treating or storing natural gas and other products, +are subject to stringent environmental regulation by state and federal +authorities including the United States Environmental Protection Agency ("EPA"). +Such regulation can increase the cost of planning, designing, installation and +operation of such facilities. In most instances, the regulatory requirements +relate to water and air pollution control measures. Although the Company +believes that compliance with environmental regulations will not have a material +adverse effect on it, risks of substantial costs and liabilities are inherent in +oil and gas production operations, and there can be no assurance that +significant costs and liabilities will not be incurred. Moreover, it is possible +that other developments, such as stricter environmental laws and regulations, +and claims for damages to property or persons resulting from oil and gas +production, would result in substantial costs and liabilities to the Company. +SOLID AND HAZARDOUS WASTE. The Company owns or leases numerous properties that +have been used for production of oil and gas for many years. Although the +Company has utilized operating and disposal practices standard in the industry +at the time, hydrocarbons or other solid wastes may have been disposed or +released on or under these properties. In addition, many of these properties +have been operated by third parties. The Company had no control over such +entities' treatment of hydrocarbons or other solid wastes and the manner in +which such substances may have been disposed or released. State and federal laws +applicable to oil and gas +12 +13 +wastes and properties have gradually become stricter over time. Under these new +laws, the Company could be required to remove or remediate previously disposed +wastes (including wastes disposed or released by prior owners or operators) or +property contamination (including groundwater contamination by prior owners or +operators) or to perform remedial plugging operations to prevent future +contamination. +The Company generates wastes, including hazardous wastes, that are subject to +the Federal Resource Conservation and Recovery Act ("RCRA") and comparable state +statutes. The EPA has limited the disposal options for certain hazardous wastes +and is considering the adoption of stricter disposal standards for nonhazardous +wastes. Furthermore, it is possible that certain wastes currently exempt from +treatment as "hazardous wastes" generated by the Company's oil and gas +operations may in the future be designated as "hazardous wastes" under RCRA or +other applicable statutes, and therefore may be subject to more rigorous and +costly disposal requirements. +SUPERFUND. The Comprehensive Environmental Response, Compensation and Liability +Act ("CERCLA"), also known as the "Superfund" law, imposes liability, without +regard to fault or the legality of the original conduct, on certain classes of +persons with respect to the release of a "hazardous substance" into the +environment. These persons include the owner and operator of a site and persons +that disposed or arranged for the disposal of the hazardous substances found at +a site. CERCLA also authorizes the EPA and, in some cases, third parties to take +actions in response to threats to the public health or the environment and to +seek to recover from the responsible classes of persons the costs of such +action. Neither the Company nor its predecessors has been designated as a +potentially responsible party by the EPA under CERCLA with respect to any such +site. +OIL POLLUTION ACT. The Oil Pollution Act of 1990 (the "OPA") and regulations +thereunder impose a variety of regulations on "responsible parties" related to +the prevention of oil spills and liability for damages resulting from such +spills in United States waters. A "responsible party" includes the owner or +operator of a facility or vessel, or the lessee or permittee of the area in +which an offshore facility is located. The OPA assigns liability to each +responsible party for oil removal costs and a variety of public and private +damages. While liability limits apply in some circumstances, a party cannot take +advantage of liability limits if the spill was caused by gross negligence or +willful misconduct or resulted from violation of a federal safety, construction +or operating regulation. If the party fails to report a spill or to cooperate +fully in the cleanup, liability limits likewise do not apply. Few defenses exist +to the liability imposed by the OPA. +The OPA also imposes ongoing requirements on a responsible party, including +proof of financial responsibility to cover at least some costs in a potential +spill. Certain amendments to the OPA that were enacted in 1996 require owners +and operators of offshore facilities that have a worst case oil spill potential +of more than 1,000 barrels to demonstrate financial responsibility in amounts +ranging from $10 million in specified state waters and $35 million in federal +OCS waters, with higher amounts, up to $150 million based upon worst case +oil-spill discharge volume calculations. The Company believes that it currently +has established adequate proof of financial responsibility for its offshore +facilities. +AIR EMISSIONS. The operations of the Company are subject to local, state and +federal regulations for the control of emissions from sources of air pollution. +Administrative enforcement actions for failure to comply strictly with air +regulations or permits are generally resolved by payment of monetary fines and +correction of any identified deficiencies. Alternatively, regulatory agencies +could require the Company to forego construction or operation of certain air +emission sources, although the Company believes that in such case it would have +enough permitted or permittable capacity to continue its operations without a +material adverse effect on any particular producing field. +13 +14 +OSHA. The Company is subject to the requirements of the Federal Occupational +Safety and Health Act ("OSHA") and comparable state statutes. The OSHA hazard +communication standard, the EPA community right-to-know regulations under Title +III of the Federal Superfund Amendment and Reauthorization Act and similar state +statutes require the Company to organize and/or disclose information about +hazardous materials used or produced in its operations. Certain of this +information must be provided to employees, state and local governmental +authorities and local citizens. +Management believes that the Company is in substantial compliance with current +applicable environmental laws and regulations and that continued compliance with +existing requirements would not have a material adverse impact on the Company. \ No newline at end of file diff --git a/raw/filings/0000928022/2000/0000950134-01-002893/item13.txt b/raw/filings/0000928022/2000/0000950134-01-002893/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2000/0000950134-01-002893/item9a.txt b/raw/filings/0000928022/2000/0000950134-01-002893/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2000/0000950134-01-002893/rp_note.txt b/raw/filings/0000928022/2000/0000950134-01-002893/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2000/0000950134-01-002893/rpt_disclosure.txt b/raw/filings/0000928022/2000/0000950134-01-002893/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..bc67dd34e1f12390166612fbb8158eaad0d24de5 --- /dev/null +++ b/raw/filings/0000928022/2000/0000950134-01-002893/rpt_disclosure.txt @@ -0,0 +1,11 @@ +TRANSACTIONS WITH RELATED PERSONS +REGISTRATION RIGHTS. The Callon Family (including John S. Callon and +Fred L. Callon) is party to a Registration Rights Agreement dated September 16, +1994 (the "Registration Rights Agreement"), pursuant to which they are entitled +to require the Company to register Common Stock owned by them with the +Commission for sale to the public in a firm commitment public offering and +generally to include shares owned by them in registration statements filed by +the Company. NOCO and the Company have entered into a similar agreement, which +was subsequently amended to include F.O. Energy. The registration rights +agreement with F.O. Energy also covers Common Stock held by its assignees, +Ganger Rolf and Bonheur. \ No newline at end of file diff --git a/raw/filings/0000928022/2001/0000950134-02-003092/filing.txt b/raw/filings/0000928022/2001/0000950134-02-003092/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..9687de8af1b26ae657ad36a71a4817191b0c623b --- /dev/null +++ b/raw/filings/0000928022/2001/0000950134-02-003092/filing.txt @@ -0,0 +1,3003 @@ +10-K405 +1 +d95444e10-k405.txt +FORM 10-K FOR FISCAL YEAR END DECEMBER 31, 2001 +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF +THE SECURITIES EXCHANGE ACT OF 1934 +FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001 +COMMISSION FILE NUMBER 001-14039 +CALLON PETROLEUM COMPANY +(Exact name of Registrant as specified in its charter) +DELAWARE 64-0844345 +------------------------------- -------------------------------- +(State or other jurisdiction of (I.R.S. Employer +incorporation or organization) Identification No.) +200 NORTH CANAL STREET +NATCHEZ, MISSISSIPPI 39120 (601) 442-1601 +------------------------------- -------------------------------- +(Address of Principal Executive (Registrant's telephone number +Offices)(Zip Code) including area code) +Securities registered pursuant to Section 12(b) of the Act: +TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED +------------------------------------------- ------------------------------------ +Convertible Exchangeable Preferred Stock, New York Stock Exchange +Series A, Par Value $.01 Per Share +Common Stock, Par Value $.01 Per Share New York Stock Exchange +Preferred Stock Purchase Rights New York Stock Exchange +11% Senior Subordinated Notes due 2005 New York Stock Exchange +10.25% Senior Subordinated Notes due 2004 New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: NONE +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 if disclosure of delinquent filers pursuant to Item 405 +of Regulation S-K is not contained herein, and will not be contained, to the +best of Registrant's knowledge, in definitive proxy or information statements +incorporated by reference in Part III of this Form 10-K or any amendment to this +Form 10-K. [X] +The aggregate market value of the voting stock held by nonaffiliates of the +registrant was approximately $98,778,082 as of March 18, 2002 (based on the last +reported sale price of such stock on the New York Stock Exchange). +As of March 18, 2002, there were 13,424,216 shares of the Registrant's Common +Stock, par value $.01 per share, outstanding. +Document incorporated by reference: Portions of the definitive Proxy Statement +of Callon Petroleum Company (to be filed no later than 120 days after December +31, 2001) relating to the Annual Meeting of Stockholders to be held on May 8, +2002, which is incorporated into Part III of this Form 10-K. +PART I. +ITEM 1. BUSINESS +OVERVIEW +Callon Petroleum Company has been engaged in the exploration, development, +acquisition and production of oil and gas properties since 1950. Our properties +are geographically concentrated primarily offshore in the Gulf of Mexico and +onshore in Louisiana and Alabama. The public Company was formed under the laws +of the state of Delaware in 1994 through the consolidation of a publicly traded +limited partnership, a joint venture with a consortium of European institutional +investors and an independent energy company owned by certain members of current +management (the "Consolidation"). As used herein, the "Company," "Callon," "we," +"us," and "our" refer to Callon Petroleum Company and its predecessors and +subsidiaries unless the context requires otherwise. +In 1989, we began increasing our reserves through the acquisition of producing +properties that were geologically complex, had (or were analogous to fields +with) an established production history from stacked pay zones and were +candidates for exploitation. We focused on reducing operating costs and +implementing production enhancements through the application of technologically +advanced production and recompletion techniques. +Over the past several years, we have also placed emphasis on the acquisition of +acreage with exploration and development drilling opportunities in the Gulf of +Mexico Shelf area. We acquired an infrastructure of production platforms, +gathering systems and pipelines to minimize development expenditures of these +drilling opportunities. We also joined with other industry partners, primarily +Murphy Exploration and Production, Inc., ("Murphy") to explore federal offshore +blocks acquired in the Gulf of Mexico. Over the last several years we have +expanded our areas of exploration to include the Gulf of Mexico Deepwater area +(generally 900 to 5,500 feet of water). +We ended the year 2001 with estimated net proved reserves of 303 billion cubic +feet of natural gas equivalent ("Bcfe"). This represents a decrease of 9% from +2000 year-end estimated net proved reserves of 334 Bcfe. +The major focus of our future operations is expected to continue to be the +exploration for and development of oil and gas properties, primarily in the Gulf +of Mexico. +BUSINESS STRATEGY +Our goal is to increase shareholder value by increasing our reserves, +production, cash flow and earnings. We seek to achieve these goals through the +following strategies: +o Focus on Gulf of Mexico exploration with a balance between shelf and +deepwater areas using the latest available technology. +o Aggressively explore our existing prospect inventory. +o Replenish our prospect inventory with increasing emphasis on prospect +generation. +o Achieve moderate increases in current production levels through continued +shelf exploration. +o Achieve significant increases in longer-term production levels through +development of deepwater discoveries and ongoing deepwater exploration. +2 +EXPLORATION AND DEVELOPMENT ACTIVITIES +Capital expenditures for exploration and development costs related to oil and +gas properties totaled approximately $112.6 million in 2001. We incurred +approximately $63.7 million in the Gulf of Mexico Shelf area. +The Gulf of Mexico Deepwater area expenditures ($31.9 million) accounted for the +remainder of the total capital expended, along with $4.2 million incurred in +leasehold and seismic acquisition costs and $12.8 million of interest and +general and administrative costs allocable directly to exploration and +development projects. The Gulf of Mexico Deepwater area expenditures included +one unsuccessful exploration project totaling $2.2 million and the balance was +incurred for additional delineation drilling and production facility fabrication +at our Medusa discovery and the delineation drilling at Habanero. +As a result of recent successes in the Gulf of Mexico Deepwater area, we are +faced with increased costs to develop these significant proved undeveloped +reserves. A large portion of these future development costs will be incurred in +2002 and beyond. We are currently evaluating various financing alternatives to +address these issues. While management believes there are a number of financing +sources available to us, no assurances can be made that we will be able to fund +these development costs. +RISK FACTORS +DECREASE IN OIL AND GAS PRICES MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS +AND FINANCIAL CONDITION. Our success is highly dependent on prices for oil and +gas, which are extremely volatile. Any substantial or extended decline in the +price of oil or gas would have a material adverse effect on us. Oil and gas +markets are both seasonal and cyclical. The prices of oil and gas depend on +factors we cannot control such as weather, economic conditions, levels of +production, actions by OPEC and other countries and government actions. Prices +of oil and gas will affect the following aspects of our business: +o our revenues, cash flows and earnings; +o the amount of oil and gas that we are economically able to produce; +o our ability to attract capital to finance our operations and the cost of +the capital; +o the amount we are allowed to borrow under our senior credit facility; +o the value of our oil and gas properties; and +o the profit or loss we incur in exploring for and developing our reserves. +UNLESS WE ARE ABLE TO REPLACE RESERVES, WHICH WE HAVE PRODUCED, OUR CASH FLOWS +AND PRODUCTION WILL DECREASE OVER TIME. Our future success depends upon our +ability to find, develop and acquire oil and gas reserves that are economically +recoverable. As is generally the case for Gulf Coast properties, our producing +properties usually have high initial production rates, followed by a steep +decline in production. As a result, we must continually locate and develop or +acquire new oil and gas reserves to replace those being depleted by production. +We must do this even during periods of low oil and gas prices when it is +difficult to raise the capital necessary to finance these activities and during +periods of high operating costs when it is expensive to contract for drilling +rigs and other equipment and personnel necessary to explore for oil and gas. +Without successful exploration or acquisition activities, our reserves, +production and revenues will decline rapidly. We cannot assure you that we will +be able to find and develop or acquire additional reserves at an acceptable +cost. +3 +A SIGNIFICANT PART OF THE VALUE OF OUR PRODUCTION AND RESERVES IS CONCENTRATED +IN A SMALL NUMBER OF OFFSHORE PROPERTIES, AND ANY PRODUCTION PROBLEMS OR +INACCURACIES IN RESERVE ESTIMATES RELATED TO THOSE PROPERTIES WOULD ADVERSELY +IMPACT OUR BUSINESS. During 2001, 44% of our daily production came from two of +our properties in the Gulf of Mexico. Moreover, one property accounted for 25% +of our production during this period. If mechanical problems, storms or other +events curtailed a substantial portion of this production, our results of +operations would be adversely affected. In addition, at December 31, 2001 most +of our proved reserves were located in five fields in the Gulf of Mexico, with +approximately 93% of our total net proved reserves attributable to these +properties. If the actual reserves associated with any one of these five +discoveries are less than our estimated reserves, our results of operations and +financial condition could be adversely affected. +OUR FOCUS ON EXPLORATION PROJECTS INCREASES THE RISKS INHERENT IN OUR OIL AND +GAS ACTIVITIES. Our business strategy focuses on replacing reserves through +exploration, where the risks are greater than in acquisitions and development +drilling. Although we have been successful in exploration in the past, we cannot +assure you that we will continue to increase reserves through exploration or at +an acceptable cost. Additionally, we are often uncertain as to the future costs +and timing of drilling, completing and producing wells. Our drilling operations +may be curtailed, delayed or canceled as a result of a variety of factors, +including: +o unexpected drilling conditions; +o pressure or inequalities in formations; +o equipment failures or accidents; +o adverse weather conditions; +o compliance with governmental requirements; and +o shortages or delays in the availability of drilling rigs and the +delivery of equipment. +BECAUSE WE DO NOT CONTROL ALL OF OUR PROPERTIES, ESPECIALLY OUR DEEPWATER +PROPERTIES, WE HAVE LIMITED INFLUENCE OVER THEIR DEVELOPMENT. We do not operate +all of our properties and have limited influence over the operations of some of +these properties, particularly our deepwater projects. Our lack of control could +result in the following: +o the operator may initiate exploration or development on a faster or +slower pace than we prefer; +o the operator may propose to drill more wells or build more facilities on +a project than we have funds for or that we deem appropriate, which may +mean that we are unable to participate in the project or share in the +revenues generated by the project even though we paid our share of +exploration costs; and +o if an operator refuses to initiate a project, we may be unable to pursue +the project. +Any of these events could materially reduce the value of our properties. +OUR DEEPWATER OPERATIONS HAVE SPECIAL OPERATIONAL RISKS THAT MAY NEGATIVELY +AFFECT THE VALUE OF THOSE ASSETS. Drilling operations in the deepwater area are +by their nature more difficult and costly than drilling operations in shallow +water. They require the application of more advanced drilling technologies, +involving a higher risk of technological failure and usually resulting in +significantly higher drilling costs. Deepwater wells are completed using subsea +completion techniques that require substantial time and the use of advanced +remote installation equipment. These operations involve a high risk of +mechanical difficulties and equipment failures that could result in significant +cost overruns. +4 +In deepwater, the time required to commence production following a discovery is +much longer than in shallow water and on-shore. Our deepwater discoveries and +prospects will require the construction of expensive production facilities and +pipelines prior to the beginning of production. We cannot estimate the costs and +timing of the construction of these facilities with certainty, and the accuracy +of our estimates will be affected by a number of factors beyond our control, +including the following: +o decisions made by the operators of our deepwater wells; +o the availability of materials necessary to construct the facilities; +o the proximity of our discoveries to pipelines; and +o the price of oil and natural gas. +Delays and cost overruns in the commencement of production will affect the value +of our deepwater prospects and the discounted present value of reserves +attributable to those prospects. +COMPETITIVE INDUSTRY CONDITIONS MAY NEGATIVELY AFFECT OUR ABILITY TO CONDUCT +OPERATIONS. We operate in the highly competitive areas of oil and gas +exploration, development and production. We compete for the purchase of leases +in the Gulf of Mexico from the U. S. government and from other oil and gas +companies. These leases include exploration prospects as well as properties with +proved reserves. Factors that affect our ability to compete in the marketplace +include: +o our access to the capital necessary to drill wells and acquire +properties; +o our ability to acquire and analyze seismic, geological and other +information relating to a property; +o our ability to retain the personnel necessary to properly evaluate +seismic and other information relating to a property; +o the location of, and our ability to access, platforms, pipelines and +other facilities used to produce and transport oil and gas production; +o the standards we establish for the minimum projected return on an +investment of our capital; and +o the availability of alternate fuel sources. +Our competitors include major integrated oil companies, substantial independent +energy companies, affiliates of major interstate and intrastate pipelines and +national and local gas gatherers, many of which possess greater financial, +technological and other resources than we do. +OUR COMPETITORS MAY USE SUPERIOR TECHNOLOGY, WHICH WE MAY BE UNABLE TO AFFORD OR +WHICH WOULD REQUIRE COSTLY INVESTMENT BY US IN ORDER TO COMPETE. Our industry is +subject to rapid and significant advancements in technology, including the +introduction of new products and services using new technologies. As our +competitors use or develop new technologies, we may be placed at a competitive +disadvantage, and competitive pressures may force us to implement new +technologies at a substantial cost. In addition, our competitors may have +greater financial, technical and personnel resources that allow them to enjoy +technological advantages and may in the future allow them to implement new +technologies before we can. We cannot be certain that we will be able to +implement technologies on a timely basis or at a cost that is acceptable to us. +One or more of the technologies that we currently use or that we may implement +in the future may become obsolete, and we may be adversely affected. For +example, marine seismic acquisition technology has been characterized by rapid +technological advancements in recent years, and further significant +technological developments could substantially impair our 3-D seismic data's +value. +WE MAY NOT BE ABLE TO REPLACE OUR RESERVES OR GENERATE CASH FLOWS IF WE ARE +UNABLE TO RAISE CAPITAL. We will be required to make substantial capital +expenditures to develop our existing reserves, and to discover new oil and gas +reserves. +5 +Historically, we have financed these expenditures primarily with cash from +operations, proceeds from bank borrowings and proceeds from the sale of debt and +equity securities. See "Management's Discussion and Analysis of Financial +Condition and Results of Operations -- Liquidity and Capital Resources" for a +discussion of our capital budget. We cannot assure you that we will be able to +raise capital in the future. We also make offers to acquire oil and gas +properties in the ordinary course of our business. If these offers are accepted, +our capital needs may increase substantially. +We expect to continue using our senior credit facility to borrow funds to +supplement our available cash. The amount we may borrow under our senior credit +facility may not exceed a borrowing base determined by the lenders based on +their projections of our future production, future production costs, taxes, +commodity prices and any other factors deemed relevant by our lenders. We cannot +control the assumptions the lenders use to calculate our borrowing base. The +lenders may, without our consent, adjust the borrowing base semiannually or in +situations where we purchase or sell assets or issue debt securities. If our +borrowings under the senior credit facility exceed the borrowing base, the +lenders may require that we repay the excess. If this were to occur, we might +have to sell assets or seek financing from other sources. Sales of assets could +further reduce the amount of our borrowing base. We cannot assure you that we +would be successful in selling assets or arranging substitute financing. If we +were not able to repay borrowings under our senior credit facility to reduce the +outstanding amount to less than the borrowing base, we would be in default under +our senior credit facility. For a description of our senior credit facility and +its principal terms and conditions, see "Management's Discussion and Analysis of +Financial Condition and Results of Operations -- Liquidity and Capital +Resources." +OUR RESERVE INFORMATION REPRESENTS ESTIMATES THAT MAY TURN OUT TO BE INCORRECT +IF THE ASSUMPTIONS UPON WHICH THESE ESTIMATES ARE BASED ARE INACCURATE. ANY +MATERIAL INACCURACIES IN THESE RESERVE ESTIMATES OR UNDERLYING ASSUMPTIONS WILL +MATERIALLY AFFECT THE QUANTITIES AND PRESENT VALUE OF OUR RESERVES. The process +of estimating oil and gas reserves is complex. It requires interpretations of +available technical data and various assumptions, including assumptions relating +to economic factors. Any significant inaccuracies in these interpretations or +assumptions could materially affect the estimated quantities and present value +of reserves shown in this prospectus. +In order to prepare these estimates, we must project production rates and the +timing of development expenditures. The assumptions regarding the timing and +costs to commence production from our deepwater wells used in preparing our +reserves are often subject to revisions over time as described under "our +deepwater operations have special operational risks that may negatively affect +the value of those assets." We must also analyze available geological, +geophysical, production and engineering data, the extent, quality and +reliability of which can vary. The process also requires economic assumptions, +such as oil and gas prices, drilling and operating expenses, capital +expenditures, taxes and availability of funds. Therefore, estimates of oil and +gas reserves are inherently imprecise. Actual future production, oil and gas +prices, revenues, taxes, development expenditures, operating expenses and +quantities of recoverable oil and gas reserves most likely will vary from our +estimates. Any significant variance could materially affect the estimated +quantities and present value of reserves shown in this prospectus. In addition, +we may adjust estimates of proved reserves to reflect production history, +results of exploration and development, prevailing oil and gas prices and other +factors, many of which are beyond our control. +You should not assume that the present value of future net cash flows from our +proved reserves referred to in this prospectus is the current market value of +our estimated oil and gas reserves. In accordance with SEC requirements, we +generally base the estimated discounted future net cash flows from our proved +reserves on +6 +prices and costs on the date of the estimate. Actual future prices and costs may +differ materially from those used in the present value estimate. +Information about reserves constitutes forward-looking information. See +"Forward-Looking Statements" for information regarding forward-looking +information. The discounted present value of our oil and gas reserves is +prepared in accordance with guidelines established by the SEC. A purchaser of +reserves would use numerous other factors to value our reserves. The discounted +present value of reserves, therefore, does not represent the fair market value +of those reserves. +On December 31, 2001, approximately 77.3% of the discounted present value of our +estimated net proved reserves were proved undeveloped. Substantially all of +these proved undeveloped reserves were attributable to our deepwater properties. +Development of these properties is subject to additional risks as described +above. +WEATHER, UNEXPECTED SUBSURFACE CONDITIONS, AND OTHER UNFORESEEN OPERATING +HAZARDS MAY ADVERSELY IMPACT OUR ABILITY TO CONDUCT BUSINESS. There are many +operating hazards in exploring for and producing oil and gas, including: +o our drilling operations may encounter unexpected formations or pressures, +which could cause damage to equipment or personal injury; +o we may experience equipment failures which curtail or stop production; +and +o we could experience blowouts or other damages to the productive +formations that may require a well to be re-drilled or other corrective +action to be taken. +In addition, any of the foregoing may result in environmental damages for which +we will be liable. Moreover, a substantial portion of our operations are +offshore and are subject to a variety of risks peculiar to the marine +environment such as capsizings, collisions, hurricanes and other adverse weather +conditions. These conditions can cause substantial damage to facilities and +interrupt production. Offshore operations are also subject to more extensive +governmental regulation. +We cannot assure you that we will be able to maintain adequate insurance at +rates we consider reasonable to cover our possible losses from operating +hazards. The occurrence of a significant event not fully insured or indemnified +against could materially and adversely affect our financial condition and +results of operations. +WE MAY NOT HAVE PRODUCTION TO OFFSET HEDGES; BY HEDGING, WE MAY NOT BENEFIT FROM +PRICE INCREASES. Part of our business strategy is to reduce our exposure to the +volatility of oil and gas prices by hedging a portion of our production. In a +typical hedge transaction, we will have the right to receive from the other +parties to the hedge the excess of the fixed price specified in the hedge over a +floating price based on a market index, multiplied by the quantity hedged. If +the floating price exceeds the fixed price, we are required to pay the other +parties this difference multiplied by the quantity hedged. We are required to +pay the difference between the floating price and the fixed price when the +floating price exceeds the fixed price regardless of whether we have sufficient +production to cover the quantities specified in the hedge. Significant +reductions in production at times when the floating price exceeds the fixed +price could require us to make payments under the hedge agreements even though +such payments are not offset by sales of production. Hedging will also prevent +us from receiving the full advantage of increases in oil or gas prices above the +fixed amount specified in the hedge. See "Quantitative and Qualitative +Disclosures About Market Risks" for a discussion of our hedging practices. +7 +COMPLIANCE WITH ENVIRONMENTAL AND OTHER GOVERNMENT REGULATIONS COULD BE COSTLY +AND COULD NEGATIVELY IMPACT PRODUCTION. Our operations are subject to numerous +laws and regulations governing the operation and maintenance of our facilities +and discharge of materials into the environment or otherwise relating to +environmental protection. For a discussion of the material regulations +applicable to us, see "Federal Regulations," "State Regulations," and +"Environmental Regulations." These laws and regulations may: +o require that we acquire permits before commencing drilling; +o restrict the substances that can be released into the environment in +connection with drilling and production activities; +o limit or prohibit drilling activities on protected areas such as wetlands +or wilderness areas; and +o require remedial measures to mitigate pollution from former operations, +such as dismantling abandoned production facilities. +Under these laws and regulations, we could be liable for personal injury and +clean-up costs and other environmental and property damages, as well as +administrative, civil and criminal penalties. We maintain limited insurance +coverage for sudden and accidental environmental damages. We do not believe that +insurance coverage for environmental damages that occur over time is available +at a reasonable cost. Also, we do not believe that insurance coverage for the +full potential liability that could be caused by sudden and accidental +environmental damages is available at a reasonable cost. Accordingly, we may be +subject to liability or we may be required to cease production from properties +in the event of environmental damages. +FACTORS BEYOND OUR CONTROL AFFECT OUR ABILITY TO MARKET PRODUCTION AND OUR +FINANCIAL RESULTS. The ability to market oil and gas from our wells depends upon +numerous factors beyond our control. These factors include: +o the extent of domestic production and imports of oil and gas; +o the proximity of the gas production to gas pipelines; +o the availability of pipeline capacity; +o the demand for oil and gas by utilities and other end users; +o the availability of alternative fuel sources; +o the effects of inclement weather; +o state and federal regulation of oil and gas marketing; and +o federal regulation of gas sold or transported in interstate commerce. +Because of these factors, we may be unable to market all of the oil or gas we +produce. In addition, we may be unable to obtain favorable prices for the oil +and gas we produce. +IF OIL AND GAS PRICES DECREASE, WE MAY BE REQUIRED TO TAKE WRITEDOWNS. We may be +required to writedown the carrying value of our oil and gas properties when oil +and gas prices are low or if we have substantial downward adjustments to our +estimated net proved reserves, increases in our estimates of development costs +or deterioration in our exploration results. Under the full-cost method we use +to account for our oil and gas properties, the net capitalized costs of our oil +and gas properties may not exceed the present value, discounted at 10%, of +future net cash flows from estimated net proved reserves, using period end oil +and gas prices or prices as of the date of our auditor's report, plus the lower +of cost or fair market value of our unproved properties. If net capitalized +costs of our oil and gas properties exceed this limit, we must charge the amount +of the excess to earnings. This type of charge will not affect our cash flows, +but will reduce the book value of our stockholders' equity. We review the +carrying value of our properties +8 +quarterly, based on prices in effect as of the end of each quarter or at the +time of reporting our results. Once incurred, a writedown of oil and gas +properties is not reversible at a later date, even if prices increase. +FORWARD-LOOKING STATEMENTS +In this report, we have made many forward-looking statements. We cannot assure +you that the plans, intentions or expectations upon which our forward-looking +statements are based will occur. Our forward-looking statements are subject to +risks, uncertainties and assumptions, including those discussed elsewhere in +this report. Forward-looking statements include statements regarding: +o our oil and gas reserve quantities, and the discounted present value of +these reserves; +o the amount and nature of our capital expenditures; +o drilling of wells; +o the timing and amount of future production and operating costs; +o business strategies and plans of management; and +o prospect development and property acquisitions. +Some of the risks, which could affect our future results and could cause results +to differ materially from those expressed in our forward-looking statements +include: +o general economic conditions; +o the volatility of oil and natural gas prices; +o the uncertainty of estimates of oil and natural gas reserves; +o the impact of competition; +o the availability and cost of seismic, drilling and other equipment; +o operating hazards inherent in the exploration for and production of oil +and natural gas; +o difficulties encountered during the exploration for and production of oil +and natural gas; +o difficulties encountered in delivering oil and natural gas to commercial +markets; +o changes in customer demand and producers' supply; +o the uncertainty of our ability to attract capital; +o compliance with, or the effect of changes in, the extensive governmental +regulations regarding the oil and natural gas business; +o actions of operators of our oil and gas properties; and +o weather conditions. +The information contained in this report, including the information set forth +under the heading "Risk Factors," identifies additional factors that could +affect our operating results and performance. We urge you to carefully consider +these factors and the other cautionary statements in this report. Our +forward-looking statements speak only as of the date made, and we have no +obligation to update these forward-looking statements. +CORPORATE OFFICES +Our headquarters are located in Natchez, Mississippi, in approximately 51,500 +square feet of owned space. In late 2000, we opened a field office in Houston, +Texas, staffed with recently hired technical professionals, to enhance +exploration and development efforts. We also maintain owned or leased field +offices in the area of the major fields in which we operate properties or have a +significant interest. Replacement of any of our leased offices would not result +in material expenditures by us as alternative locations to our leased space are +anticipated to be readily available. +9 +EMPLOYEES +We had 103 employees as of December 31, 2001, none of whom are currently +represented by a union. We believe that we have good relations with our +employees. We employ nine petroleum engineers and eight petroleum geoscientists. +FEDERAL REGULATIONS +SALES OF NATURAL GAS. Effective January 1, 1993, the Natural Gas Wellhead +Decontrol Act deregulated prices for all "first sales" of natural gas. Thus, all +sales of gas by the Company may be made at market prices, subject to applicable +contract provisions. +TRANSPORTATION OF NATURAL GAS. The rates, terms and conditions applicable to the +interstate transportation of natural gas by pipelines are regulated by the +Federal Energy Regulatory Commission ("FERC") under the Natural Gas Act ("NGA"), +as well as under section 311 of the Natural Gas Policy Act ("NGPA"). Since 1985, +the FERC has implemented regulations intended to make natural gas transportation +more accessible to gas buyers and sellers on an open-access, non-discriminatory +basis. +The FERC has announced several important transportation-related policy +statements and rule changes, including a statement of policy and final rule +issued February 25, 2000 concerning alternatives to its traditional +cost-of-service rate-making methodology to establish the rates interstate +pipelines may charge for their services. The final rule revises FERC's pricing +policy and current regulatory framework to improve the efficiency of the market +and further enhance competition in natural gas markets. +With respect to the transportation of natural gas on or across the Outer +Continental Shelf ("OCS"), the FERC requires, as part of its regulation under +the Outer Continental Shelf Lands Act, that all pipelines provide open and +non-discriminatory access to both owner and non-owner shippers. Although to date +the FERC has imposed light-handed regulation on off-shore facilities that meet +its traditional test of gathering status, it has the authority to exercise +jurisdiction under the Outer Continental Shelf Lands Act ("OCSLA") over +gathering facilities, if necessary, to permit non-discriminatory access to +service. For those facilities transporting natural gas across the OCS that are +not considered to be gathering facilities, the rates, terms, and conditions +applicable to this transportation are regulated by FERC under the NGA and NGPA, +as well as the OCSLA. +SALES AND TRANSPORTATION OF CRUDE OIL. Sales of crude oil and condensate can be +made by the Company at market prices not subject at this time to price controls. +The price that the Company receives from the sale of these products will be +affected by the cost of transporting the products to market. The rates, terms, +and conditions applicable to the interstate transportation of oil and related +products by pipelines are regulated by the FERC under the Interstate Commerce +Act. As required by the Energy Policy Act of 1992, the FERC has revised its +regulations governing the rates that may be charged by oil pipelines. The new +rules, which were effective January 1, 1995, provide a simplified, generally +applicable method of regulating such rates by use of an index for setting rate +ceilings. The FERC will also, under defined circumstances, permit alternative +ratemaking methodologies for interstate oil pipelines such as the use of cost of +service rates, settlement rates, and market-based rates. Market-based rates will +be permitted to the extent the pipeline can demonstrate that it lacks +significant market power in the market in which it proposes to charge +market-based rates. The cumulative effect that these rules may have on moving +the Company's production to market cannot yet be determined. +10 +With respect to the transportation of oil and condensate on or across the OCS, +the FERC requires, as part of its regulation under the OCSLA, that all pipelines +provide open and non-discriminatory access to both owner and non-owner shippers. +Accordingly, the FERC has the authority to exercise jurisdiction under the +OCSLA, if necessary, to permit non-discriminatory access to service. +LEGISLATIVE PROPOSALS. In the past, Congress has been very active in the area of +natural gas regulation. There are legislative proposals pending in Congress and +in various state legislatures which, if enacted, could significantly affect the +petroleum industry. At the present time it is impossible to predict what +proposals, if any, might actually be enacted by Congress or the various state +legislatures and what effect, if any, such proposals might have on the Company's +operations. +FEDERAL, STATE OR INDIAN LEASES. In the event the Company conducts operations on +federal, state or Indian oil and gas leases, such operations must comply with +numerous regulatory restrictions, including various nondiscrimination statutes, +royalty and related valuation requirements, and certain of such operations must +be conducted pursuant to certain on-site security regulations and other +appropriate permits issued by the Bureau of Land Management ("BLM") or Minerals +Management Service ("MMS") or other appropriate federal or state agencies. +The Company's OCS leases in federal waters are administered by the MMS and +require compliance with detailed MMS regulations and orders. The MMS has +promulgated regulations implementing restrictions on various production-related +activities, including restricting the flaring or venting of natural gas. Under +certain circumstances, the MMS may require Company operations on federal leases +to be suspended or terminated. Any such suspension or termination could +materially and adversely affect the Company's financial condition and +operations. On March 15, 2000, the MMS issued a final rule effective June 1, +2000 which amends its regulations governing the calculation of royalties and the +valuation of crude oil produced from federal leases. Among other matters, this +rule amends the valuation procedure for the sale of federal royalty oil by +eliminating posted prices as a measure of value and relying instead on arm's +length sales prices and spot market prices as market value indicators. Because +the Company sells its production in the spot market and therefore pays royalties +on production from federal leases, it is not anticipated that this final rule +will have any substantial impact on the Company. +The Mineral Leasing Act of 1920 ("Mineral Act") prohibits direct or indirect +ownership of any interest in federal onshore oil and gas leases by a foreign +citizen of a country that denies "similar or like privileges" to citizens of the +United States. Such restrictions on citizens of a "non-reciprocal" country +include ownership or holding or controlling stock in a corporation that holds a +federal onshore oil and gas lease. If this restriction is violated, the +corporation's lease can be canceled in a proceeding instituted by the United +States Attorney General. Although the regulations of the BLM (which administers +the Mineral Act) provide for agency designations of non-reciprocal countries, +there are presently no such designations in effect. The Company owns interests +in numerous federal onshore oil and gas leases. It is possible that holders of +equity interests in the Company may be citizens of foreign countries, which at +some time in the future might be determined to be non-reciprocal under the +Mineral Act. +STATE REGULATIONS +Most states regulate the production and sale of oil and natural gas, including +requirements for obtaining drilling permits, the method of developing new +fields, the spacing and operation of wells and the prevention of waste of oil +and gas resources. The rate of production may be regulated and the maximum daily +production allowable from both oil and gas wells may be established on a market +demand or conservation basis or both. +11 +The Company may enter into agreements relating to the construction or operation +of a pipeline system for the transportation of natural gas. To the extent that +such gas is produced, transported and consumed wholly within one state, such +operations may, in certain instances, be subject to the jurisdiction of such +state's administrative authority charged with the responsibility of regulating +intrastate pipelines. In such event, the rates which the Company could charge +for gas, the transportation of gas, and the costs of construction and operation +of such pipeline would be impacted by the rules and regulations governing such +matters, if any, of such administrative authority. Further, such a pipeline +system would be subject to various state and/or federal pipeline safety +regulations and requirements, including those of, among others, the Department +of Transportation. Such regulations can increase the cost of planning, +designing, installation and operation of such facilities. The impact of such +pipeline safety regulations would not be any more adverse to the Company than it +would be to other similar owners or operators of such pipeline facilities. +ENVIRONMENTAL REGULATIONS +GENERAL. The Company's activities are subject to federal, state and local laws +and regulations governing environmental quality and pollution control. Although +no assurances can be made, the Company believes that, absent the occurrence of +an extraordinary event, compliance with existing federal, state and local laws, +rules and regulations regulating the release of materials in the environment or +otherwise relating to the protection of the environment will not have a material +effect upon the capital expenditures, earnings or the competitive position of +the Company with respect to its existing assets and operations. The Company +cannot predict what effect additional regulation or legislation, enforcement +policies thereunder, and claims for damages to property, employees, other +persons and the environment resulting from the Company's operations could have +on its activities. +Activities of the Company with respect to natural gas facilities, including the +operation and construction of pipelines, plants and other facilities for +transporting, processing, treating or storing natural gas and other products, +are subject to stringent environmental regulation by state and federal +authorities including the United States Environmental Protection Agency ("EPA"). +Such regulation can increase the cost of planning, designing, installation and +operation of such facilities. In most instances, the regulatory requirements +relate to water and air pollution control measures. Although the Company +believes that compliance with environmental regulations will not have a material +adverse effect on it, risks of substantial costs and liabilities are inherent in +oil and gas production operations, and there can be no assurance that +significant costs and liabilities will not be incurred. Moreover, it is possible +that other developments, such as stricter environmental laws and regulations, +and claims for damages to property or persons resulting from oil and gas +production, would result in substantial costs and liabilities to the Company. +SOLID AND HAZARDOUS WASTE. The Company owns or leases numerous properties that +have been used for production of oil and gas for many years. Although the +Company has utilized operating and disposal practices standard in the industry +at the time, hydrocarbons or other solid wastes may have been disposed or +released on or under these properties. In addition, many of these properties +have been operated by third parties. The Company had no control over such +entities' treatment of hydrocarbons or other solid wastes and the manner in +which such substances may have been disposed or released. State and federal laws +applicable to oil and gas wastes and properties have gradually become stricter +over time. Under these new laws, the Company could be required to remove or +remediate previously disposed wastes (including wastes disposed or released by +prior owners or operators) or property contamination (including groundwater +contamination by prior owners or operators) or to perform remedial plugging +operations to prevent future contamination. +The Company generates wastes, including hazardous wastes, that are subject to +the Federal Resource Conservation and Recovery Act ("RCRA") and comparable state +statutes. The EPA has limited the disposal +12 +options for certain hazardous wastes and is considering the adoption of stricter +disposal standards for nonhazardous wastes. Furthermore, it is possible that +certain wastes currently exempt from treatment as "hazardous wastes" generated +by the Company's oil and gas operations may in the future be designated as +"hazardous wastes" under RCRA or other applicable statutes, and therefore may be +subject to more rigorous and costly disposal requirements. +SUPERFUND. The Comprehensive Environmental Response, Compensation and Liability +Act ("CERCLA"), also known as the "Superfund" law, imposes liability, without +regard to fault or the legality of the original conduct, on certain classes of +persons with respect to the release of a "hazardous substance" into the +environment. These persons include the owner and operator of a site and persons +that disposed or arranged for the disposal of the hazardous substances found at +a site. CERCLA also authorizes the EPA and, in some cases, third parties to take +actions in response to threats to the public health or the environment and to +seek to recover from the responsible classes of persons the costs of such +action. Neither the Company nor its predecessors has been designated as a +potentially responsible party by the EPA under CERCLA with respect to any such +site. +OIL POLLUTION ACT. The Oil Pollution Act of 1990 (the "OPA") and regulations +thereunder impose a variety of regulations on "responsible parties" related to +the prevention of oil spills and liability for damages resulting from such +spills in United States waters. A "responsible party" includes the owner or +operator of a facility or vessel, or the lessee or permittee of the area in +which an offshore facility is located. The OPA assigns liability to each +responsible party for oil removal costs and a variety of public and private +damages. While liability limits apply in some circumstances, a party cannot take +advantage of liability limits if the spill was caused by gross negligence or +willful misconduct or resulted from violation of a federal safety, construction +or operating regulation. If the party fails to report a spill or to cooperate +fully in the cleanup, liability limits likewise do not apply. Few defenses exist +to the liability imposed by the OPA. +The OPA also imposes ongoing requirements on a responsible party, including +proof of financial responsibility to cover at least some costs in a potential +spill. Certain amendments to the OPA that were enacted in 1996 require owners +and operators of offshore facilities that have a worst case oil spill potential +of more than 1,000 barrels to demonstrate financial responsibility in amounts +ranging from $10 million in specified state waters and $35 million in federal +OCS waters, with higher amounts, up to $150 million based upon worst case +oil-spill discharge volume calculations. The Company believes that it currently +has established adequate proof of financial responsibility for its offshore +facilities. +AIR EMISSIONS. The operations of the Company are subject to local, state and +federal regulations for the control of emissions from sources of air pollution. +Administrative enforcement actions for failure to comply strictly with air +regulations or permits are generally resolved by payment of monetary fines and +correction of any identified deficiencies. Alternatively, regulatory agencies +could require the Company to forego construction or operation of certain air +emission sources, although the Company believes that in such case it would have +enough permitted or permittable capacity to continue its operations without a +material adverse effect on any particular producing field. +OSHA. The Company is subject to the requirements of the Federal Occupational +Safety and Health Act ("OSHA") and comparable state statutes. The OSHA hazard +communication standard, the EPA community right-to-know regulations under Title +III of the Federal Superfund Amendment and Reauthorization Act and similar state +statutes require the Company to organize and/or disclose information about +hazardous materials used or produced in its operations. Certain of this +information must be provided to employees, state and local governmental +authorities and local citizens. +13 +Management believes that the Company is in substantial compliance with current +applicable environmental laws and regulations and that continued compliance with +existing requirements would not have a material adverse impact on the Company. +ITEM 2. PROPERTIES +We are engaged in the exploration, development, acquisition and production of +oil and gas properties and natural gas transmission and provide oil and gas +property management services for other investors. Our properties are +concentrated offshore in the Gulf of Mexico and onshore, primarily, in Louisiana +and Alabama. We have historically grown our reserves and production by focusing +primarily on low to moderate risk exploration and acquisition opportunities in +the Gulf of Mexico Shelf area. Over the last several years, we have expanded our +area of exploration to include the Gulf of Mexico Deepwater area. As of December +31, 2001, our estimated net proved reserves totaled 30.2 million barrels of oil +("MBbl") and 121.5 billion cubic feet of natural gas ("Bcf"), with a pre-tax +present value, discounted at 10%, of the estimated future net revenues based on +constant prices in effect at year-end ("Discounted Cash Flow") of $272.1 +million. Gas constitutes approximately 40% of our total estimated proved +reserves and approximately 17% of our reserves are proved producing reserves. +14 +SIGNIFICANT PROPERTIES +The following table shows discounted cash flows and estimated net proved oil and +gas reserves by major field, within focus area, for our nine largest fields and +for all other properties combined at December 31, 2001. +ESTIMATED NET PROVED RESERVES PRE-TAX +---------------------------------- DISCOUNTED +OIL GAS TOTAL PRESENT VALUE +OPERATOR (MBBLS) (MMCF) (MMCFE) ($000) +-------- ------- -------- --------- ------------- +(b) (b) (a)(b) +GULF OF MEXICO SHELF: +Mobile Block 864 Area Callon -- 41,054 41,054 $ 45,496 +Main Pass Block 26 SL 15827 Callon 40 915 1,152 693 +East Cameron Block 294 Unocal 14 2,860 2,945 3,598 +High Island Block A-494 +"Snapper" PetroQuest -- 4,614 4,614 7,285 +GULF OF MEXICO DEEPWATER: +Garden Banks Blocks 738/782/826/827 +"Entrada" BP Amoco 7,823 29,341 76,279 54,218 +Mississippi Canyon 538/582 +"Medusa" Murphy 9,507 9,374 66,415 68,028 +Garden Banks Block 341 +"Habanero" Shell 4,736 12,270 40,685 46,737 +Ewing Bank Block 994 +"Boomslang" Murphy 7,244 13,040 56,505 38,917 +ONSHORE AND OTHER: +Big Escambia Creek Exxon 412 1,027 3,500 2,638 +Other Various 433 6,958 9,557 4,443 +------- -------- -------- -------- +TOTAL PROVED RESERVES 30,209 121,453 302,706 $272,053 +======= ======== ======== ======== +(a) Represents the present value of future net cash flows before deduction of +federal income taxes, discounted at 10%, attributable to estimated net +proved reserves as of December 31, 2001, as set forth in the Company's +reserve reports prepared by its independent petroleum reserve engineers, +Huddleston & Co., Inc. of Houston, Texas. +(b) The estimates include reserve volumes of approximately 1.2 Bcf with a +pre-tax discounted present value of $2.9 million that are dedicated to a +volumetric production payment. +15 +GULF OF MEXICO DEEPWATER +Entrada, Garden Banks Blocks 738/782/826/827 +The Entrada discovery is located in approximately 4,500 feet of water in the +Gulf of Mexico. Two wells and seven sidetracks have been drilled to date on +Garden Banks 782 on a northwest plunging salt ridge along the southern edge of +the Entrada Basin. Multiple stacked amplitudes trapped against a salt or fault +interface characterize the Entrada Area. We own a 20% working interest in this +discovery with BP Amoco, the operator, holding the remaining working interest. +Information obtained in a data swap with another exploration company that has +announced a similar discovery adjacent to Entrada, is being incorporated into +the Entrada development plans. The owners of the adjacent discovery have +announced their plans to construct production facilities to enable them to be a +regional off-take point in Southeastern Garden banks. These plans include +handling third party tie-ins, which we expect to include Entrada. First +production from their discovery is expected in late 2004. +Medusa, Mississippi Canyon Block 538/582 +Medusa was our third deepwater discovery and was announced in September 1999. We +drilled the initial test well in 2,235 feet of water to a total depth of 16,241 +feet and encountered over 120 feet of pay in two intervals. We performed +subsequent sidetrack drilling from the well bore to determine the extent of the +discovery. We drilled a second successful well in the first quarter of 2000 to +further delineate the extent of the pay intervals. We own a 15% working +interest, Murphy, the operator, owns a 60% interest and British-Borneo +Petroleum, Inc. owns the remaining 25%. +In 2001 a delineation program began which included four development wells and +one sidetrack. These will provide the take points for initial production. Also +in 2001, the operator submitted an Authorization For Expenditure for a floating +production system at Medusa and awarded the contract to J. Ray McDermott, Inc. +Construction of the facility is in progress. Upon completion, it is estimated +the production facility will have the capacity to handle 40,000 barrels of crude +oil and 110 million cubic feet of natural gas per day. First production is +anticipated in late 2002 or early 2003. +Habanero, Garden Banks Block 341 +During February 1999 the initial test well on our Habanero prospect encountered +over 200 feet of net pay. Located in 2,000 feet of water, the well was drilled +to a measured depth of 21,158 feet. This discovery was our second deepwater +success. We own an 11.25% working interest in the well. It is operated by Shell +Deepwater Development Inc., which owns a 55% working interest, with the +remaining working interest being owned by Murphy. +A field delineation program began in midyear 2001, which included sidetracking +the existing well with three sidetracks. Development plans include sub-sea +completion and tie back to an existing production facility in the area. The +operator has submitted to the co-owners a development schedule with estimated +initial production in November 2003. +Boomslang, Ewing Bank Block 994 +Located in 900 feet of water, the Boomslang prospect was drilled to a total +depth of 12,955 feet and encountered 185 net feet of oil pay in three separate +zones. In December 1999, we purchased from Santos +16 +USA Corporation an additional 20% working interest in the Boomslang deepwater +discovery on Ewing Bank Block 994 for $7.3 million. This brought our total +working interest in the well to 55%. +A complete field study was initiated in 2001, which resulted in a delineation +and development plan that is scheduled to commence by the second half of 2003. +Plans include a sub-sea completion with a tieback to an existing shelf +production facility. Plans could be altered if the Sidewinder prospect, located +immediately to the southeast of Boomslang on Ewing Bank Block 995 and Green +Canyon Blocks 24 and 25, is drilled and results in a discovery. This could +result in the need for a stand-alone production facility to serve both Boomslang +and Sidewinder. We own a 15% working interest in the Ewing Bank Block 995 and +Green Canyon Blocks 24 and 25 leases. +GULF OF MEXICO SHELF +Mobile Block 864 Area +The Mobile Block 864 Area is located offshore Alabama in the federal waters of +the Outer Continental Shelf area. We consummated five acquisitions in this area +for a total of $63.8 million. In total, we acquired an average 81.6% working +interest in seven blocks, a 66.4% working interest in the Mobile Block 864 Area +unit and the unit production facilities, and a 100% working interest in three +producing wells. We have been appointed operator of the Mobile Block 864 unit +and three other wells. Net average daily production during 2001 was 18 MMcf per +day. +During the first quarter of 2001, we drilled the Mobile Block 908 #4, an +exploratory well, and the Mobile Block 864 A-3, a development well, in our +Mobile Block 864 area, both of which were successful. During the fourth quarter +of 2000, the Company performed acid stimulation on three wells. The 908 #4 well +commenced production during February 2001 and the A-3 well commenced production +during March 2001. These projects increased production in this area during 2001. +In the fourth quarter of 2001, we initiated a production acceleration program +for Mobile Blocks 952, 953 and 955, which currently produce through the Mobile +Block 864 unit facilities. Plans include at least one acceleration well, which +was successfully drilled in the fourth quarter of 2001, stand-alone production +facilities and the rerouting of production flow lines. The project is scheduled +to be completed late in the first quarter or early second quarter 2002. +East Cameron Block 294 +In the first quarter of 2001, this prospect was drilled at a water depth of 186 +feet and encountered approximately 80 feet of pay in two intervals at +approximately 3,500 and 4,200 feet. First production commenced in the first +quarter of 2002 at a net average daily rate of 6 MMcf. We own a 50% working +interest in this well and Unocal, the operator, owns the remaining interest. +Main Pass 26 / SL 15827 #1 +We negotiated a farm-in agreement in 1998 for a 97% working interest after +identifying a prospect on Main Pass Block 26 based upon a seismic survey we +completed in 1996. In August 1998, we drilled the SL 15827 well to a depth of +10,450 feet. This well produced during 2001 at a net average daily rate of 2 +MMcf of gas and 85 Bbls of oil. We operate this property. +17 +Snapper, High Island Block A-494 +In January 1999, we announced a discovery on our Snapper prospect, which was +drilled to a total depth of 8,800 feet. In the second half of 2001, the well was +sidetracked and a second well was drilled to test the same zone in an adjacent +fault block. The second well had over 100 feet of pay which is fault separated +from the initial well with no apparent water. We own a 50% working interest in +these wells, which are operated by PetroQuest Energy. The wells began production +in the third quarter of 2001, and averaged 7 net MMcf per day for December 2001. +ONSHORE +We own various small royalty and working interests in several onshore areas, +which as of December 31, 2001 had total net proved reserves of 9.4 Bcfe with a +discounted present value of $5.0 million. Over 50% of these reserves and their +related discounted present value were attributable to our interest in the Big +Escambia Creek gas field located in south Alabama and operated by Exxon/Mobil. +OIL AND GAS RESERVES +The following table sets forth certain information about our estimated proved +reserves as of the dates set forth below. +YEARS ENDED DECEMBER 31, +---------------------------------------------- +2001(a) 2000(a) 1999(a) +---------- ---------- ---------- +(IN THOUSANDS) +Proved developed: +Oil (Bbls) 885 2,192 1,376 +Gas (Mcf) 52,375 67,463 82,109 +Proved undeveloped: +Oil (Bbls) 29,324 31,190 22,458 +Gas (Mcf) 69,078 65,940 34,326 +Total proved: +Oil (Bbls) 30,209 33,382 23,834 +Gas (Mcf) 121,453 133,403 116,435 +Estimated pre-tax future net cash flows $ 473,896 $1,610,320 $ 528,659 +========== ========== ========== +Pre-tax discounted present value $ 272,053 $ 939,325 $ 296,513 +========== ========== ========== +Standardized measure of discounted future +net cash flows $ 254,857 $ 671,197 $ 256,322 +========== ========== ========== +(a) The estimates include reserve volumes of approximately 5.8 Bcf, $12.1 +million of pre-tax future net cash flows and $10.7 million of pre-tax +discounted present value in 1999, 3.5 Bcf, $31.8 million of pre-tax future +net cash flows and $29.5 million of pre-tax discounted present value in +2000, and 1.2 Bcf, $2.9 million of pre-tax discounted present value in 2001, +attributable to a volumetric production payment. Standardized measure of +discounted future net cash flows does not include any volumes or cash flows +associated with the volumetric production payment. +18 +Our independent reserve engineers, Huddleston & Co., Inc. prepared the estimates +of the proved reserves and the future net cash flows and present value thereof +attributable to such proved reserves. Reserves were estimated using oil and gas +prices and production and development costs in effect on December 31 of each +such year, without escalation, and were otherwise prepared in accordance with +Securities and Exchange Commission regulations regarding disclosure of oil and +gas reserve information. +There are numerous uncertainties inherent in estimating quantities of proved +reserves, including many factors beyond our control or the control of the +reserve engineers. Reserve engineering is a subjective process of estimating +underground accumulations of oil and gas that cannot be measured in an exact +manner, and the accuracy of any reserve or cash flow estimate is a function of +the quality of available data and of engineering and geological interpretation +and judgment. Estimates by different engineers often vary, sometimes +significantly. In addition, physical factors, such as the results of drilling, +testing and production subsequent to the date of an estimate, as well as +economic factors, such as an increase or decrease in product prices that renders +production of such reserves more or less economic, may justify revision of such +estimates. Accordingly, reserve estimates are different from the quantities of +oil and gas that are ultimately recovered. +We have not filed any reports with other federal agencies which contain an +estimate of total proved net oil and gas reserves. +PRODUCTIVE WELLS +The following table sets forth the wells we have drilled and completed during +the periods indicated. All such wells were drilled in the continental United +States including federal and state waters in the Gulf of Mexico. +YEARS ENDED DECEMBER 31, +------------------------ +2001 2000 1999 +---- ---- ---- +GROSS NET GROSS NET GROSS NET +----- ----- ----- ----- ----- ----- +Development: +Oil 6 .45 2 .35 -- -- +Gas 4 3.17 -- -- -- -- +Non-productive -- -- -- -- -- -- +----- ----- ----- ----- ----- ----- +Total 10 3.62 2 .35 -- -- +===== ===== ===== ===== ===== ===== +Exploration: +Oil -- -- 1 .20 2 0.26 +Gas 3 2.00 2 2.00 5 3.79 +Non-productive 12 5.77 6 2.29 2 1.20 +----- ----- ----- ----- ----- ----- +Total 15 7.77 9 4.49 9 5.25 +===== ===== ===== ===== ===== ===== +We owned working and royalty interests in approximately 246 gross (6.7 net) +producing oil and 288 gross (29.9 net) producing gas wells as of December 31, +2001. A well is categorized as an oil well or a natural gas well based upon the +ratio of oil to gas reserves on a Mcfe basis. However, some of our wells produce +both oil and gas. At December 31, 2001, we had 3 gross (.53 net) wells with +multiple completions. At December 31, 2001, we had 1 gross (.15 net) development +oil well and 1 gross (1 net) exploratory gas well in progress. +19 +LEASEHOLD ACREAGE +The following table shows our approximate developed and undeveloped (gross and +net) leasehold acreage as of December 31, 2001. +LEASEHOLD ACREAGE +----------------- +DEVELOPED UNDEVELOPED +--------------------- --------------------- +LOCATION GROSS NET GROSS NET +-------- -------- -------- -------- -------- +Alabama 19,451 16,635 80 2 +Louisiana 8,178 5,221 3,795 1,212 +Other States 860 388 934 744 +Federal Waters 127,966 85,196 341,995 117,748 +-------- -------- -------- -------- +Total 156,455 107,440 346,804 119,706 +======== ======== ======== ======== +As of December 31, 2001, we owned various royalty and overriding royalty +interests in 1,336 net developed and 6,862 undeveloped acres. In addition, we +owned 5,184 developed and 120,816 undeveloped mineral acres. +MAJOR CUSTOMERS +Our production is sold on month-to-month contracts at prevailing prices. The +following table identifies customers to whom we sold a significant percentage of +our total oil and gas production during each of the twelve-month periods ended: +DECEMBER 31, +------------ +2001 2000 1999 +---- ---- ---- +Adams Resources Marketing, Ltd. -- 14% 16% +Columbia Energy Services -- -- 29% +Dynegy 8% -- 12% +Prior Energy Corporation 20% -- -- +Reliant Energy Services 49% 37% -- +Unocal Exploration Corporation -- 8% -- +Because alternative purchasers of oil and gas are readily available, we believe +that the loss of any of these purchasers would not result in a material adverse +effect on our ability to market future oil and gas production. +TITLE TO PROPERTIES +We believe that the title to our oil and gas properties is good and defensible +in accordance with standards generally accepted in the oil and gas industry, +subject to such exceptions which, in our opinion are not so material as to +detract substantially from the use or value of such properties. Our properties +are typically subject, in one degree or another, to one or more of the +following: royalties and other burdens and obligations, express or implied, +under oil and gas leases; overriding royalties and other burdens created by us +or our predecessors in title; a variety of contractual obligations (including, +in some cases, development obligations) arising under operating agreements, +farmout agreements, production sales contracts and other agreements that +20 +may affect the properties or their titles; back-ins and reversionary interests +existing under purchase agreements and leasehold assignments; liens that arise +in the normal course of operations, such as those for unpaid taxes, statutory +liens securing obligations to unpaid suppliers and contractors and contractual +liens under operating agreements; pooling, unitization and communitization +agreements, declarations and orders; and easements, restrictions, rights-of-way +and other matters that commonly affect property. To the extent that such burdens +and obligations affect our rights to production revenues, they have been taken +into account in calculating our net revenue interests and in estimating the size +and value of our reserves. We believe that the burdens and obligations affecting +our properties are conventional in the industry for properties of the kind owned +by us. +ITEM 3. LEGAL PROCEEDINGS +We are a defendant in various legal proceedings and claims, which arise in the +ordinary course of our business. We do not believe the ultimate resolution of +any such actions will have a material affect on our financial position or +results of operations. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +There were no matters submitted to a vote of security holders during the fourth +quarter of 2001. +PART II. +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS +Our common stock trades on the New York Stock Exchange under the symbol "CPE". +The following table sets forth the high and low sale prices per share as +reported for the periods indicated. +QUARTER ENDED HIGH LOW +------------- -------- ------- +2000: +First quarter $ 15.625 $ 9.625 +Second quarter 16.500 10.625 +Third quarter 17.625 12.500 +Fourth quarter 17.188 12.938 +2001: +First quarter $ 16.688 $10.000 +Second quarter 13.220 10.650 +Third quarter 11.820 5.900 +Fourth quarter 7.200 5.350 +As of March 18, 2002, there were approximately 5,036 common stockholders of +record. +We have not paid dividends on our common stock and intend to retain our cash +flow from operations, net of preferred stock dividends, for the future operation +and development of our business. In addition, our primary credit facility and +the terms of our outstanding subordinated debt restrict payments of dividends on +our common stock. +21 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth, as of the dates and for the periods indicated, +selected financial information about us. The financial information for each of +the five years in the period ended December 31, 2001 have been derived from our +audited Consolidated Financial Statements for such periods. The information +should be read in conjunction with "Management's Discussion and Analysis of +Financial Condition and Results of Operations" and the Consolidated Financial +Statements and notes thereto. The following information is not necessarily +indicative of our future results. +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) +YEARS ENDED DECEMBER 31, +------------------------------------------------------------------- +2001 2000 1999 1998 1997 +---------- ---------- ---------- ---------- ---------- +STATEMENT OF OPERATIONS DATA: +Revenues: +Oil and gas sales $ 60,010 $ 56,310 $ 37,140 $ 35,624 $ 42,130 +Interest and other 1,742 1,767 1,853 2,094 1,508 +---------- ---------- ---------- ---------- ---------- +Total revenues 61,752 58,077 38,993 37,718 43,638 +---------- ---------- ---------- ---------- ---------- +Costs and expenses: +Lease operating expenses 11,252 9,339 7,536 7,817 8,123 +Depreciation, depletion and amortization 21,081 17,153 16,727 19,284 16,488 +General and administrative 4,635 4,155 4,575 5,285 4,433 +Writedown of Enron derivatives 9,186 -- -- -- -- +Interest 12,805 8,420 6,175 1,925 1,957 +Accelerated vesting and retirement benefits -- -- -- 5,761 -- +Impairment of oil and gas properties -- -- -- 43,500 -- +---------- ---------- ---------- ---------- ---------- +Total costs and expenses 58,959 39,067 35,013 83,572 31,001 +---------- ---------- ---------- ---------- ---------- +Income (loss) from operations 2,793 19,010 3,980 (45,854) 12,637 +Income tax expense (benefit) 977 6,463 1,353 (15,100) 4,200 +---------- ---------- ---------- ---------- ---------- +Net income (loss) 1,816 12,547 2,627 (30,754) 8,437 +Preferred stock dividends 1,277 2,403 2,497 2,779 2,795 +---------- ---------- ---------- ---------- ---------- +Net income (loss) available to common shares $ 539 $ 10,144 $ 130 $ (33,533) $ 5,642 +========== ========== ========== ========== ========== +Net income (loss) per common share: +Basic $ .04 $ .82 $ .01 $ (4.17) $ .91 +Diluted $ .04 $ .80 $ .01 $ (4.17) $ .88 +Shares used in computing net income (loss) per common share: +Basic 13,273 12,420 8,976 8,034 6,194 +Diluted 13,366 12,745 9,075 8,034 6,422 +BALANCE SHEET DATA (END OF PERIOD): +Oil and gas properties, net $ 343,158 $ 258,613 $ 194,365 $ 141,905 $ 150,494 +Total assets $ 372,095 $ 301,569 $ 259,877 $ 181,652 $ 190,421 +Long-term debt, less current portion $ 161,733 $ 134,000 $ 100,250 $ 78,250 $ 60,250 +Stockholders' equity $ 147,224 $ 136,328 $ 124,380 $ 84,484 $ 113,701 +We use the full-cost method of accounting. Under this method of accounting, our +net capitalized costs to acquire, explore and develop oil and gas properties may +not exceed the standardized measure of our proved reserves. If these capitalized +costs exceed a ceiling amount, the excess is charged to expense. As a result of +the significant decline in oil and gas prices, we recorded a non-cash impairment +expense related to our oil and gas properties in the amount of $43.5 million +during the fourth quarter of 1998. +22 +ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS +OF OPERATIONS +The following discussion is intended to assist in an understanding of our +financial condition and results of operations. Our Financial Statements and +Notes thereto contain detailed information that should be referred to in +conjunction with the following discussion. See Item 8. "Financial Statements and +Supplementary Data." +GENERAL +Callon Petroleum Company has been engaged in the exploration, development, +acquisition and production of oil and gas properties since 1950. Our revenues, +profitability and future growth and the carrying value of our oil and gas +properties are substantially dependent on prevailing prices of oil and gas and +our ability to find, develop and acquire additional oil and gas reserves that +are economically recoverable. Our ability to maintain or increase our borrowing +capacity and to obtain additional capital on attractive terms is also influenced +by oil and gas prices. +Our estimated net proved oil and gas reserves decreased at December 31, 2001 to +303 billion cubic feet of natural gas equivalent (Bcfe). This represents a +decrease of 9% over previous year-end 2000 estimated proved reserves of 334 +Bcfe. This decrease in 2001 is primarily due to production and revisions +exceeding exploration additions to the reserve base. These reserve estimates +include 1.2 Bcfe at December 31, 2001 and 3.5 Bcfe at December 31, 2000 +dedicated to a volumetric production payment. +Prices for oil and gas are subject to large fluctuations in response to +relatively minor changes in the supply of and demand for oil and gas, market +uncertainty and a variety of additional factors beyond our control. These +factors include weather conditions in the United States, the condition of the +United States economy, the actions of the Organization of Petroleum Exporting +Countries, governmental regulation, political stability in the Middle East and +elsewhere, the foreign supply of crude oil and natural gas, the price of foreign +imports and the availability of alternate fuel sources. Any substantial and +extended decline in the price of crude oil or natural gas would have an adverse +effect on our carrying value of our proved reserves, borrowing capacity, +revenues, profitability and cash flows from operations. We use derivative +financial instruments (see Note 6 and Item 7A. "Quantitative and Qualitative +Disclosures About Market Risks") for price protection purposes on a limited +amount of our future production and do not use them for trading purposes. On a +Mcfe basis, natural gas represents 92% of the budgeted 2002 production and 40% +of proved reserves at year-end 2001. +Inflation has not had a material impact on us and is not expected to have a +material impact on us in the future. +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +RECENT ACCOUNTING PRONOUNCEMENTS. In June 1998, the Financial Accounting +Standards Board issued Statement of Financial Accounting Standards No. 133 +("SFAS 133"), Accounting for Derivative Instruments and Hedging Activities. The +Statement establishes accounting and reporting standards requiring that every +derivative instrument, including certain derivative instruments embedded in +other contracts, be recorded in the balance sheet as either an asset or +liability measured at its fair value. SFAS 133 requires the Company to report +changes in the fair value of our derivative financial instruments that qualify +as cash flow hedges in other comprehensive income, a component of stockholders' +equity, until realized. We adopted SFAS 133 effective January 1, 2001. +In July 2001, the Financial Accounting Standards Board approved Statement of +Accounting Standards No. 143, Asset Retirement Obligations ("SFAS 143"). SFAS +143 will require that the fair value of abandonment +23 +obligations be reflected as a liability, resulting in a corresponding increase +to the historical cost of the related assets and potentially an adjustment for +the cumulative effect of a change in accounting principle. This standard is +required to be adopted by us beginning no later that January 1, 2003. We have +not yet determined timing or the impact of the adoption of SFAS 143. +PROPERTY AND EQUIPMENT. We follow the full-cost method of accounting for oil and +gas properties whereby all costs incurred in connection with the acquisition, +exploration and development of oil and gas reserves, including certain overhead +costs, are capitalized. We include in such amounts the cost of drilling and +equipping productive wells, dry hole costs, lease acquisition costs, delay +rentals, interest capitalized on unevaluated leases and other costs related to +exploration and development activities. Our payroll and general and +administrative costs capitalized include salaries and related fringe benefits +paid to employees directly engaged in the acquisition, exploration and/or +development of oil and gas properties as well as other directly identifiable +general and administrative costs associated with such activities. Such +capitalized costs do not include any costs related to our production or our +general corporate overhead. Costs associated with unevaluated properties are +excluded from amortization. Unevaluated property costs are transferred to +evaluated property costs at such time as wells are completed on the properties, +the properties are sold or our management determines these costs have been +impaired and increase our depletion rates as they are transferred to evaluated +property. +Costs of properties, including future development and net future site +restoration, dismantlement and abandonment costs, which have proved reserves and +those which have been determined to be worthless, are depleted using the +unit-of-production method based on proved reserves. Increases in these costs +increase our depletion rates. Additions to reserves decrease our depletion +rates. +Under the full cost accounting rules of the SEC, we reviewed the carrying value +of our proved oil and gas properties each quarter on a country-by-country basis. +Under these rules, capitalized costs of proved oil and gas properties net of +accumulated depreciation, depletion and amortization (DD&A) and deferred income +taxes, may not exceed the present value of our estimated future net cash flows +from proved oil and gas reserves, discounted at 10 percent, plus the lower of +cost or fair value of unproved properties included in the costs being amortized, +net of related tax effects. These rules generally require pricing future oil and +gas production at the unescalated market price for oil and gas at the end of +each fiscal quarter and require a write-down if the "ceiling" is exceeded, +unless prices recover sufficiently before the date of our auditor's report. +Given the volatility of oil and gas prices, it is reasonably possible that our +estimates of discounted future net cash flows from proved oil and gas reserves +could change in the near term. If oil and gas priced decline significantly, even +if only for a short period of time, it is possible that writedowns of oil and +gas properties could occur in the future. Based on prices at December 31, 2001 +we would have been required to writedown our assets by $37.5 million. However, +as of the date of our auditor's report, commodity prices increased sufficiently +to eliminate any writedown. +Upon the acquisition or discovery of oil and gas properties, we estimate the +future net costs to be incurred to dismantle, abandon and restore the property +using geological, engineering and regulatory data available. Such cost estimates +are periodically updated for changes in conditions and requirements. Such +estimated amounts are considered as part of the full cost pool subject to +amortization upon acquisition or discovery. Such costs are capitalized as oil +and gas properties as the actual restoration, dismantlement and abandonment +activities take place. These cost estimates, if revised upward for future +changes, could increase our depletion rate. +The estimates used to calculate our oil and gas reserves are imprecise and are +based on assumptions about future production levels, prices and future operating +costs. As a result, the quantity of our proved reserves may be subject to +downward or upward adjustment as additional information or analysis become +available. In addition, estimates of the economically recoverable oil and gas +reserves, classifications of such reserves, +24 +and estimates of future net cash flows, prepared by different engineers or by +the same engineers at different times, may vary substantially. In particular, +the assumptions regarding the timing and costs to commence production from our +deepwater wells used in preparing our reserves are subject to revisions over +time. These assumptions could affect quantities used to calculate depletion and +any significant revisions to our reserves could impact our depletion +computations. +DERIVATIVES. We use derivative financial instruments for price protection +purposes on a limited amount of our future production and do not use them for +trading purposes. Such derivatives were accounted for in years prior to 2001 as +hedges and have been recognized as an adjustment to oil and gas sales in the +period in which they are related. Current accounting treatment is under SFAS +133. +LIQUIDITY AND CAPITAL RESOURCES +Our primary sources of capital are cash flows from operations, borrowings from +financial institutions and the sale of debt and equity securities. Net cash and +cash equivalents decreased during 2001 by $5.0 million. Cash provided from +operating activities during 2001 totaled $35.2 million. Dividends paid on +preferred stock were $1.3 million. Average debt outstanding was $164.9 million +during 2001 compared to $118.3 million in 2000. At December 31, 2001, we had +working capital of $.4 million, excluding current maturities of long-term debt +and liabilities to be refinanced. +In May 2001, we initiated a combination of offerings of equity and senior notes +to investors with proceeds to be used to call certain of our subordinated debt, +repay borrowings under our senior secured credit facility and to finance capital +expenditures. Subsequently, we withdrew our offer to sell the senior notes and +the equity sale was terminated. Approximately $358,000 of costs associated with +the withdrawn offering were expensed during the second quarter. +In early July of 2001, we closed a $95 million multiple advance term loan with a +private lender. We drew $45 million on July 3, 2001 and paid down our revolving +Credit Facility. We drew the remaining $50 million in December 2001. Under the +terms of the agreement, we also issued warrants for the purchase, at a nominal +exercise price, of 265,210 shares of our common stock to the lender and conveyed +an overriding royalty interest equal to 2% of our net interest in four of our +deepwater discoveries. The warrants and the overriding royalty interest were +earned by the lender based on the ratio of the amount of the loan proceeds +advanced to the total loan facility amount. This senior debt will mature March +31, 2005 and contains restrictions on certain types of future indebtedness and +dividends on common stock. +Effective October 31, 2000, we entered into a $75 million Credit Facility with +First Union National Bank. Borrowings under the Credit Facility are secured by +mortgages covering substantially all of our producing oil and gas properties and +guaranteed by our subsidiaries. The Credit Facility currently provides for a $50 +million borrowing base ("Borrowing Base"), which is adjusted periodically on the +basis of a discounted present value of future net cash flows attributable to our +proved producing oil and gas reserves as determined by the bank. We may borrow, +pay, reborrow and repay under the Credit Facility until July 31, 2002, on which +date, we must repay in full all amounts then outstanding. The maturity date can +be extended to July 31, 2004 if redemption of the 10.125% Senior Subordinated +Notes due September 15, 2002 is completed prior to July 31, 2002. We expect to +redeem or extend the Notes due in September 2002 prior to their maturity and +anticipate extensions of maturity of the Credit Facility to July 2004. At +December 31, 2001, availability under the Credit Facility was $50 million. +25 +The Credit Facility and the subordinated debt contain various covenants +including restrictions on additional indebtedness and payment of cash dividends +as well as maintenance of certain financial ratios. We are in compliance with +these covenants at December 31, 2001. +Our plans for 2002 include non-discretionary capital expenditures of $50 +million. Approximately $23 million of the investment will be allocated to the +development of two of our deepwater discoveries. Our non-discretionary +expenditure on the shelf includes the completion of a production acceleration +project in the Mobile Block 864 area, well completions for 2001 discoveries and +other commitments to existing properties. +Cash flow and current availability under the Credit Facility, subject to the +maturity of the same as discussed above, is expected to be sufficient to fund +our 2002 non-discretionary capital expenditures. These expenditures include +completion of the Medusa deepwater discovery, currently scheduled to begin +production late in the fourth quarter of 2002 or early 2003. We are currently +evaluating options for redeeming the Senior Subordinated Notes due 2002. These +options include, but are not limited to, (i) negotiated extensions of the +maturity of a portion of these notes, (ii) increased availability under the +Credit Facility and (iii) the issuance of additional Senior Notes. +We anticipate that these options would provide necessary capital to enable us to +continue our operational activities until such time as production from the +Medusa discovery begins. At that time, we anticipate the inclusion of the Medusa +reserves and production will be integrated in our borrowing base from our Credit +Facility and provide available borrowing capacity as well as cash flow from the +new production for future discretionary capital expenditures. +Options currently under consideration to provide longer-term liquidity include +(i) the sale of one of our deepwater discoveries, (ii) lease or similar +financing of our deepwater infrastructure particularly at Medusa and (iii) the +sale of common equity. +The following table describes our outstanding contractual obligations (in +thousands) as of December 31, 2001: +CONTRACTUAL LESS THAN ONE-THREE FOUR-FIVE AFTER-FIVE +OBLIGATIONS TOTAL ONE YEAR YEARS YEARS YEARS +----------- ------- --------- --------- --------- ---------- +Credit Facility $ 100 $ 100 -- -- -- +Senior Notes 95,000 -- -- $ 95,000 -- +10.125% Senior +Subordinated Debt 36,000 36,000 -- -- -- +10.25% Senior -- -- -- +Subordinated Debt 40,000 -- $ 40,000 -- -- +11% Senior Subordinated Debt 33,000 -- -- 33,000 -- +Capital lease (future minimum payments) 8,413 2,175 3,863 1,138 $ 1,237 +26 +RESULTS OF OPERATIONS +The following table sets forth certain operating information with respect to our +oil and gas operations for each of the three years in the period ended December +31, 2001. +DECEMBER 31, +---------------------------------- +2001(a)(b) 2000(a)(b) 1999(a)(b) +---------- ---------- ---------- +Production: +Oil (MBbls) 273 232 330 +Gas (MMcf) 13,566 13,943 14,606 +Total production (MMcfe) 15,206 15,334 16,589 +Average daily production (MMcfe) 41.7 41.9 45.5 +Average sales price: +Oil (per Bbl) $ 22.95 $ 27.88 $ 12.16 +Gas (per Mcf) $ 3.96 $ 3.57 $ 2.27 +Total production (per Mcfe) $ 3.95 $ 3.67 $ 2.24 +Average costs (per Mcfe): +Lease operating expenses $ .73 $ .61 $ .46 +Depletion $ 1.37 $ 1.10 $ .99 +General and administrative (net of management fees) $ .30 $ .27 $ .28 +(a) Includes hedging gains and losses. +(b) Includes volumes of 2,300 MMcf for each of the years 2001 and 2000 and +volumes of 1,300 MMcf in 1999, at an average price of $2.08 per Mcf +associated with a volumetric production payment. +27 +COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2001 AND +2000 +OIL AND GAS REVENUES +Oil and gas revenues for 2001 were $60.0 million, a 7% increase from the 2000 +amount of $56.3 million. However, 2001 oil and gas production of 15,206 MMcfe +decreased slightly from the 2000 amount of 15,334 MMcfe. +Oil production increased from 232,000 barrels in 2000 to 273,000 barrels in 2001 +but the average sales price decreased from $27.88 in 2000 to $22.95 in 2001. As +a result, oil revenues dropped from $6.5 million in 2000 to $6.3 million in +2001. The production increase was primarily from increased oil production at +South Marsh Island 261 offset by older properties' normal and expected decline +in production. The slight decrease in oil revenue was due to the decline in +average oil prices received in 2001. +Gas revenues for 2001 were $53.7 million based on sales of 13.6 Bcf at an +average sales price of $3.96 per Mcf. For 2000, gas revenues were $49.8 million +based on production of 13.9 Bcf sold at an average sales price of $3.57 per Mcf. +Our gas production in 2001 decreased when compared to last year as a result of +production declines at East Cameron 275 and South Marsh Island 261, offset by +increases in production at Mobile Block 864 and Chandeleur Block 40. The +production declines at East Cameron 275 and South Marsh Island 261 were normal +and expected as the 2000 rates were indicative of higher initial production. The +Mobile Block 864 Area increased production due to a well stimulation program as +well additions to production through exploratory and developmental drilling on +the property. Gas revenue increased due to higher prices received for production +in 2001. +LEASE OPERATING EXPENSES +Lease operating expenses increased from $9.3 million ($.61 per Mcfe) in 2000 to +$11.3 million ($.73 per Mcfe) in 2001. The increase was attributable to higher +operating costs at South Marsh Island 261 and at Mobile Block 864. Also, +production declines related to older properties that have relatively fixed +operating costs contributed to the higher per Mcf costs with lower production +levels for those properties in 2001. +WRITEDOWN OF ENRON DERIVATIVES +In April of 2001, we entered into derivative contracts for 2002 production with +Enron North America Corp. Enron North America Corp. filed for protection under +the bankruptcy laws in late 2001. As a result of the credit risk associated with +the derivatives with Enron North America Corp., hedge accounting was not +available due to ineffectiveness as of September 30, 2001 and the contracts at +December 31, 2001 have been marked to the market. In the fourth quarter of 2001, +we charged to expense (non-cash) $9.2 million related to these Enron North +America Corp. derivatives. We have no other contracts with Enron or their +related subsidiaries. +DEPRECIATION, DEPLETION AND AMORTIZATION +Depreciation, depletion and amortization increased by 23% due to a combination +of an increase in the amortization base due to higher drilling costs with +reserve additions being less than expected from exploration efforts in 2001 and +downward reserve revisions as a result of a field delineation program at +Habanero. +28 +Total charges increased from $17.2 million, or $1.12 per Mcfe in 2000 to $21.1 +million, or $1.39 per Mcfe in 2001. +GENERAL AND ADMINISTRATIVE +General and administrative expenses for 2001 were $4.6 million, or $.30 per +Mcfe, compared to $4.2 million, or $.27 per Mcfe, in 2000. This increase was due +primarily to expenses incurred in the second quarter of 2001 related to our +withdrawn debt offering. +INTEREST EXPENSE +Interest expense for 2001 was $12.8 million increasing from $8.4 million in +2000. This is a result of an increase in our long-term debt as well as higher +interest rates associated with additional debt incurred in 2001. +INCOME TAXES +Our 2001 results include a deferred income tax expense of $977,000. We evaluated +the deferred income tax asset in light of its reserve quantity estimates, its +long-term outlook for oil and gas prices and its expected level of future +revenues and expenses. We believe it is more likely than not, based upon this +evaluation, that it will realize the recorded deferred income tax asset. +However, there is no assurance that such asset will ultimately be realized. +COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2000 AND +1999 +OIL AND GAS REVENUES +Oil and gas revenues for 2000 were $56.3 million, a 52% increase from the 1999 +amount of $37.1 million. However, 2000 oil and gas production of 15,334 MMcfe +decreased by 8% from the 1999 amount of 16,589 MMcfe. +Oil production decreased from 330,000 barrels in 1999 to 232,000 barrels in 2000 +but the average sales price increased from $12.16 in 1999 to $27.88 in 2000. As +a result, oil revenues went from $4.0 million in 1999 to $6.5 million in 2000. +The decrease in oil production was primarily from older properties' normal and +expected decline in production and the depletion of Main Pass 31. The +significant increase in oil revenue was due to the price of oil received for +2000 oil production more than doubling over 1999 average prices. +Gas revenues for 2000 were $49.8 million based on sales of 13.9 Bcf at an +average sales price of $3.57 per Mcf. For 1999, gas revenues were $33.1 million +based on production of 14.6 Bcf sold at an average sales price of $2.27 per Mcf. +When compared to 1999, production decreased due to a combination of older +properties' normal and expected decline in production and the depletion of Main +Pass 31. This decrease was offset by production gains at East Cameron Block 275 +and South Marsh Island 261 as they began production in early 2000. East Cameron +Block 275 experienced a significant drop in the fourth quarter of 2000 due to +work on the host platform, which caused the well to be shut in for the entire +quarter. This property was back online in January 2001 and currently is +producing at or near levels prior to the shut-in. Gas revenue increased due to +higher prices received for production in 2000, especially in the fourth quarter, +compared to 1999 offset by the 5% decline in gas production. +29 +LEASE OPERATING EXPENSES AND SEVERANCE TAXES +Lease operating expenses, including severance taxes, increased from $7.5 million +($.46 per Mcfe) in 1999 to $9.3 million ($.61 per Mcfe) in 2000. The increase +per Mcfe is primarily attributable to production declines in 2000 related to +older properties that have relatively fixed operating costs, which contributed +to the higher per Mcf costs. +DEPRECIATION, DEPLETION AND AMORTIZATION +Depreciation, depletion and amortization increased by almost 3% due to an +increase in the amortization base by 56%, primarily as a result of increased +future development costs over 1999 offset by a 28% increase in reserves and by a +decrease in production. +Total charges increased from $16.7 million, or $1.01 per Mcfe in 1999 to $17.2 +million, or $1.12 per Mcfe in 2000. +GENERAL AND ADMINISTRATIVE +General and administrative expenses for 2000 were $4.2 million, or $.27 per +Mcfe, compared to $4.6 million, or $.28 per Mcfe, in 1999. This 9% decrease is +primarily due to an increase in direct overhead allocable to employees engaged +in the acquisition, exploration and development of oil and gas properties in +2000. +INTEREST EXPENSE +Interest expense for 2000 and 1999 was $8.4 million and $6.2 million, +respectively. This increase is a result of the increase in interest rates and in +average debt outstanding in 2000 versus 1999. This average debt outstanding +increase is directly related to the Senior Subordinated Notes issued in October +2000 and borrowings under the Credit Facility during the year. +INCOME TAXES +Our 2000 results include a deferred income tax expense of $6.5 million. We have +evaluated the deferred income tax asset in light of our reserve quantity +estimates, our long-term outlook for oil and gas prices and our expected level +of future revenues and expenses. We believe it is more likely than not, based +upon this evaluation, that we will realize the recorded deferred income tax +asset. However, there is no assurance that such asset will ultimately be +realized. +30 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS +Our revenues are derived from the sale of our crude oil and natural gas +production. From time to time, we have entered into hedging transactions that +lock in for specified periods the prices we will receive for the production +volumes to which the hedge relates. The hedges reduce exposure on the hedged +volumes to decreases in commodities prices and limit the benefit might otherwise +have received from any increases in commodities prices on the hedged volumes. +We have put options in effect for 2002, other than those certain Enron North +America Corp. derivatives discussed previously under Management Discussion and +Analysis of Financial Condition and Results of Operation-Comparison of Results +of Operations for the Years Ended December 31, 2001 and 2000 and in Note 6 of +the financial statements. In March 2002, we purchased put options, which +established an average floor price of $2.65 per Mcf on 6.1 Bcf of production +from April 2002 through September 2002. +Based on projected annual sales volumes for 2002 (excluding forecast production +increases over 2001), a 10% decline in the prices we receive for our crude oil +and natural gas production would have an approximate $4.0 million impact on our +revenues. +31 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +---- +Report of Independent Public Accountants 33 +Consolidated Balance Sheets as of December 31, 2001 34 +and 2000 +Consolidated Statements of Operations for Each of the Three Years +in the Period Ended December 31, 2001 35 +Consolidated Statements of Stockholders' Equity +for Each of the Three Years in the Period Ended December 31, 2001 36 +Consolidated Statements of Cash Flows for Each of the Three Years +in the Period Ended December 31, 2001 37 +Notes to Consolidated Financial Statements 38 +32 +REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS +To the Stockholders and Board of Directors of Callon Petroleum Company: +We have audited the accompanying consolidated balance sheets of Callon +Petroleum Company (a Delaware corporation) and subsidiaries as of December 31, +2001 and 2000, and the related consolidated statements of operations, +stockholders' equity and cash flows for each of the three years in the period +ended December 31, 2001. These financial statements are the responsibility of +the Company's management. Our responsibility is to express an opinion on these +financial statements based on our audits. +We conducted our audits in accordance with auditing standards generally +accepted in the United States. Those standards require that we plan and perform +the audit to obtain reasonable assurance about whether the financial statements +are free of material misstatement. An audit includes examining, on a test basis, +evidence supporting the amounts and disclosures in the financial statements. An +audit also includes assessing the accounting principles used and significant +estimates made by management, as well as evaluating the overall financial +statement presentation. We believe that our audits provide a reasonable basis +for our opinion. +In our opinion, the financial statements referred to above present fairly, +in all material respects, the financial position of Callon Petroleum Company and +subsidiaries, as of December 31, 2001 and 2000, and the results of their +operations and their cash flows for each of the three years in the period ended +December 31, 2001, in conformity with accounting principles generally accepted +in the United States. +As discussed in Note 2 to the consolidated financial statements effective +January 1, 2001, the Company adopted SFAS 133, "Accounting for Derivative +Instruments and Hedging Activities." +ARTHUR ANDERSEN LLP +New Orleans, Louisiana +March 29, 2002 +33 +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(IN THOUSANDS, EXCEPT SHARE DATA) +DECEMBER 31, +-------------------------- +2001 2000 +---------- ---------- +ASSETS +Current assets: +Cash and cash equivalents $ 6,887 $ 11,876 +Accounts receivable 5,908 9,244 +Advance to operators -- 1,131 +Other current assets 209 207 +---------- ---------- +Total current assets 13,004 22,458 +---------- ---------- +Oil and gas properties, full-cost accounting method: +Evaluated properties 704,937 589,549 +Less accumulated depreciation, depletion and amortization (399,339) (378,589) +---------- ---------- +305,598 210,960 +Unevaluated properties excluded from amortization 37,560 47,653 +---------- ---------- +Total oil and gas properties 343,158 258,613 +---------- ---------- +Pipeline and other facilities, net 5,364 5,537 +Other property and equipment, net 2,455 1,790 +Deferred tax asset 4,399 8,573 +Long-term gas balancing receivable 473 643 +Other assets, net 3,242 3,955 +---------- ---------- +Total assets $ 372,095 $ 301,569 +========== ========== +LIABILITIES AND STOCKHOLDERS' EQUITY +Current liabilities: +Accounts payable and accrued liabilities $ 9,985 $ 17,842 +Undistributed oil and gas revenues 1,131 1,411 +Accrued net profits interest payable 1,501 2,146 +Accounts payable and accrued liabilities to be refinanced 9,558 -- +Current maturities of long-term debt 37,345 -- +---------- ---------- +Total current liabilities 59,520 21,399 +---------- ---------- +Long-term debt-excluding current maturities 161,733 134,000 +Deferred revenue on sale of production payment 2,406 7,236 +Accrued retirement benefits 137 1,886 +Long-term gas balancing payable 1,075 720 +---------- ---------- +Total liabilities 224,871 165,241 +---------- ---------- +Stockholders' equity: +Preferred Stock, $.01 par value; 2,500,000 shares +authorized; 600,861 shares of Convertible +Exchangeable Preferred Stock, Series A issued +and outstanding at December 31, 2001 +with a liquidation preference of $15,021,525 6 6 +Common Stock, $.01 par value; 20,000,000 shares +authorized; 13,397,706 and 13,327,675 shares +outstanding at December 31, 2001 and 2000, respectively 134 133 +Treasury stock (99,078 shares at cost) (1,183) (1,183) +Capital in excess of par value 155,608 151,223 +Accumulated other comprehensive income 5,971 -- +Retained earnings (deficit) (13,312) (13,851) +---------- ---------- +Total stockholders' equity 147,224 136,328 +---------- ---------- +Total liabilities and stockholders' equity $ 372,095 $ 301,569 +========== ========== +The accompanying notes are an integral part of these financial statements. +34 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF OPERATIONS +FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 +(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) +2001 2000 1999 +-------- -------- -------- +Revenues: +Oil and gas sales $ 60,010 $ 56,310 $ 37,140 +Interest and other 1,742 1,767 1,853 +-------- -------- -------- +Total revenues 61,752 58,077 38,993 +-------- -------- -------- +Costs and expenses: +Lease operating expenses 11,252 9,339 7,536 +Depreciation, depletion and amortization 21,081 17,153 16,727 +General and administrative 4,635 4,155 4,575 +Writedown of Enron derivatives 9,186 -- -- +Interest 12,805 8,420 6,175 +-------- -------- -------- +Total costs and expenses 58,959 39,067 35,013 +-------- -------- -------- +Income from operations 2,793 19,010 3,980 +Income tax expense 977 6,463 1,353 +-------- -------- -------- +Net income 1,816 12,547 2,627 +Preferred stock dividends 1,277 2,403 2,497 +-------- -------- -------- +Net income available to common shares $ 539 $ 10,144 $ 130 +======== ======== ======== +Net income per common share: +Basic $ .04 $ .82 $ .01 +======== ======== ======== +Diluted $ .04 $ .80 $ .01 +======== ======== ======== +Shares used in computing net income per common share: +Basic 13,273 12,420 8,976 +======== ======== ======== +Diluted 13,366 12,745 9,075 +======== ======== ======== +The accompanying notes are an integral part of these financial statements. +35 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY +(IN THOUSANDS) +ACCUMULATED TOTAL +CAPITAL IN OTHER RETAINED STOCK- +PREFERRED COMMON TREASURY EXCESS OF COMPREHENSIVE EARNINGS HOLDER'S +STOCK STOCK STOCK PAR VALUE INCOME (DEFICIT) EQUITY +--------- ------ -------- ---------- ------------- --------- -------- +Balances, December 31, 1998 $ 13 $ 82 $ (915) $ 109,429 $ -- $ (24,125) $ 84,484 +--------- ------ -------- ---------- ------- --------- -------- +Net income -- -- -- -- -- 2,627 2,627 +Sale of common stock -- 37 -- 40,994 -- -- 41,031 +Preferred stock dividends -- -- -- -- -- (2,222) (2,222) +Shares issued pursuant to employee +benefit and option plan -- -- -- 274 -- -- 274 +Employee stock purchase plan -- -- -- 67 -- -- 67 +Restricted stock plan -- (2) -- (1,613) -- -- (1,615) +Conversion of preferred shares +to common stock (2) 5 -- 274 -- (275) 2 +Stock buyback plan -- -- (268) -- -- -- (268) +--------- ------ -------- ---------- ------- --------- -------- +Balances, December 31, 1999 11 122 (1,183) 149,425 -- (23,995) 124,380 +--------- ------ -------- ---------- ------- --------- -------- +Net income -- -- -- -- -- 12,547 12,547 +Preferred stock dividends -- -- -- -- -- (1,978) (1,978) +Shares issued pursuant to employee +benefit and option plan -- -- -- 1,069 -- -- 1,069 +Employee stock purchase plan -- -- -- 269 -- -- 269 +Tax benefits related to stock +compensation plans -- -- -- 41 -- -- 41 +Conversion of preferred shares to +common (5) 11 -- 419 -- (425) -- +--------- ------ -------- ---------- ------- --------- -------- +Balances, December 31, 2000 6 133 (1,183) 151,223 -- (13,851) 136,328 +--------- ------ -------- ---------- ------- --------- -------- +Comprehensive income: +Net income -- -- -- -- -- 1,816 +Other comprehensive income -- -- -- -- 5,971 -- +-------- +Total comprehensive income 7,787 +Preferred stock dividends -- -- -- -- -- (1,277) (1,277) +Shares issued pursuant to employee +benefit and option plan -- 1 -- 942 -- -- 943 +Employee stock purchase plan -- -- -- 357 -- -- 357 +Tax benefits related to stock +compensation plans -- -- -- 18 -- -- 18 +Warrants -- -- -- 3,068 -- -- 3,068 +--------- ------ -------- ---------- ------- --------- -------- +Balances, December 31, 2001 $ 6 $ 134 $ (1,183) $ 155,608 $ 5,971 $ (13,312) $147,224 +========= ====== ======== ========== ======= ========= ======== +The accompanying notes are an integral part of these financial statements. +36 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 +(IN THOUSANDS) +2001 2000 1999 +---------- ---------- ---------- +Cash flows from operating activities: +Net income $ 1,816 $ 12,547 $ 2,627 +Adjustments to reconcile net income (loss) to +cash provided by operating activities: +Depreciation, depletion and amortization 21,709 17,598 17,232 +Amortization of deferred costs 2,485 1,034 707 +Amortization of deferred production payment revenue (4,830) (4,844) (2,710) +Writedown of Enron derivatives 9,186 -- -- +Deferred income tax expense 977 6,463 1,353 +Noncash charge related to compensation plans 942 1,069 275 +Changes in current assets and liabilities: +Accounts receivable 3,336 (3,882) 662 +Advance to operators 1,131 (1,131) 1,271 +Other current assets (2) (18) (11) +Current liabilities (8,782) 1,077 1,981 +Increase in accounts payable and accrued liabilities to be refinanced 9,558 -- -- +Change in gas balancing receivable 170 (400) (44) +Change in gas balancing payable 355 204 27 +Change in other long-term liabilities (1,749) (221) (216) +Change in other assets, net (1,071) (751) (134) +---------- ---------- ---------- +Cash provided (used) by operating activities 35,231 28,745 23,020 +---------- ---------- ---------- +Cash flows from investing activities: +Capital expenditures (113,833) (81,849) (51,709) +Cash proceeds from sale of mineral interests 1,195 -- -- +---------- ---------- ---------- +Cash provided (used) by investing activities (112,638) (81,849) (51,709) +---------- ---------- ---------- +Cash flows from financing activities: +Equity issued related to employee stock plans 357 269 68 +Purchase of treasury shares -- -- (268) +Payment on debt (84,900) (29,250) (42,500) +Increase in debt 155,000 63,000 64,500 +Deferred financing costs (2,374) (1,496) (1,823) +Restricted stock plan -- -- (1,615) +Sale of common stock -- -- 41,031 +Capital lease 5,612 -- -- +Cash dividends on preferred stock (1,277) (2,214) (2,333) +---------- ---------- ---------- +Cash provided (used) by financing activities 72,418 30,309 57,060 +---------- ---------- ---------- +Net increase (decrease) in cash and cash equivalents (4,989) (22,795) 28,371 +Cash and cash equivalents: +Balance, beginning of period 11,876 34,671 6,300 +---------- ---------- ---------- +Balance, end of period $ 6,887 $ 11,876 $ 34,671 +========== ========== ========== +The accompanying notes are an integral part of these financial statements. +37 +CALLON PETROLEUM COMPANY +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +GENERAL +Callon Petroleum Company (the "Company") was organized under the laws of the +state of Delaware in March 1994 to serve as the surviving entity in the +consolidation and combination of several related entities (referred to herein +collectively as the "Constituent Entities"). The combination of the businesses +and properties of the Constituent Entities with the Company was completed on +September 16, 1994 (the "Consolidation"). +As a result of the Consolidation, all of the businesses and properties of the +Constituent Entities are owned (directly or indirectly) by the Company. Certain +registration rights were granted to the stockholders of certain of the +Constituent Entities. See Note 7. +The Company and its predecessors have been engaged in the acquisition, +development and exploration of crude oil and natural gas since 1950. The +Company's properties are geographically concentrated in Louisiana, Alabama, +Texas and offshore Gulf of Mexico. +LIQUIDITY AND CAPITAL RESOURCES +As discussed in Note 5, the $36.0 million of the 10.125% Senior Subordinated +Notes will mature on September 15, 2002. When these notes are extended or +redeemed, maturity of the Credit Facility, currently scheduled for July 31, +2002, can be extended until July 31, 2004. We are currently evaluating options +for redeeming the Senior Subordinated Notes due 2002. These options include, but +are not limited to, (i) negotiated extensions of the maturity of a portion of +these notes, (ii) increased availability under the Credit Facility and (iii) the +issuance of additional Senior Notes. +Capital commitments in 2002 include non-discretionary capital expenditures and +the redemption or extension of the $36.0 million of the 10.125% Senior +Subordinated Notes that will mature on September 15, 2002. Capital expenditures +include completion of the Medusa deepwater discovery, currently scheduled to +begin production late in the fourth quarter of 2002. The Company expects that, +in addition to cash flow generated during 2002 and current availability under +the Credit Facility, approximately $27 million of additional funding will be +required to finance our capital commitments. We expect these requirements to be +met through the options discussed above. As of March 27, 2002, the company has +obtained a commitment from holders of approximately $10 million of the Notes to +extend the maturity of the Notes until 2004. +We anticipate that these funding sources will provide necessary capital to +enable us to continue our operational activities until such time as production +from the Medusa discovery begins. At that time, we anticipate the inclusion of +the Medusa reserves and production will be integrated in our borrowing base from +our Credit Facility and provide available borrowing capacity as well as +significant additional cash flow from the new production for future +discretionary capital expenditures. +38 +Longer-term liquidity options currently under consideration include (i) the sale +of one of our deepwater discoveries, (ii) lease or similar financing of our +deepwater infrastructure, particularly at Medusa and (iii) the sale of common +equity. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +PRINCIPLES OF CONSOLIDATION AND REPORTING +The Consolidated Financial Statements include the accounts of the Company, and +its subsidiary, Callon Petroleum Operating Company ("CPOC"). CPOC also has +subsidiaries, namely Callon Offshore Production, Inc. and Mississippi Marketing, +Inc. All intercompany accounts and transactions have been eliminated. Certain +prior year amounts have been reclassified to conform to presentation in the +current year. +USE OF ESTIMATES +The preparation of financial statements in conformity with generally accepted +accounting principles requires management to make estimates and assumptions that +affect the reported amounts of assets and liabilities and disclosure of +contingent assets and liabilities at the date of the financial statements and +the reported amounts of revenues and expenses during the reporting period. +Actual results could differ from those estimates. +ACCOUNTING PRONOUNCEMENTS +In June 1998, the Financial Accounting Standards Board issued Statement of +Financial Accounting Standards No. 133 ("SFAS 133"), Accounting for Derivative +Instruments and Hedging Activities. The Statement establishes accounting and +reporting standards requiring that every derivative instrument, including +certain derivative instruments embedded in other contracts, be recorded in the +balance sheet as either an asset or liability measured at its fair value. The +Company adopted SFAS 133 effective January 1, 2001. +SFAS 133 requires the Company to report changes in the fair value of our +derivative financial instruments that qualify as cash flow hedges in other +comprehensive income, a component of stockholders' equity, until realized. See +Note 6 for a discussion of our derivative financial instruments. +As discussed in Note 1, the Company adopted SFAS 133 effective January 1, 2001. +The cumulative effect of the accounting change, net of tax, recorded as other +comprehensive loss was $3.8 million. In 2001, this amount was offset by an +increase in the fair value of derivatives recorded as other comprehensive income +and the settlement of the derivatives that contractually matured in 2001. +In July 2001, the Financial Accounting Standards Board approved Statement of +Accounting Standards No. 143, Asset Retirement Obligations ("SFAS 143"). SFAS +143 will require that the fair value of abandonment obligations be reflected as +a liability, resulting in a corresponding increase to the historical cost of the +related assets and potentially an adjustment for the cumulative effect of a +change in accounting principle. This standard is required to be adopted by the +Company beginning no later that January 1, 2003. The Company has not yet +determined timing or the impact of the adoption of SFAS 143. +39 +PROPERTY AND EQUIPMENT +The Company follows the full-cost method of accounting for oil and gas +properties whereby all costs incurred in connection with the acquisition, +exploration and development of oil and gas reserves, including certain overhead +costs, are capitalized. Such amounts include the cost of drilling and equipping +productive wells, dry hole costs, lease acquisition costs, delay rentals, +interest capitalized on unevaluated leases and other costs related to +exploration and development activities. Payroll and general and administrative +costs capitalized include salaries and related fringe benefits paid to employees +directly engaged in the acquisition, exploration and/or development of oil and +gas properties as well as other directly identifiable general and administrative +costs associated with such activities. Such capitalized costs do not include any +costs related to production or general corporate overhead. Costs associated with +unevaluated properties are excluded from amortization. Unevaluated property +costs are transferred to evaluated property costs at such time as wells are +completed on the properties, the properties are sold or management determines +these costs have been impaired. +Costs of properties, including future development and net future site +restoration, dismantlement and abandonment costs, which have proved reserves and +those which have been determined to be worthless, are depleted using the +unit-of-production method based on proved reserves. If the total capitalized +costs of oil and gas properties, net of amortization, exceed the sum of (1) the +estimated future net revenues from proved reserves at current prices and +discounted at 10% and (2) the lower of cost or market of unevaluated properties +(the full-cost ceiling amount), net of tax effects, then such excess is charged +to expense during the period in which the excess occurs. See Note 8. +Upon the acquisition or discovery of oil and gas properties, management +estimates the future net costs to be incurred to dismantle, abandon and restore +the property using geological, engineering and regulatory data available. Such +cost estimates are periodically updated for changes in conditions and +requirements. Such estimated amounts are considered as part of the full cost +pool subject to amortization upon acquisition or discovery. Such costs are +capitalized as oil and gas properties as the actual restoration, dismantlement +and abandonment activities take place. +Depreciation of other property and equipment is provided using the straight-line +method over estimated lives of three to 20 years. Depreciation of pipeline and +other facilities is provided using the straight-line method over estimated lives +of 15 to 27 years. +SALE OF PRODUCTION PAYMENT INTEREST +In June 1999, the Company acquired a working interest in the Mobile Block 864 +Area where the Company already owned an interest. Concurrent with this +acquisition, the seller received a volumetric production payment, valued at +approximately $14.8 million, from production attributable to a portion of the +Company's interest in the area over a 39-month period. The Company recorded a +liability associated with the sale of this production payment interest because a +substantial obligation for future performance exists. Under the terms of the +sale, the Company is obligated to deliver the production volumes free and clear +of royalties, lease operating expenses, production taxes and all capital costs. +The production payment was recorded at the present value of the volumetric +production committed to the seller at market value and, beginning in June 1999, +is amortized to oil and gas sales on the units-of-production method as +associated hydrocarbons are delivered and will expire in July 2002. +40 +NATURAL GAS IMBALANCES +The Company follows an entitlement method of accounting for its proportionate +share of gas production on a well-by-well basis, recording a receivable to the +extent that a well is in an "undertake" position and conversely recording a +liability to the extent that a well is in an "overtake" position. Imbalance +positions are not significant at December 31, 2001. +DERIVATIVES +The Company uses derivative financial instruments for price protection purposes +on a limited amount of its future production and does not use them for trading +purposes. Such derivatives were accounted for, prior to adoption of SFAS 133, as +hedges and have been recognized as an adjustment to oil and gas sales in the +period in which they are related. Current accounting treatment is under SFAS 133 +(see Note 6). +ACCOUNTS RECEIVABLE +Accounts receivable consists primarily of accrued oil and gas production +receivables. The balance in the reserve for doubtful accounts included in +accounts receivable was $68,000 and $78,000 at December 31, 2001 and 2000, +respectively. Net charge offs were $10,000 in 2001 and net recoveries were +$40,000 in 2000. There were no provisions to expense in the three-year period +ended December 31, 2001. +MAJOR CUSTOMERS +Our production is sold primarily on month-to-month contracts at prevailing +prices. The following table identifies customers to whom we sold a significant +percentage of our total oil and gas production during each of the twelve-month +periods ended: +DECEMBER 31, +------------ +2001 2000 1999 +---- ---- ---- +Adams Resources Marketing, Ltd. -- 14% 16% +Columbia Energy Services -- -- 29% +Dynegy 8% -- 12% +Prior Energy Corporation 20% -- -- +Reliant Energy Services 49% 37% -- +Unocal Exploration Corporation -- 8% -- +Because alternative purchasers of oil and gas are readily available, we believe +that the loss of any of these purchasers would not result in a material adverse +effect on our ability to market future oil and gas production. +STATEMENTS OF CASH FLOWS +For purposes of the Consolidated Financial Statements, the Company considers all +highly liquid investments purchased with an original maturity of three months or +less to be cash equivalents. +41 +The Company paid no federal income taxes for the three years ended December 31, +2001. During the years ended December 31, 2001, 2000 and 1999, the Company made +cash payments of $16,441,000, $11,449,000 and $9,013,000 respectively, for +interest. +PER SHARE AMOUNTS +Basic income or loss per common share were computed by dividing net income or +loss by the weighted average number of shares of common stock outstanding during +the year. Diluted income or loss per common share was determined on a weighted +average basis using common shares issued and outstanding adjusted for the effect +of stock options considered common stock equivalents computed using the treasury +stock method. The conversion of the preferred stock was not included in any +annual calculation due to its antidilutive effect on diluted income or loss per +common share. +A reconciliation of the basic and diluted per share computation is as follows +(in thousands, except per share amounts): +2001 2000 1999 +-------- -------- -------- +(a) Net income available for common stock $ 539 $ 10,144 $ 130 +Preferred dividends assuming conversion of +preferred stock (if dilutive) -- -- -- +(b) Income available for common stock assuming +conversion of preferred stock (if dilutive) $ 539 $ 10,144 $ 130 +(c) Weighted average shares outstanding 13,273 12,420 8,976 +Dilutive impact of stock options 27 325 99 +Dilutive impact of warrants 66 -- -- +Convertible preferred stock (if dilutive) -- -- -- +(d) Total diluted shares 13,366 12,745 9,075 +Stock options and warrants excluded due to +antidilutive impact 1,438 150 590 +Basic income per share (a/c) $ .04 $ .82 $ .01 +Diluted income per share (b/d) $ .04 $ .80 $ .01 +FAIR VALUE OF FINANCIAL INSTRUMENTS +Fair value of cash, cash equivalents, accounts receivable, accounts payable, the +capital lease and the Credit Facility approximates book value at December 31, +2001 and 2000. Fair value of long-term debt (specifically, the 10.125%, the +10.25%, the 11% Senior Subordinated Notes and the 12% Senior Notes) have an +estimated fair value of between 95% and 97% of face value at December 31, 2001. +3. INCOME TAXES +The Company follows the asset and liability method of accounting for deferred +income taxes prescribed by Statement of Financial Accounting Standards No. 109 +("SFAS 109") "Accounting for Income Taxes". The statement provides for the +recognition of a deferred tax asset for deductible temporary timing differences, +capital and operating loss carryforwards, statutory depletion carryforward and +tax credit carryforwards, net of +42 +a "valuation allowance". The valuation allowance is provided for that portion of +the asset, for which it is deemed more likely than not, that it will not be +realized. The Company's management determined that no valuation allowance was +required in 2001 or 2000. Accordingly, the Company has recorded a deferred tax +asset at December 31, 2001 and 2000 as follows: +DECEMBER 31, +------------ +2001 2000 +---------- ---------- +(IN THOUSANDS) +Federal net operating loss carryforwards $ 29,723 $ 14,352 +Statutory depletion carryforward 4,184 4,152 +Temporary differences: +Oil and gas properties (28,685) (8,937) +Pipeline and other facilities (1,822) (1,938) +Non-oil and gas property (62) (81) +Other 1,061 1,025 +---------- ---------- +Total tax asset 4,399 8,573 +Valuation allowance -- -- +---------- ---------- +Net tax asset $ 4,399 $ 8,573 +========== ========== +At December 31, 2001, the Company had, for federal tax reporting purposes, net +operating loss carryforwards of $84.9 million, which expire in 2002 through +2016. Net operating loss carryforwards includes approximately $1.5 million of +the total that will expire within the next five years. Additionally, the Company +had available for tax reporting purposes $11.9 million in statutory depletion +deductions, which can be carried forward for an indefinite period. +The Company has significant state net operating loss carryforwards that are not +included in the deferred tax asset above, as the Company does not anticipate +generating taxable state income in the states in which these loss carryforwards +apply. The Company has very limited state taxable income as primarily all of its +revenue is generated in federal waters not subject to state income taxes. +The provision for income taxes at the Company's effective tax rate approximated +the provision for income taxes at the statutory rate. +4. OTHER COMPREHENSIVE INCOME +The Company did not have any items of other comprehensive income prior to 2001. +A recap of the Company's 2001 comprehensive income (net of tax) is shown below +(in thousands): +YEAR ENDED +DECEMBER 31, 2001 +----------------- +Other comprehensive income (loss): +Cumulative effect of change in +accounting principle $(3,764) +Change in unrealized derivatives' +fair value 9,735 +------- +Total other comprehensive income $ 5,971 +======= +43 +5. LONG-TERM DEBT +Long-term debt consisted of the following at: +DECEMBER 31, +------------ +2001 2000 +---------- ---------- +(IN THOUSANDS) +Credit Facility $ 100 $ 25,000 +Senior Notes, net of discount 84,366 -- +10.125% Senior Subordinated Notes (due 2002) 36,000 36,000 +10.25% Senior Subordinated Notes (due 2004) 40,000 40,000 +11% Senior Subordinated Notes (due 2005) 33,000 33,000 +Capital lease 5,612 -- +---------- ---------- +199,078 134,000 +Less: current portion 37,345 -- +---------- ---------- +$ 161,733 $ 134,000 +========== ========== +The Company negotiated a new Credit Facility effective October 31, 2000 with +First Union National Bank. Borrowings under the Credit Facility are secured by +mortgages covering substantially all of the Company's producing oil and gas +properties. Currently, the Credit Facility is for $75 million with an initial +$50 million borrowing base ("Borrowing Base"), which is adjusted periodically on +the basis of a discounted present value of future net cash flows attributable to +the Company's proved producing oil and gas reserves. Pursuant to the Credit +Facility, the interest rate is equal to the lender's prime rate plus 0.25%. The +Company, at its option, may fix the interest rate on all or a portion of the +outstanding principal balance at 1.5% to 2.0% above a defined "Eurodollar" rate +for periods up to six months depending on borrowing base utilization. The +weighted average interest rate for the Credit Facility debt outstanding at +December 31, 2001 and 2000 was 4.75% and 8.53%, respectively. Under the Credit +Facility, a commitment fee of 0.25% or 0.375% per annum, depending on the amount +of the unused portion of the borrowing base, is payable quarterly. The Company +may borrow, pay, reborrow and repay under the Credit Facility until July 31, +2002 up to the borrowing base amount, on which date, the Company must repay in +full all amounts then outstanding. The maturity date will extend to July 31, +2004 upon redemption of the 10.125% Senior Subordinated Notes due September 15, +2002. +On July 31, 1997, the Company issued $36 million of its 10.125% Series A Senior +Subordinated Notes due September 15, 2002. Interest on the 10.125% Notes is +payable quarterly, on March 15, June 15, September 15, and December 15 of each +year. The 10.125% Notes are redeemable at the option of the Company in whole or +in part, at any time on or after September 15, 2000. The 10.125% Notes are +general unsecured obligations of the Company, subordinated in right of payment +to all existing and future indebtedness of the Company. The 10.125% Senior +Subordinated Notes due September 15, 2002 have been classified as a current +liability. +44 +On July 15, 1999, the Company completed the sale of $40 million of Senior +Subordinated Notes due 2004 at 10.25%. The net proceeds of approximately $38.2 +million were used to pay down the Credit Facility at that time. These notes are +not entitled to any mandatory sinking fund payments and are subject to +redemption at the Company's option at par plus unpaid interest at any time after +March 15, 2001. The notes are listed on the New York Stock Exchange under the +symbol "CPE 04" and are subject to a change of control clause that obligates the +Company to repurchase the notes for 101% of par should a change of control +occur. Interest is paid quarterly. +The Company completed the sale of $33 million of 11% Senior Subordinated Notes +due 2005, on October 26, 2000. The Company netted $31.5 million from the +offering after deducting the underwriters' discount and offering expenses. +Approximately $20.8 million of the net proceeds from the offering were used to +purchase a portion of the Company's outstanding 10% Senior Subordinated Notes +due 2001 in conjunction with a tender offer. The Company redeemed the remaining +$3.4 million of its 10% Senior Subordinated Notes due 2001 not tendered in the +offer. +In May 2001, the Company initiated a combination of offerings of equity and +senior notes to investors with proceeds to be used to call certain of the +Company's subordinated debt, repay borrowings under its senior secured credit +facility and to finance capital expenditures. Subsequently, the Company withdrew +its offer to sell the senior notes and the equity sale was terminated. +Approximately $358,000 of costs associated with the withdrawn offering were +expensed during the quarter. +In July 2001, the Company entered into a $95 million multiple advance term loan +with a private lender. The Company issued $45 million of 12% Senior Notes upon +closing of the loan and issued the remaining $50 million of Senior Notes in +December 2001. Under the terms of the agreement Callon also issued warrants to +purchase, at a nominal exercise price, 265,210 shares of its common stock (fair +value of $3.1 million) and conveyed an overriding royalty interest equal to 2% +of the Company's net interest in four existing deepwater discoveries (fair value +of $5.9 million). The warrants and the overriding royalty interest were earned +by the lender based on the ratio of the amount of the loan proceeds advanced to +the total loan facility amount. The Senior Notes will mature March 31, 2005, +have an effective interest rate of approximately 16% and contain restrictions on +certain types of future indebtedness. +In December 2001, the Company entered into a ten-year gas processing agreement +associated with a production facility on Callon's Mobile 952 field with Hanover +Compression Limited Partnership, which is being accounted for as a capital +lease. Total minimum obligations are $8.4 million with interest representing +approximately $2.8 million and the present value minimum obligation were $5.6 +million ($1.2 million current). +Future minimum lease payments and debt maturities (in thousands) are as follows: +CAPITAL LEASE +YEAR PAYMENTS DEBT +---- ------------- -------- +2002 $ 2,175 $ 36,100 +2003 1,982 -- +2004 1,881 40,000 +2005 752 128,000 +2006 413 -- +Thereafter 1,236 -- +45 +The Credit Facility, the subordinated debt and the $95 million Senior Notes +contain various covenants including restrictions on additional indebtedness and +payment of cash dividends as well as maintenance of certain financial ratios. +The Company is in compliance with these covenants at December 31, 2001. +6. HEDGING CONTRACTS +The Company periodically uses derivative financial instruments to manage oil and +gas price risk. Settlements of gains and losses on commodity price contracts are +generally based upon the difference between the contract price or prices +specified in the derivative instrument and a NYMEX price or other cash or +futures index price. Approximately $3,290,000 and $1,559,000 were recognized as +a reduction of oil and gas revenue in 2000 and 1999 respectively, and $1,371,000 +was recognized as additional oil and gas revenue in 2001 as a result of such +agreements. +In March 2002, the Company purchased put options, which established an average +floor price of $2.65 per Mcf on 6.1 Bcf of production from April 2002 through +September 2002. +In April of 2001, the Company entered into derivative contracts for 2002 +production with Enron North America Corp. These agreements are for average gas +volumes of approximately 600,000 Mcf per month in 2002 with a weighted average +ceiling price of $6.09 and floor price of $4.11. Enron North America Corp. filed +for protection under the bankruptcy laws in late 2001. As a result of the credit +risk associated with the derivatives with Enron North America Corp., hedge +accounting was not available due to ineffectiveness as of September 30, 2001 and +the contracts at December 31, 2001 have been marked to the market. In the fourth +quarter of 2001, the Company charged to expense (non-cash) $9.2 million related +to these Enron North America Corp. derivatives. The Company has no other +contracts with Enron or its subsidiaries. +The $5,971,000 (net of tax) recorded in other comprehensive income at December +31, 2001 is related to the fair value as of September 30, 2001 of the natural +gas collar contracts with Enron North America Corp., which matures in 2002. As +the contracts mature in 2002, the Company will record non-cash revenue each +month, offsetting the amounts in other comprehensive income related to the +derivatives. +The Company has no other derivative contracts. +7. COMMITMENTS AND CONTINGENCIES +As described in Note 9, abandonment trusts (the "Trusts") have been established +for future abandonment obligations of those oil and gas properties of the +Company burdened by a net profits interest. The management of the Company +believes the Trusts will be sufficient to offset those future abandonment +liabilities; however, the Company is responsible for any abandonment expenses in +excess of the Trusts' balances. As of December 31, 2001 total estimated site +restoration, dismantlement and abandonment costs were approximately $6,567,000, +net of expected salvage value. Substantially all such costs are expected to be +funded through the Trusts' funds, all of which will be accessible to the Company +when abandonment work begins. In addition, as a working interest owner and/or +operator of oil and gas properties, the Company is responsible for the cost of +abandonment of such properties. See Note 2. +From time to time, the Company, as part of the Consolidation and other capital +transactions, entered into Registration Rights Agreements whereby certain +parties to the transactions are entitled to require the +46 +Company to register Common Stock of the Company owned by them with the +Securities and Exchange Commission for sale to the public in firm commitment +public offerings and generally to include shares owned by them, at no cost, in +registration statements filed by the Company. Costs of the offering will not +include broker's discounts and commissions, which will be paid by the respective +sellers of the Common Stock. +The Company is involved in various claims and lawsuits incidental to its +business. In the opinion of management, the ultimate liability thereunder, if +any, will not have a material adverse effect on the financial position or +results of operations of the Company. +The Company's activities are subject to federal, state and local laws and +regulations governing environmental quality and pollution control. Although no +assurances can be made, the Company believes that, absent the occurrence of an +extraordinary event, compliance with existing federal, state and local laws, +rules and regulating the release of materials in the environment or otherwise +relating to the protection of the environment will not have a material effect +upon the capital expenditures, earnings or the competitive position of the +Company with respect to its existing assets and operations. The Company cannot +predict what effect additional regulation or legislation, enforcement polices +thereunder, and claims for damages to property, employees, other persons and the +environment resulting from the Company's operations could have on its +activities. +47 +8. OIL AND GAS PROPERTIES +The following table discloses certain financial data relating to the Company's +oil and gas activities, all of which are located in the United States. +YEARS ENDED DECEMBER 31, +------------------------------------------ +2001 2000 1999 +---------- ---------- ---------- +(IN THOUSANDS) +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance $ 589,549 $ 511,689 $ 444,579 +Property acquisition costs 1,713 3,211 24,153 +Exploration costs 85,782 51,837 37,427 +Development costs 34,980 25,242 5,530 +Sale of mineral interests (7,087) (2,430) -- +---------- ---------- ---------- +End of period balance $ 704,937 $ 589,549 $ 511,689 +========== ========== ========== +Unevaluated Properties (excluded from +amortization) - +Beginning of period balance $ 47,653 $ 44,434 $ 42,679 +Additions 2,350 4,381 4,890 +Capitalized interest 4,879 4,548 3,497 +General and administrative costs 6,410 5,036 3,623 +Transfers to evaluated (23,732) (10,746) (10,255) +---------- ---------- ---------- +End of period balance $ 37,560 $ 47,653 $ 44,434 +========== ========== ========== +Accumulated depreciation, depletion +and amortization +Beginning of period balance $ 378,589 $ 361,758 $ 345,353 +Provision charged to expense 20,750 16,831 16,405 +---------- ---------- ---------- +End of period balance $ 399,339 $ 378,589 $ 361,758 +========== ========== ========== +Unevaluated property costs, primarily lease acquisition costs incurred at +federal lease sales, unevaluated drilling costs, capitalized interest and +general and administrative costs being excluded from the amortizable evaluated +property base consisted of $7.5 million incurred in 2001, $8.3 million incurred +in 2000 and $21.9 million incurred in 1999 and prior. These costs are directly +related to the acquisition and evaluation of unproved properties and major +development projects. The excluded costs and related reserves are included in +the amortization base as the properties are evaluated and proved reserves are +established or impairment is determined. The Company expects that the majority +of these costs will be evaluated over the next three to five year period. +Depletion per unit-of-production (thousand cubic feet of gas equivalent) +amounted to $1.37, $1.10 and $.99 for the years ended December 31, 2001, 2000, +and 1999, respectively. +Under the full cost accounting rules of the SEC, the Company reviews the +carrying value of its proved oil and gas properties each quarter on a +country-by-country basis. Under these rules, capitalized costs of proved oil and +gas properties net of accumulated depreciation, depletion and amortization +(DD&A) and deferred income taxes, may not exceed the present value of estimated +future net cash flows from proved oil and gas reserves, discounted at 10 +percent, plus the lower of cost or fair value of unproved properties included in +the costs being amortized, net of related tax effects. These rules generally +require pricing future oil and gas +48 +production at the unescalated market price for oil and gas at the end of each +fiscal quarter and require a write-down if the "ceiling" is exceeded, unless +prices recover sufficiently before the date of the auditor's report. Given the +volatility of oil and gas prices, it is reasonably possible that the Company's +estimate of discounted future net cash flows from proved oil and gas reserves +could change in the near term. If oil and gas priced decline significantly, even +if only for a short period of time, it is possible that writedowns of oil and +gas properties could occur in the future. Based on prices at December 31, 2001 +the Company would be required to writedown its assets by $37.5 million. However, +as of the date of the auditor's report, commodity prices increased sufficiently +to eliminate any writedown. +9. NET PROFITS INTEREST +From 1989 through 1994, the Constituent Entities entered into separate +agreements to purchase certain oil and gas properties with gross contract +acquisition prices of $170,000,000 ($150,000,000 net as of closing dates) and in +simultaneous transactions, entered into agreements to sell overriding royalty +interests ("ORRI") in the acquired properties. These ORRI are in the form of net +profits interests ("NPI") equal to a significant percentage of the excess of +gross proceeds over production costs, as defined, from the acquired oil and gas +properties. A net deficit incurred in any month can be carried forward to +subsequent months until such deficit is fully recovered. The Company has the +right to abandon the purchased oil and gas properties if it deems the properties +to be uneconomical. +The Company has, pursuant to the purchase agreements, created abandonment trusts +whereby funds are provided out of gross production proceeds from the properties +for the estimated amount of future abandonment obligations related to the +working interests owned by the Company. The Trusts are administered by unrelated +third party trustees for the benefit of the Company's working interest in each +property. The Trust agreements limit their funds to be disbursed for the +satisfaction of abandonment obligations. Any funds remaining in the Trusts after +all restoration, dismantlement and abandonment obligations have been met will be +distributed to the owners of the properties in the same ratio as contributions +to the Trusts. The Trusts' assets are excluded from the Consolidated Balance +Sheets of the Company because the Company does not control the Trusts. Estimated +future revenues and costs associated with the NPI and the Trusts are also +excluded from the oil and gas reserve disclosures at Note 12. As of December 31, +2001 and 2000, the Trusts' assets (all cash and investments) totaled $6,567,000 +and $6,227,000 respectively, all of which will be available to the Company to +pay its portion, as working interest owner, of the restoration, dismantlement +and abandonment costs discussed at Note 7. +At the time of acquisition of properties by the Company, the property owners +estimated the future costs to be incurred for site restoration, dismantlement +and abandonment, net of salvage value. A portion of the amounts necessary to pay +such estimated costs was deposited in the Trusts upon acquisition of the +properties, and the remainder is deposited from time to time out of the proceeds +from production. The determination of the amount deposited upon the acquisition +of the properties and the amount to be deposited as proceeds from production was +based on numerous factors, including the estimated reserves of the properties. +The amounts deposited in the Trusts upon acquisition of the properties were +capitalized by the Company as oil and gas properties. +As operator, the Company receives all of the revenues and incurs all of the +production costs for the purchased oil and gas properties but retains only that +portion applicable to its net ownership share. As a result, the payables and +receivables associated with operating the properties included in the Company's +Consolidated Balance Sheets include both the Company's and all other outside +owners' shares. However, +49 +revenues and production costs associated with the acquired properties reflected +in the accompanying Consolidated Statements of Operations represent only the +Company's share, after reduction for the NPI. +10. EMPLOYEE BENEFIT PLANS +The Company has adopted a series of incentive compensation plans designed to +align the interest of the executives and employees with those of its +stockholders. The following is a brief description of each plan: +o The Savings and Protection Plan provides employees with the option to +defer receipt of a portion of their compensation and the Company may, +at its discretion, match a portion of the employee's deferral with cash +and Company Common Stock. The Company may also elect, at its +discretion, to contribute a non-matching amount in cash and Company +Common Stock to employees. The amounts held under the Savings and +Protection Plan are invested in various funds maintained by a third +party in accordance with the directions of each employee. An employee +is fully vested, including Company discretionary contributions, +immediately upon participation in the Savings and Protection Plan. The +total amounts contributed by the Company, including the value of the +common stock contributed, were $595,000, $500,000 and $466,000 in the +years 2001, 2000 and 1999, respectively. +o The 1994 Stock Incentive Plan (the "1994 Plan") provides for 600,000 +shares of Common Stock to be reserved for issuance pursuant to such +plan. Under the 1994 Plan the Company may grant both stock options +qualifying under Section 422 of the Internal Revenue Code and options +that are not qualified as incentive stock options, as well as +performance shares. These options have an expiration date 10 years from +date of grant. +o On August 23, 1996, the Board of Directors of the Company approved and +adopted the Callon Petroleum Company 1996 Stock Incentive Plan (the +"1996 Plan"). The 1996 Plan provides for the same types of awards as +the 1994 Plan and is limited to a maximum of 1,200,000 shares (as +amended from the original 900,000 shares) of common stock that may be +subject to outstanding awards. Unvested options are subject to +forfeiture upon certain termination of employment events and expire 10 +years from date of grant. +o The Company granted 533,000 stock options to employees on March 23, +2000 and 120,000 stock options to directors on July 25, 2000 at $10.50 +per share. The March 23, 2000 grant was subject to shareholder approval +of an amendment to the 1996 Stock Incentive Plan. The amendment, which +was approved on May 9, 2000 at the Annual Meeting of Shareholders, +increased the number of shares reserved for issuance under the 1996 +plan to 2,200,000 shares. The excess of the market price over the +exercise price on the approval date of the amendment is amortized over +the three-year vesting period of the options. Compensation costs of +$611,000 and $801,000 were recognized in income in 2001 and 2000 +respectively related to these options. +The Company accounts for the options issued pursuant to the stock incentive +plans under APB Opinion No. 25, under which no compensation cost has been +recognized unless the exercise price is less than the market price at the +measurement date. Had compensation cost for these plans been determined +consistent with Statement of Financial Accounting Standards No. 123 ("SFAS +123"), "Accounting for Stock-Based +50 +Compensation", the Company's net income and earnings per common share would have +been reduced to the following pro forma amounts: +2001 2000 1999 +-------- -------- -------- +(IN THOUSANDS, EXCEPT PER SHARE DATA) +Net income (loss) available for +common shares: As Reported $ 539 $ 10,144 $ 130 +Pro Forma (839) 8,418 (1,212) +Basic earnings (loss) per share: As Reported .04 .82 .01 +Pro Forma (.06) .68 (.14) +Diluted earnings (loss) per share: As Reported .04 .80 .01 +Pro Forma (.06) .66 (.14) +A summary of the status of the Company's two stock option plans for the three +most recent years and changes during the years then ended is presented in the +table and narrative below: +2001 2000 1999 +------------------------ ------------------------ ----------------------- +WTD AVG WTD AVG WTD AVG +SHARES EX PRICE SHARES EX PRICE SHARES EX PRICE +---------- -------- ---------- -------- ---------- -------- +Outstanding, beginning of year 2,304,167 $ 10.83 1,536,500 $ 10.60 1,266,000 $ 11.00 +Granted (at market) 30,000 11.61 135,000 14.73 270,500 9.27 +Granted (below market) -- -- 653,000 10.50 -- -- +Exercised (1,500) 9.00 (20,333) 9.00 -- -- +Forfeited -- -- -- -- -- -- +Expired -- -- -- -- -- -- +---------- -------- ---------- -------- ---------- -------- +Outstanding, end of year 2,332,667 $ 10.84 2,304,167 $ 10.83 1,536,500 $ 10.60 +========== ======== ========== ======== ========== ======== +Exercisable, end of year 2,057,977 $ 10.80 1,647,657 $ 10.71 1,247,600 $ 10.47 +========== ======== ========== ======== ========== ======== +Weighted average fair value of +options granted (at market) $ 5.80 $ 7.68 $ 4.94 +========== ========== ========== +Weighted average fair value of +options granted (below market) N/A $ 7.90 N/A +========= +At December 31, 2001, 2,157,667 of the 2,332,667 options outstanding have +exercise prices between $9 and $13.50 with a weighted average exercise price of +$10.53 and a weighted average remaining contractual life of 5.90 years. Of these +options, 1,919,277 are exercisable at a weighted average exercise price of +$10.53. The remaining 175,000 options have exercise prices between $13.50 and +$15.31 with a weighted average exercise price of $14.69 and a weighted average +remaining contractual life of 7.98 years. Of these options, 138,700 are +exercisable at a weighted average exercise price of $14.61. +The fair value of each option grant is estimated on the date of grant using the +Black-Scholes option pricing model with the following weighted average +assumptions used for options granted during the years presented are as follows: +2001 2000 1999 +------ ------ ------ +Risk free interest rate 4.5% 6.3% 6.3% +Expected life (years) 5.0 5.0 7.0 +Expected volatility 43.9% 52.1% 46.0% +Expected dividends -- -- -- +51 +11. EQUITY TRANSACTIONS +In November 1995, the Company sold 1,315,500 shares of $2.125 Convertible +Exchangeable Preferred Stock, Series A (the "Preferred Stock") for net proceeds +of $30.9 million. Annual dividends are $2.125 per share and are cumulative. The +net proceeds of the $.01 par value stock after underwriters discount and expense +was $30,899,000. Each share has a liquidation preference of $25.00, plus accrued +and unpaid dividends. Dividends on the Preferred Stock are cumulative from the +date of issuance and are payable quarterly, commencing January 15, 1996. The +Preferred Stock is convertible at any time, at the option of the holders +thereof, unless previously redeemed, into shares of Common Stock of the Company +at an initial conversion price of $11 per share of Common Stock, subject to +adjustments under certain conditions. +The Preferred Stock is redeemable at any time on or after December 31, 1998, in +whole or in part at the option of the Company at a redemption price of $26.488 +per share beginning at December 31, 1998 and at premiums declining to the $25.00 +liquidation preference by the year 2005 and thereafter, plus accrued and unpaid +dividends. The Preferred Stock is also exchangeable, in whole, but not in part, +at the option of the Company on or after January 15, 1998 for the Company's 8.5% +Convertible Subordinated Debentures due 2010 (the "Debentures") at a rate of +$25.00 principal amount of Debentures for each share of Preferred Stock. The +Debentures will be convertible into Common Stock of the Company on the same +terms as the Preferred Stock and will pay interest semi-annually. +In a December 1998 private transaction, a preferred stockholder elected to +convert 59,689 shares of Preferred Stock into 136,867 shares of the Company's +Common Stock. In 1999 certain other preferred stockholders, through private +transactions, agreed to convert 210,350 shares of Preferred Stock into 502,637 +shares of the Company's Common Stock under similar terms. Likewise in 2000, +444,600 shares of Preferred Stock were converted into 1,036,098 shares of the +Company's Common Stock. Any noncash premium negotiated in excess of the +conversion rate was recorded as additional preferred stock dividends and +excluded from the Consolidated Statements of Cash Flows. +In November of 1999, the Company sold 3,680,000 shares of Common Stock in a +public offering at a price to the public of $11.875 per share. Cash proceeds +received by the Company were $41.1 million net of underwriting discount and +offering costs. +In 2001, under the terms of the $95 million multiple advance loan, the Company +issued warrants to purchase, at a nominal exercise price, 265,210 shares of its +common stock. See Note 5. +The Company adopted a stockholder rights plan on March 30, 2000, designed to +assure that the Company's stockholders receive fair and equal treatment in the +event of any proposed takeover of the Company and to guard against partial +tender offers, squeeze-outs, open market accumulations, and other abusive +tactics to gain control without paying all stockholders a fair price. The rights +plan was not adopted in response to any specific takeover proposal. Under the +rights plan, the Company declared a dividend of one right ("Right") on each +share of the Company's Common Stock. Each Right will entitle the holder to +purchase one one-thousandth of a share of a Series B Preferred Stock, par value +$0.01 per share, at an exercise price of $90 per one one-thousandth of a share. +The Rights are not currently exercisable and will become exercisable only in the +event a person or group acquires, or engages in a tender or exchange offer to +acquire, beneficial ownership of 15 percent or more (one existing stockholder +was granted an exception for up to 21 percent) of the Company's Common Stock. +After the Rights become exercisable, each Right will also entitle its holder to +purchase a number of common shares of the Company having a market value of twice +the exercise price. +52 +The dividend distribution was made to stockholders of record at the close of +business on April 10, 2000. The Rights will expire on March 30, 2010. +12. SUPPLEMENTAL OIL AND GAS RESERVE DATA (UNAUDITED) +The Company's proved oil and gas reserves at December 31, 2001, 2000 and 1999 +have been estimated by independent petroleum consultants in accordance with +guidelines established by the Securities and Exchange Commission ("SEC"). +Accordingly, the following reserve estimates are based upon existing economic +and operating conditions. These estimates have been adjusted (per SEC +guidelines) to exclude the volumetric production payment described in Note 2. +There are numerous uncertainties inherent in establishing quantities of proved +reserves. The following reserve data represent estimates only and should not be +construed as being exact. In addition, the standard measure of discounted future +net cash flows should not be construed as the current market value of the +Company's oil and gas properties or the cost that would be incurred to obtain +equivalent reserves. +53 +ESTIMATED RESERVES +Changes in the estimated net quantities of crude oil and natural gas reserves, +all of which are located onshore and offshore in the continental United States, +are as follows: +RESERVE QUANTITIES +YEARS ENDED DECEMBER 31, +------------------------------------ +2001 2000 1999 +-------- -------- -------- +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period 33,382 23,834 6,898 +Revisions to previous estimates (2,290) 85 (686) +Purchase of reserves in place -- -- 2,629 +Sales of reserves in place (624) -- -- +Extensions and discoveries 14 9,695 15,323 +Production (273) (232) (330) +-------- -------- -------- +End of period 30,209 33,382 23,834 +======== ======== ======== +Natural Gas (MMcf): +Beginning of period 129,922 110,621 88,030 +Revisions to previous estimates (5,874) (4,817) (11,492) +Purchase of reserves in place -- 347 4,733 +Sales of reserves in place -- -- -- +Extensions and discoveries 7,483 35,387 42,662 +Production (11,232) (11,616) (13,312) +-------- -------- -------- +End of period 120,299 129,922 110,621 +======== ======== ======== +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period 2,192 1,376 1,774 +======== ======== ======== +End of period 885 2,192 1,376 +======== ======== ======== +Natural Gas (MMcf): +Beginning of period 63,982 76,295 76,895 +======== ======== ======== +End of period 51,221 63,982 76,295 +======== ======== ======== +54 +STANDARDIZED MEASURE +The following tables present the Company's standardized measure of discounted +future net cash flows and changes therein relating to proved oil and gas +reserves and were computed using reserve valuations based on regulations +prescribed by the SEC. These regulations provide that the oil, condensate and +gas price structure utilized to project future net cash flows reflects current +prices ($2.58 for natural gas and $20.10 for oil for the 2001 disclosures) at +each date presented and have been escalated only when known and determinable +price changes are provided by contract and law. Future production, development +and net abandonment costs are based on current costs without escalation. The +resulting net future cash flows have been discounted to their present values +based on a 10% annual discount factor. +STANDARDIZED MEASURE +YEARS ENDED DECEMBER 31, +------------------------------------------------ +2001 2000 1999 +------------ ------------ ------------ +(IN THOUSANDS) +Future cash inflows $ 883,145 $ 2,080,680 $ 847,930 +Future costs - +Production (220,857) (284,667) (207,615) +Development and net abandonment (191,369) (217,507) (123,749) +------------ ------------ ------------ +Future net inflows before income taxes 470,919 1,578,506 516,567 +Future income taxes (30,315) (472,637) (109,238) +------------ ------------ ------------ +Future net cash flows 440,604 1,105,869 407,329 +10% discount factor (185,747) (434,672) (151,007) +------------ ------------ ------------ +Standardized measure of discounted +future net cash flows $ 254,857 $ 671,197 $ 256,322 +============ ============ ============ +CHANGES IN STANDARDIZED MEASURE +YEARS ENDED DECEMBER 31, +------------------------------------------- +2001 2000 1999 +---------- ---------- ---------- +(IN THOUSANDS) +Standardized measure - beginning of period $ 671,197 $ 256,322 $ 99,751 +Sales and transfers, net of production costs (45,672) (42,132) (27,076) +Net change in sales and transfer prices, +Net of production costs (604,391) 361,179 57,246 +Exchange and sale of in place reserves (5,850) -- -- +Purchases, extensions, discoveries, and improved +recovery, net of future production and +development costs 9,358 276,770 181,185 +Revisions of quantity estimates (23,314) (12,399) (22,438) +Accretion of discount 90,978 28,581 9,975 +Net change in income taxes 224,290 (209,090) (29,492) +Changes in production rates, timing and other (61,739) 11,966 (12,829) +---------- ---------- ---------- +Standardized measure - end of period $ 254,857 $ 671,197 $ 256,322 +========== ========== ========== +55 +13. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) +FIRST SECOND THIRD FOURTH +QUARTER QUARTER QUARTER QUARTER +------- ------- ------- ------- +(IN THOUSANDS, EXCEPT PER SHARE DATA) +2001 +Total revenues $20,812 $17,712 $12,715 $10,513 +Total costs and expenses 11,314 12,398 12,311 22,936 +Income tax expense (benefit) 3,324 1,860 142 (4,349) +Net income 6,174 3,454 262 (8,074) +Net income per share-basic 0.44 0.24 0.00 (.63) +Net income per share-diluted 0.41 0.23 0.00 (.63) +2000 +Total revenues $10,118 $14,716 $16,422 $16,821 +Total costs and expenses 8,354 9,935 9,958 10,820 +Income tax expense 600 1,626 2,197 2,040 +Net income 1,164 3,155 4,267 3,961 +Net income per share-basic 0.05 0.21 0.30 0.25 +Net income per share-diluted 0.05 0.21 0.29 0.24 +56 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND +FINANCIAL DISCLOSURE +None. +PART III. +ITEMS 10, 11, 12 &13 +For information concerning Item 10 - Directors and Executive Officers of the +Registrant, Item 11 - Executive Compensation, Item 12 - Security Ownership of +Certain Beneficial Owners and Management and Item 13 - Certain Relationships and +Related Transactions, see the definitive Proxy Statement of Callon Petroleum +Company relating to the Annual Meeting of Stockholders on May 8, 2002 which will +be filed with the Securities and Exchange Commission and is incorporated herein +by reference. +57 +PART IV. +ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K +(a) 1. The following is an index to the financial statements and financial +statement schedules that are filed as part of this Form 10-K on pages 33 through +56. +Report of Independent Public Accountants +Consolidated Balance Sheets as of the Years Ended December 31, 2001 and +2000 +Consolidated Statements of Operations for the Three Years in the Period +Ended December 31, 2001 +Consolidated Statements of Stockholders' Equity for the Three Years in the +Period Ended December 31, 2001 +Consolidated Statements of Cash Flows for the Three Years in the Period +Ended December 31, 2001 +Notes to Consolidated Financial Statements +(a) 2. Schedules other than those listed above are omitted because they are not +required, not applicable or the required information is included in the +financial statements or notes thereto. +(a) 3. Exhibits: +2. Plan of acquisition, reorganization, arrangement, liquidation or +succession* +3. Articles of Incorporation and Bylaws +3.1 Certificate of Incorporation of the Company, as amended +(incorporated by reference from Exhibit 3.1 of the Company's +Registration Statement on Form S-4, filed August 4, 1994, Reg. +No. 33-82408) +3.2 Certificate of Merger of Callon Consolidated Partners, L. P. with +and into the Company dated September 16, 1994 (incorporated by +reference from Exhibit 3.2 of the Company's Report on Form 10-K +for the fiscal year ended December 31, 1994, File No. 000-25192) +3.3 Bylaws of the Company (incorporated by reference from Exhibit 3.2 +of the Company's Registration Statement on Form S-4, filed August +4, 1994, Reg. No. 33-82408) +4. Instruments defining the rights of security holders, including +indentures +4.1 Specimen Common Stock Certificate (incorporated by reference from +Exhibit 4.1 of the Company's Registration Statement on Form S-4, +filed August 4, 1994, Reg. No. 33-82408) +58 +4.2 Specimen Preferred Stock Certificate (incorporated by reference +from Exhibit 4.2 of the Company's Registration Statement on Form +S-1, filed November 13, 1995, Reg. No. 33-96700) +4.3 Designation for Convertible, Exchangeable Preferred Stock, Series +A (incorporated by reference from Exhibit 4.3 of the Company's +Registration Statement on Form S-1, filed November 13, 1995, Reg. +No. 33-96700) +4.4 Indenture for Convertible Debentures (incorporated by reference +from Exhibit 4.4 of the Company's Registration Statement on Form +S-1, filed November 13, 1995, Reg. No. 33-96700) +4.5 Certificate of Correction on Designation of Series A Preferred +Stock (incorporated by reference from Exhibit 4.4 of the +Company's Registration Statement on Form S-1, filed November 22, +1996, Reg. No. 333-15501) +4.6 Indenture for the Company's 10.125% Senior Subordinated Notes due +2002 dated as of July 31, 1997 (incorporated by reference from +Exhibit 4.1 of the Company's Registration Statement on Form S-4, +filed September 25, 1997, Reg. No. 333-36395) +4.7 Form of Note Indenture for the Company's 10.25% Senior +Subordinated Notes due 2004 (incorporated by reference from +Exhibit 4.10 of the Company's Registration Statement on Form S-2, +filed June 14, 1999, Reg. No. 333-80579) +4.8 Rights Agreement between Callon Petroleum Company and American +Stock Transfer & Trust Company, Rights Agent, dated March 30, +2000 (incorporated by reference from Exhibit 99.1 of the +Company's Registration Statement on Form 8-A, filed April 6, +2000, File No. 001-14039) +4.9 Subordinated Indenture for the Company dated October 26, 2000 +(incorporated by reference from Exhibit 4.1 of the Company's +Current Report on Form 8-K dated October 24, 2000, File No. +001-14039) +4.10 Supplemental Indenture for the Company's 11% Senior Subordinated +Notes due 2005 (incorporated by reference from Exhibit 4.2 of the +Company's Current Report on Form 8-K dated October 24, 2000, File +No. 001-14039) +4.11 Warrant dated as of June 29, 2001 entitling Duke Capital +Partners, LLC to purchase common stock from the Company. +(incorporated by reference to Exhibit 4.11 of the Company's +Quarterly Report on Form 10-Q for the period ended June 30, 2001, +File No. 001-14039) +9. Voting trust agreement +None. +59 +10. Material contracts +10.1 Registration Rights Agreement dated September 16, 1994 between +the Company and NOCO Enterprises, L. P. (incorporated by +reference from Exhibit 10.2 of the Company's Registration +Statement on Form 8-B filed October 3, 1994) +10.2 Counterpart to Registration Rights Agreement by and between the +Company, Ganger Rolf ASA and Bonheur ASA. (incorporated by +reference from Exhibit 10.2 of the Company's Report on Form 10-K +for the fiscal year ended December 31, 2000, File No. 001-14039) +10.3 Registration Rights Agreement dated September 16, 1994 between +the Company and Callon Stockholders (incorporated by reference +from Exhibit 10.3 of the Company's Registration Statement on Form +8-B filed October 3, 1994) +10.4 Callon Petroleum Company 1994 Stock Incentive Plan (incorporated +by reference from Exhibit 10.5 of the Company's Registration +Statement on Form 8-B filed October 3, 1994) +10.5 Consulting Agreement between the Company and John S. Callon dated +June 19, 1996 (incorporated by reference from Exhibit 10.10 of +the Company's Registration Statement on Form S-1, filed November +5, 1996, Reg. No. 333-15501) +10.6 Callon Petroleum Company Amended 1996 Stock Incentive Plan +(incorporated by reference from Exhibit 4.4 of the Post-Effective +Amendment No. 1 to the Company's Registration Statement on Form +S-8, filed February 5, 1999, Reg No. 333-29537) +10.7 Purchase and Sale Agreement between Callon Petroleum Operating +Company and Murphy Exploration Company, dated May 26, 1999 +(incorporated by reference from Exhibit 10.11 on Form S-2, filed +June 14, 1999, Reg. No. 333-80579) +10.8 Callon Petroleum Company 1996 Stock Incentive Plan as amended on +May 9, 2000 (incorporated by reference from Appendix I of the +Company's Definitive Proxy Statement of Schedule 14A filed March +28, 2000) +10.9 Credit Agreement dated as of October 30, 2000 between the Company +and First Union National Bank, as administrative agent for the +lenders (incorporated by reference from Exhibit 10.2 of the +Company's Quarterly Report on Form 10-Q for the period ended +September 30, 2000, File No. 001-14039) +10.10 Credit Agreement dated as of June 29, 2001 between the Company +and Duke Capital Partners, LLC, as Administrative Agent +(incorporated by reference to Exhibit 10.01 of the Company's +Quarterly Report on Form 10-Q for the period ended June 30, 2001, +File No. 001-14039) +10.11 Second Amendment to Credit Agreement by and among the Company and +First Union National Bank, as Administrative Agent, effective as +of June 29, 2001 (incorporated by reference to Exhibit 10.01 of +the Company's Quarterly Report on Form 10-Q for the period ended +June 30, 2001, File No. 001-14039) +60 +10.12 Conveyance of Overriding Royalty Interest from the Company to +Duke Capital Partners, LLC, dated June 29, 2001 (incorporated by +reference to Exhibit 10.03 of the Company's Quarterly Report on +Form 10-Q for the period ended June 30, 2001, File No. 001-14039) +10.13 Callon Petroleum Company 2002 Stock Incentive Plan. +10.14 Change of Control Severance Compensation Agreement by and between +Callon Petroleum and John S. Weatherly dated January 1, 2002. +10.15 Change of Control Severance Compensation Agreement by and between +Callon Petroleum Company and Fred L. Callon, dated January 1, +2002. +10.16 Change of Control Severance Compensation Agreement by and between +Callon Petroleum Company and Dennis W. Christian, dated January +1, 2002. +11. Statement re computation of per share earnings* +12. Statements re computation of ratios* +13. Annual Report to security holders, Form 10-Q or quarterly +reports* +16. Letter re change in certifying accountant* +18. Letter re change in accounting principles* +21. Subsidiaries of the Company +21.1 Subsidiaries of the Company (incorporated by reference from +Exhibit 21.1 of the Company's Registration Statement on Form 8-B +filed October 3, 1994) +22. Published report regarding matters submitted to vote of security +holders* +23. Consents of experts and counsel +23.1 Consent of Arthur Andersen LLP +24. Power of attorney* +99. Additional Exhibits +99.1 Letter to the Commission re: Arthur Andersen Representations +*Inapplicable to this filing. +(b) Reports on Form 8-K. +None +61 +SIGNATURES +Pursuant to the requirements of the Securities Exchange Act of 1934, this report +has been signed below by the following persons on behalf of the registrant and +in the capacities and on the dates indicated. +CALLON PETROLEUM COMPANY +Date: March 29, 2002 /s/ Fred L. Callon +--------------- ------------------ +Fred L. Callon (principal executive officer, director) +Date: March 29, 2002 /s/ John S. Weatherly +--------------- --------------------- +John S. Weatherly (principal financial officer) +Date: March 29, 2002 /s/ James O. Bassi +--------------- ------------------ +James O. Bassi (principal accounting officer) +Date: March 29, 2002 /s/ John S. Callon +--------------- ------------------ +John S. Callon (director) +Date: March 29, 2002 /s/ Dennis W. Christian +--------------- ----------------------- +Dennis W. Christian (director) +Date: March 29, 2002 /s/ B. F. Weatherly +--------------- ------------------- +B. F. Weatherly (director) +Date: March 29, 2002 /s/ Robert A. Stanger +--------------- --------------------- +Robert A. Stanger (director) +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange +Act of 1934, the registrant has duly caused this report to be signed on its +behalf by the undersigned, thereunto duly authorized. +CALLON PETROLEUM COMPANY +Date: March 29, 2002 By: /s/ John S. Weatherly +--------------- ---------------------- +John S. Weatherly, Senior Vice President +and Chief Financial Officer +62 +INDEX TO EXHIBITS +EXHIBIT +NUMBER DESCRIPTION +------- ----------- +2. Plan of acquisition, reorganization, arrangement, liquidation or +succession* +3. Articles of Incorporation and Bylaws +3.1 Certificate of Incorporation of the Company, as amended +(incorporated by reference from Exhibit 3.1 of the Company's +Registration Statement on Form S-4, filed August 4, 1994, Reg. +No. 33-82408) +3.2 Certificate of Merger of Callon Consolidated Partners, L. P. with +and into the Company dated September 16, 1994 (incorporated by +reference from Exhibit 3.2 of the Company's Report on Form 10-K +for the fiscal year ended December 31, 1994, File No. 000-25192) +3.3 Bylaws of the Company (incorporated by reference from Exhibit 3.2 +of the Company's Registration Statement on Form S-4, filed August +4, 1994, Reg. No. 33-82408) +4. Instruments defining the rights of security holders, including +indentures +4.1 Specimen Common Stock Certificate (incorporated by reference from +Exhibit 4.1 of the Company's Registration Statement on Form S-4, +filed August 4, 1994, Reg. No. 33-82408) +4.2 Specimen Preferred Stock Certificate (incorporated by reference +from Exhibit 4.2 of the Company's Registration Statement on Form +S-1, filed November 13, 1995, Reg. No. 33-96700) +4.3 Designation for Convertible, Exchangeable Preferred Stock, Series +A (incorporated by reference from Exhibit 4.3 of the Company's +Registration Statement on Form S-1, filed November 13, 1995, Reg. +No. 33-96700) +4.4 Indenture for Convertible Debentures (incorporated by reference +from Exhibit 4.4 of the Company's Registration Statement on Form +S-1, filed November 13, 1995, Reg. No. 33-96700) +4.5 Certificate of Correction on Designation of Series A Preferred +Stock (incorporated by reference from Exhibit 4.4 of the +Company's Registration Statement on Form S-1, filed November 22, +1996, Reg. No. 333-15501) +4.6 Indenture for the Company's 10.125% Senior Subordinated Notes due +2002 dated as of July 31, 1997 (incorporated by reference from +Exhibit 4.1 of the Company's Registration Statement on Form S-4, +filed September 25, 1997, Reg. No. 333-36395) +4.7 Form of Note Indenture for the Company's 10.25% Senior +Subordinated Notes due 2004 (incorporated by reference from +Exhibit 4.10 of the Company's Registration Statement on Form S-2, +filed June 14, 1999, Reg. No. 333-80579) +4.8 Rights Agreement between Callon Petroleum Company and American +Stock Transfer & Trust Company, Rights Agent, dated March 30, +2000 (incorporated by reference from Exhibit 99.1 of the +Company's Registration Statement on Form 8-A, filed Aril 6, 2000, +File No. 001-14039) +4.9 Subordinated Indenture for the Company dated October 26, 2000 +(incorporated by reference from Exhibit 4.1 of the Company's +Current Report on Form 8-K dated October 24, 2000, File No. +001-14039) +4.10 Supplemental Indenture for the Company's 11% Senior Subordinated +Notes due 2005 (incorporated by reference from Exhibit 4.2 of the +Company's Current Report on Form 8-K dated October 24, 2000, File +No. 001-14039) +4.11 Warrant dated as of June 29, 2001 entitling Duke Capital +Partners, LLC to purchase common stock from the Company. +(incorporated by reference to Exhibit 4.11 of the Company's +Quarterly Report on Form 10-Q for the period ended June 30, 2001, +File No. 001-14039) +9. Voting trust agreement +None. +10. Material contracts +10.1 Registration Rights Agreement dated September 16, 1994 between +the Company and NOCO Enterprises, L. P. (incorporated by +reference from Exhibit 10.2 of the Company's Registration +Statement on Form 8-B filed October 3, 1994) +10.2 Counterpart to Registration Rights Agreement by and between the +Company, Ganger Rolf ASA and Bonheur ASA. (incorporated by +reference from Exhibit 10.2 of the Company's Report on Form 10-K +for the fiscal year ended December 31, 2000, File No. 001-14039) +10.3 Registration Rights Agreement dated September 16, 1994 between +the Company and Callon Stockholders (incorporated by reference +from Exhibit 10.3 of the Company's Registration Statement on Form +8-B filed October 3, 1994) +10.4 Callon Petroleum Company 1994 Stock Incentive Plan (incorporated +by reference from Exhibit 10.5 of the Company's Registration +Statement on Form 8-B filed October 3, 1994) +10.5 Consulting Agreement between the Company and John S. Callon dated +June 19, 1996 (incorporated by reference from Exhibit 10.10 of +the Company's Registration Statement on Form S-1, filed November +5, 1996, Reg. No. 333-15501) +10.6 Callon Petroleum Company Amended 1996 Stock Incentive Plan +(incorporated by reference from Exhibit 4.4 of the Post-Effective +Amendment No. 1 to the Company's Registration Statement on Form +S-8, filed February 5, 1999, Reg No. 333-29537) +10.7 Purchase and Sale Agreement between Callon Petroleum Operating +Company and Murphy Exploration Company, dated May 26, 1999 +(incorporated by reference from Exhibit 10.11 on Form S-2, filed +June 14, 1999, Reg. No. 333-80579) +10.8 Callon Petroleum Company 1996 Stock Incentive Plan as amended on +May 9, 2000 (incorporated by reference from Appendix I of the +Company's Definitive Proxy Statement of Schedule 14A filed March +28, 2000) +10.9 Credit Agreement dated as of October 30, 2000 between the Company +and First Union National Bank, as administrative agent for the +lenders (incorporated by reference from Exhibit 10.2 of the +Company's Quarterly Report on Form 10-Q for the period ended +September 30, 2000, File No. 001-14039) +10.10 Credit Agreement dated as of June 29, 2001 between the Company +and Duke Capital Partners, LLC, as Administrative Agent +(incorporated by reference to Exhibit 10.01 of the Company's +Quarterly Report on Form 10-Q for the period ended June 30, 2001, +File No. 001-14039) +10.11 Second Amendment to Credit Agreement by and among the Company and +First Union National Bank, as Administrative Agent, effective as +of June 29, 2001 (incorporated by reference to Exhibit 10.01 of +the Company's Quarterly Report on Form 10-Q for the period ended +June 30, 2001, File No. 001-14039) +10.12 Conveyance of Overriding Royalty Interest from the Company to +Duke Capital Partners, LLC, dated June 29, 2001 (incorporated by +reference to Exhibit 10.03 of the Company's Quarterly Report on +Form 10-Q for the period ended June 30, 2001, File No. 001-14039) +10.13 Callon Petroleum Company 2002 Stock Incentive Plan. +10.14 Change of Control Severance Compensation Agreement by and between +Callon Petroleum and John S. Weatherly dated January 1, 2002. +10.15 Change of Control Severance Compensation Agreement by and between +Callon Petroleum Company and Fred L. Callon, dated January 1, +2002. +10.16 Change of Control Severance Compensation Agreement by and between +Callon Petroleum Company and Dennis W. Christian, dated January +1, 2002. +11. Statement re computation of per share earnings* +12. Statements re computation of ratios* +13. Annual Report to security holders, Form 10-Q or quarterly +reports* +16. Letter re change in certifying accountant* +18. Letter re change in accounting principles* +21. Subsidiaries of the Company +21.1 Subsidiaries of the Company (incorporated by reference from +Exhibit 21.1 of the Company's Registration Statement on Form 8-B +filed October 3, 1994) +22. Published report regarding matters submitted to vote of security +holders* +23. Consents of experts and counsel +23.1 Consent of Arthur Andersen LLP +24. Power of attorney* +99. Additional Exhibits +99.1 Letter to the Commission re: Arthur Andersen Representations +*Inapplicable to this filing. \ No newline at end of file diff --git a/raw/filings/0000928022/2001/0000950134-02-003092/filing_metadata.csv b/raw/filings/0000928022/2001/0000950134-02-003092/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..efa3e13bdb7f9a33acdfaa354a1e631a2b19ee71 --- /dev/null +++ b/raw/filings/0000928022/2001/0000950134-02-003092/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000928022,CPE,Callon Petroleum Co,10-K405,2002-04-01,2001-12-31,2002-04-01T05:00:00.000Z,0000950134-02-003092,d95444e10-k405.txt,"FORM 10-K FOR FISCAL YEAR END DECEMBER 31, 2001",427786,0,0,https://www.sec.gov/Archives/edgar/data/928022/000095013402003092/d95444e10-k405.txt,https://www.sec.gov/Archives/edgar/data/928022/000095013402003092/,2001,2001,1 diff --git a/raw/filings/0000928022/2001/0000950134-02-003092/item1.txt b/raw/filings/0000928022/2001/0000950134-02-003092/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..9e538e8cec0105ba784f048738728fb5dbffe0c7 --- /dev/null +++ b/raw/filings/0000928022/2001/0000950134-02-003092/item1.txt @@ -0,0 +1,663 @@ +ITEM 1. BUSINESS +OVERVIEW +Callon Petroleum Company has been engaged in the exploration, development, +acquisition and production of oil and gas properties since 1950. Our properties +are geographically concentrated primarily offshore in the Gulf of Mexico and +onshore in Louisiana and Alabama. The public Company was formed under the laws +of the state of Delaware in 1994 through the consolidation of a publicly traded +limited partnership, a joint venture with a consortium of European institutional +investors and an independent energy company owned by certain members of current +management (the "Consolidation"). As used herein, the "Company," "Callon," "we," +"us," and "our" refer to Callon Petroleum Company and its predecessors and +subsidiaries unless the context requires otherwise. +In 1989, we began increasing our reserves through the acquisition of producing +properties that were geologically complex, had (or were analogous to fields +with) an established production history from stacked pay zones and were +candidates for exploitation. We focused on reducing operating costs and +implementing production enhancements through the application of technologically +advanced production and recompletion techniques. +Over the past several years, we have also placed emphasis on the acquisition of +acreage with exploration and development drilling opportunities in the Gulf of +Mexico Shelf area. We acquired an infrastructure of production platforms, +gathering systems and pipelines to minimize development expenditures of these +drilling opportunities. We also joined with other industry partners, primarily +Murphy Exploration and Production, Inc., ("Murphy") to explore federal offshore +blocks acquired in the Gulf of Mexico. Over the last several years we have +expanded our areas of exploration to include the Gulf of Mexico Deepwater area +(generally 900 to 5,500 feet of water). +We ended the year 2001 with estimated net proved reserves of 303 billion cubic +feet of natural gas equivalent ("Bcfe"). This represents a decrease of 9% from +2000 year-end estimated net proved reserves of 334 Bcfe. +The major focus of our future operations is expected to continue to be the +exploration for and development of oil and gas properties, primarily in the Gulf +of Mexico. +BUSINESS STRATEGY +Our goal is to increase shareholder value by increasing our reserves, +production, cash flow and earnings. We seek to achieve these goals through the +following strategies: +o Focus on Gulf of Mexico exploration with a balance between shelf and +deepwater areas using the latest available technology. +o Aggressively explore our existing prospect inventory. +o Replenish our prospect inventory with increasing emphasis on prospect +generation. +o Achieve moderate increases in current production levels through continued +shelf exploration. +o Achieve significant increases in longer-term production levels through +development of deepwater discoveries and ongoing deepwater exploration. +2 +EXPLORATION AND DEVELOPMENT ACTIVITIES +Capital expenditures for exploration and development costs related to oil and +gas properties totaled approximately $112.6 million in 2001. We incurred +approximately $63.7 million in the Gulf of Mexico Shelf area. +The Gulf of Mexico Deepwater area expenditures ($31.9 million) accounted for the +remainder of the total capital expended, along with $4.2 million incurred in +leasehold and seismic acquisition costs and $12.8 million of interest and +general and administrative costs allocable directly to exploration and +development projects. The Gulf of Mexico Deepwater area expenditures included +one unsuccessful exploration project totaling $2.2 million and the balance was +incurred for additional delineation drilling and production facility fabrication +at our Medusa discovery and the delineation drilling at Habanero. +As a result of recent successes in the Gulf of Mexico Deepwater area, we are +faced with increased costs to develop these significant proved undeveloped +reserves. A large portion of these future development costs will be incurred in +2002 and beyond. We are currently evaluating various financing alternatives to +address these issues. While management believes there are a number of financing +sources available to us, no assurances can be made that we will be able to fund +these development costs. +RISK FACTORS +DECREASE IN OIL AND GAS PRICES MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS +AND FINANCIAL CONDITION. Our success is highly dependent on prices for oil and +gas, which are extremely volatile. Any substantial or extended decline in the +price of oil or gas would have a material adverse effect on us. Oil and gas +markets are both seasonal and cyclical. The prices of oil and gas depend on +factors we cannot control such as weather, economic conditions, levels of +production, actions by OPEC and other countries and government actions. Prices +of oil and gas will affect the following aspects of our business: +o our revenues, cash flows and earnings; +o the amount of oil and gas that we are economically able to produce; +o our ability to attract capital to finance our operations and the cost of +the capital; +o the amount we are allowed to borrow under our senior credit facility; +o the value of our oil and gas properties; and +o the profit or loss we incur in exploring for and developing our reserves. +UNLESS WE ARE ABLE TO REPLACE RESERVES, WHICH WE HAVE PRODUCED, OUR CASH FLOWS +AND PRODUCTION WILL DECREASE OVER TIME. Our future success depends upon our +ability to find, develop and acquire oil and gas reserves that are economically +recoverable. As is generally the case for Gulf Coast properties, our producing +properties usually have high initial production rates, followed by a steep +decline in production. As a result, we must continually locate and develop or +acquire new oil and gas reserves to replace those being depleted by production. +We must do this even during periods of low oil and gas prices when it is +difficult to raise the capital necessary to finance these activities and during +periods of high operating costs when it is expensive to contract for drilling +rigs and other equipment and personnel necessary to explore for oil and gas. +Without successful exploration or acquisition activities, our reserves, +production and revenues will decline rapidly. We cannot assure you that we will +be able to find and develop or acquire additional reserves at an acceptable +cost. +3 +A SIGNIFICANT PART OF THE VALUE OF OUR PRODUCTION AND RESERVES IS CONCENTRATED +IN A SMALL NUMBER OF OFFSHORE PROPERTIES, AND ANY PRODUCTION PROBLEMS OR +INACCURACIES IN RESERVE ESTIMATES RELATED TO THOSE PROPERTIES WOULD ADVERSELY +IMPACT OUR BUSINESS. During 2001, 44% of our daily production came from two of +our properties in the Gulf of Mexico. Moreover, one property accounted for 25% +of our production during this period. If mechanical problems, storms or other +events curtailed a substantial portion of this production, our results of +operations would be adversely affected. In addition, at December 31, 2001 most +of our proved reserves were located in five fields in the Gulf of Mexico, with +approximately 93% of our total net proved reserves attributable to these +properties. If the actual reserves associated with any one of these five +discoveries are less than our estimated reserves, our results of operations and +financial condition could be adversely affected. +OUR FOCUS ON EXPLORATION PROJECTS INCREASES THE RISKS INHERENT IN OUR OIL AND +GAS ACTIVITIES. Our business strategy focuses on replacing reserves through +exploration, where the risks are greater than in acquisitions and development +drilling. Although we have been successful in exploration in the past, we cannot +assure you that we will continue to increase reserves through exploration or at +an acceptable cost. Additionally, we are often uncertain as to the future costs +and timing of drilling, completing and producing wells. Our drilling operations +may be curtailed, delayed or canceled as a result of a variety of factors, +including: +o unexpected drilling conditions; +o pressure or inequalities in formations; +o equipment failures or accidents; +o adverse weather conditions; +o compliance with governmental requirements; and +o shortages or delays in the availability of drilling rigs and the +delivery of equipment. +BECAUSE WE DO NOT CONTROL ALL OF OUR PROPERTIES, ESPECIALLY OUR DEEPWATER +PROPERTIES, WE HAVE LIMITED INFLUENCE OVER THEIR DEVELOPMENT. We do not operate +all of our properties and have limited influence over the operations of some of +these properties, particularly our deepwater projects. Our lack of control could +result in the following: +o the operator may initiate exploration or development on a faster or +slower pace than we prefer; +o the operator may propose to drill more wells or build more facilities on +a project than we have funds for or that we deem appropriate, which may +mean that we are unable to participate in the project or share in the +revenues generated by the project even though we paid our share of +exploration costs; and +o if an operator refuses to initiate a project, we may be unable to pursue +the project. +Any of these events could materially reduce the value of our properties. +OUR DEEPWATER OPERATIONS HAVE SPECIAL OPERATIONAL RISKS THAT MAY NEGATIVELY +AFFECT THE VALUE OF THOSE ASSETS. Drilling operations in the deepwater area are +by their nature more difficult and costly than drilling operations in shallow +water. They require the application of more advanced drilling technologies, +involving a higher risk of technological failure and usually resulting in +significantly higher drilling costs. Deepwater wells are completed using subsea +completion techniques that require substantial time and the use of advanced +remote installation equipment. These operations involve a high risk of +mechanical difficulties and equipment failures that could result in significant +cost overruns. +4 +In deepwater, the time required to commence production following a discovery is +much longer than in shallow water and on-shore. Our deepwater discoveries and +prospects will require the construction of expensive production facilities and +pipelines prior to the beginning of production. We cannot estimate the costs and +timing of the construction of these facilities with certainty, and the accuracy +of our estimates will be affected by a number of factors beyond our control, +including the following: +o decisions made by the operators of our deepwater wells; +o the availability of materials necessary to construct the facilities; +o the proximity of our discoveries to pipelines; and +o the price of oil and natural gas. +Delays and cost overruns in the commencement of production will affect the value +of our deepwater prospects and the discounted present value of reserves +attributable to those prospects. +COMPETITIVE INDUSTRY CONDITIONS MAY NEGATIVELY AFFECT OUR ABILITY TO CONDUCT +OPERATIONS. We operate in the highly competitive areas of oil and gas +exploration, development and production. We compete for the purchase of leases +in the Gulf of Mexico from the U. S. government and from other oil and gas +companies. These leases include exploration prospects as well as properties with +proved reserves. Factors that affect our ability to compete in the marketplace +include: +o our access to the capital necessary to drill wells and acquire +properties; +o our ability to acquire and analyze seismic, geological and other +information relating to a property; +o our ability to retain the personnel necessary to properly evaluate +seismic and other information relating to a property; +o the location of, and our ability to access, platforms, pipelines and +other facilities used to produce and transport oil and gas production; +o the standards we establish for the minimum projected return on an +investment of our capital; and +o the availability of alternate fuel sources. +Our competitors include major integrated oil companies, substantial independent +energy companies, affiliates of major interstate and intrastate pipelines and +national and local gas gatherers, many of which possess greater financial, +technological and other resources than we do. +OUR COMPETITORS MAY USE SUPERIOR TECHNOLOGY, WHICH WE MAY BE UNABLE TO AFFORD OR +WHICH WOULD REQUIRE COSTLY INVESTMENT BY US IN ORDER TO COMPETE. Our industry is +subject to rapid and significant advancements in technology, including the +introduction of new products and services using new technologies. As our +competitors use or develop new technologies, we may be placed at a competitive +disadvantage, and competitive pressures may force us to implement new +technologies at a substantial cost. In addition, our competitors may have +greater financial, technical and personnel resources that allow them to enjoy +technological advantages and may in the future allow them to implement new +technologies before we can. We cannot be certain that we will be able to +implement technologies on a timely basis or at a cost that is acceptable to us. +One or more of the technologies that we currently use or that we may implement +in the future may become obsolete, and we may be adversely affected. For +example, marine seismic acquisition technology has been characterized by rapid +technological advancements in recent years, and further significant +technological developments could substantially impair our 3-D seismic data's +value. +WE MAY NOT BE ABLE TO REPLACE OUR RESERVES OR GENERATE CASH FLOWS IF WE ARE +UNABLE TO RAISE CAPITAL. We will be required to make substantial capital +expenditures to develop our existing reserves, and to discover new oil and gas +reserves. +5 +Historically, we have financed these expenditures primarily with cash from +operations, proceeds from bank borrowings and proceeds from the sale of debt and +equity securities. See "Management's Discussion and Analysis of Financial +Condition and Results of Operations -- Liquidity and Capital Resources" for a +discussion of our capital budget. We cannot assure you that we will be able to +raise capital in the future. We also make offers to acquire oil and gas +properties in the ordinary course of our business. If these offers are accepted, +our capital needs may increase substantially. +We expect to continue using our senior credit facility to borrow funds to +supplement our available cash. The amount we may borrow under our senior credit +facility may not exceed a borrowing base determined by the lenders based on +their projections of our future production, future production costs, taxes, +commodity prices and any other factors deemed relevant by our lenders. We cannot +control the assumptions the lenders use to calculate our borrowing base. The +lenders may, without our consent, adjust the borrowing base semiannually or in +situations where we purchase or sell assets or issue debt securities. If our +borrowings under the senior credit facility exceed the borrowing base, the +lenders may require that we repay the excess. If this were to occur, we might +have to sell assets or seek financing from other sources. Sales of assets could +further reduce the amount of our borrowing base. We cannot assure you that we +would be successful in selling assets or arranging substitute financing. If we +were not able to repay borrowings under our senior credit facility to reduce the +outstanding amount to less than the borrowing base, we would be in default under +our senior credit facility. For a description of our senior credit facility and +its principal terms and conditions, see "Management's Discussion and Analysis of +Financial Condition and Results of Operations -- Liquidity and Capital +Resources." +OUR RESERVE INFORMATION REPRESENTS ESTIMATES THAT MAY TURN OUT TO BE INCORRECT +IF THE ASSUMPTIONS UPON WHICH THESE ESTIMATES ARE BASED ARE INACCURATE. ANY +MATERIAL INACCURACIES IN THESE RESERVE ESTIMATES OR UNDERLYING ASSUMPTIONS WILL +MATERIALLY AFFECT THE QUANTITIES AND PRESENT VALUE OF OUR RESERVES. The process +of estimating oil and gas reserves is complex. It requires interpretations of +available technical data and various assumptions, including assumptions relating +to economic factors. Any significant inaccuracies in these interpretations or +assumptions could materially affect the estimated quantities and present value +of reserves shown in this prospectus. +In order to prepare these estimates, we must project production rates and the +timing of development expenditures. The assumptions regarding the timing and +costs to commence production from our deepwater wells used in preparing our +reserves are often subject to revisions over time as described under "our +deepwater operations have special operational risks that may negatively affect +the value of those assets." We must also analyze available geological, +geophysical, production and engineering data, the extent, quality and +reliability of which can vary. The process also requires economic assumptions, +such as oil and gas prices, drilling and operating expenses, capital +expenditures, taxes and availability of funds. Therefore, estimates of oil and +gas reserves are inherently imprecise. Actual future production, oil and gas +prices, revenues, taxes, development expenditures, operating expenses and +quantities of recoverable oil and gas reserves most likely will vary from our +estimates. Any significant variance could materially affect the estimated +quantities and present value of reserves shown in this prospectus. In addition, +we may adjust estimates of proved reserves to reflect production history, +results of exploration and development, prevailing oil and gas prices and other +factors, many of which are beyond our control. +You should not assume that the present value of future net cash flows from our +proved reserves referred to in this prospectus is the current market value of +our estimated oil and gas reserves. In accordance with SEC requirements, we +generally base the estimated discounted future net cash flows from our proved +reserves on +6 +prices and costs on the date of the estimate. Actual future prices and costs may +differ materially from those used in the present value estimate. +Information about reserves constitutes forward-looking information. See +"Forward-Looking Statements" for information regarding forward-looking +information. The discounted present value of our oil and gas reserves is +prepared in accordance with guidelines established by the SEC. A purchaser of +reserves would use numerous other factors to value our reserves. The discounted +present value of reserves, therefore, does not represent the fair market value +of those reserves. +On December 31, 2001, approximately 77.3% of the discounted present value of our +estimated net proved reserves were proved undeveloped. Substantially all of +these proved undeveloped reserves were attributable to our deepwater properties. +Development of these properties is subject to additional risks as described +above. +WEATHER, UNEXPECTED SUBSURFACE CONDITIONS, AND OTHER UNFORESEEN OPERATING +HAZARDS MAY ADVERSELY IMPACT OUR ABILITY TO CONDUCT BUSINESS. There are many +operating hazards in exploring for and producing oil and gas, including: +o our drilling operations may encounter unexpected formations or pressures, +which could cause damage to equipment or personal injury; +o we may experience equipment failures which curtail or stop production; +and +o we could experience blowouts or other damages to the productive +formations that may require a well to be re-drilled or other corrective +action to be taken. +In addition, any of the foregoing may result in environmental damages for which +we will be liable. Moreover, a substantial portion of our operations are +offshore and are subject to a variety of risks peculiar to the marine +environment such as capsizings, collisions, hurricanes and other adverse weather +conditions. These conditions can cause substantial damage to facilities and +interrupt production. Offshore operations are also subject to more extensive +governmental regulation. +We cannot assure you that we will be able to maintain adequate insurance at +rates we consider reasonable to cover our possible losses from operating +hazards. The occurrence of a significant event not fully insured or indemnified +against could materially and adversely affect our financial condition and +results of operations. +WE MAY NOT HAVE PRODUCTION TO OFFSET HEDGES; BY HEDGING, WE MAY NOT BENEFIT FROM +PRICE INCREASES. Part of our business strategy is to reduce our exposure to the +volatility of oil and gas prices by hedging a portion of our production. In a +typical hedge transaction, we will have the right to receive from the other +parties to the hedge the excess of the fixed price specified in the hedge over a +floating price based on a market index, multiplied by the quantity hedged. If +the floating price exceeds the fixed price, we are required to pay the other +parties this difference multiplied by the quantity hedged. We are required to +pay the difference between the floating price and the fixed price when the +floating price exceeds the fixed price regardless of whether we have sufficient +production to cover the quantities specified in the hedge. Significant +reductions in production at times when the floating price exceeds the fixed +price could require us to make payments under the hedge agreements even though +such payments are not offset by sales of production. Hedging will also prevent +us from receiving the full advantage of increases in oil or gas prices above the +fixed amount specified in the hedge. See "Quantitative and Qualitative +Disclosures About Market Risks" for a discussion of our hedging practices. +7 +COMPLIANCE WITH ENVIRONMENTAL AND OTHER GOVERNMENT REGULATIONS COULD BE COSTLY +AND COULD NEGATIVELY IMPACT PRODUCTION. Our operations are subject to numerous +laws and regulations governing the operation and maintenance of our facilities +and discharge of materials into the environment or otherwise relating to +environmental protection. For a discussion of the material regulations +applicable to us, see "Federal Regulations," "State Regulations," and +"Environmental Regulations." These laws and regulations may: +o require that we acquire permits before commencing drilling; +o restrict the substances that can be released into the environment in +connection with drilling and production activities; +o limit or prohibit drilling activities on protected areas such as wetlands +or wilderness areas; and +o require remedial measures to mitigate pollution from former operations, +such as dismantling abandoned production facilities. +Under these laws and regulations, we could be liable for personal injury and +clean-up costs and other environmental and property damages, as well as +administrative, civil and criminal penalties. We maintain limited insurance +coverage for sudden and accidental environmental damages. We do not believe that +insurance coverage for environmental damages that occur over time is available +at a reasonable cost. Also, we do not believe that insurance coverage for the +full potential liability that could be caused by sudden and accidental +environmental damages is available at a reasonable cost. Accordingly, we may be +subject to liability or we may be required to cease production from properties +in the event of environmental damages. +FACTORS BEYOND OUR CONTROL AFFECT OUR ABILITY TO MARKET PRODUCTION AND OUR +FINANCIAL RESULTS. The ability to market oil and gas from our wells depends upon +numerous factors beyond our control. These factors include: +o the extent of domestic production and imports of oil and gas; +o the proximity of the gas production to gas pipelines; +o the availability of pipeline capacity; +o the demand for oil and gas by utilities and other end users; +o the availability of alternative fuel sources; +o the effects of inclement weather; +o state and federal regulation of oil and gas marketing; and +o federal regulation of gas sold or transported in interstate commerce. +Because of these factors, we may be unable to market all of the oil or gas we +produce. In addition, we may be unable to obtain favorable prices for the oil +and gas we produce. +IF OIL AND GAS PRICES DECREASE, WE MAY BE REQUIRED TO TAKE WRITEDOWNS. We may be +required to writedown the carrying value of our oil and gas properties when oil +and gas prices are low or if we have substantial downward adjustments to our +estimated net proved reserves, increases in our estimates of development costs +or deterioration in our exploration results. Under the full-cost method we use +to account for our oil and gas properties, the net capitalized costs of our oil +and gas properties may not exceed the present value, discounted at 10%, of +future net cash flows from estimated net proved reserves, using period end oil +and gas prices or prices as of the date of our auditor's report, plus the lower +of cost or fair market value of our unproved properties. If net capitalized +costs of our oil and gas properties exceed this limit, we must charge the amount +of the excess to earnings. This type of charge will not affect our cash flows, +but will reduce the book value of our stockholders' equity. We review the +carrying value of our properties +8 +quarterly, based on prices in effect as of the end of each quarter or at the +time of reporting our results. Once incurred, a writedown of oil and gas +properties is not reversible at a later date, even if prices increase. +FORWARD-LOOKING STATEMENTS +In this report, we have made many forward-looking statements. We cannot assure +you that the plans, intentions or expectations upon which our forward-looking +statements are based will occur. Our forward-looking statements are subject to +risks, uncertainties and assumptions, including those discussed elsewhere in +this report. Forward-looking statements include statements regarding: +o our oil and gas reserve quantities, and the discounted present value of +these reserves; +o the amount and nature of our capital expenditures; +o drilling of wells; +o the timing and amount of future production and operating costs; +o business strategies and plans of management; and +o prospect development and property acquisitions. +Some of the risks, which could affect our future results and could cause results +to differ materially from those expressed in our forward-looking statements +include: +o general economic conditions; +o the volatility of oil and natural gas prices; +o the uncertainty of estimates of oil and natural gas reserves; +o the impact of competition; +o the availability and cost of seismic, drilling and other equipment; +o operating hazards inherent in the exploration for and production of oil +and natural gas; +o difficulties encountered during the exploration for and production of oil +and natural gas; +o difficulties encountered in delivering oil and natural gas to commercial +markets; +o changes in customer demand and producers' supply; +o the uncertainty of our ability to attract capital; +o compliance with, or the effect of changes in, the extensive governmental +regulations regarding the oil and natural gas business; +o actions of operators of our oil and gas properties; and +o weather conditions. +The information contained in this report, including the information set forth +under the heading "Risk Factors," identifies additional factors that could +affect our operating results and performance. We urge you to carefully consider +these factors and the other cautionary statements in this report. Our +forward-looking statements speak only as of the date made, and we have no +obligation to update these forward-looking statements. +CORPORATE OFFICES +Our headquarters are located in Natchez, Mississippi, in approximately 51,500 +square feet of owned space. In late 2000, we opened a field office in Houston, +Texas, staffed with recently hired technical professionals, to enhance +exploration and development efforts. We also maintain owned or leased field +offices in the area of the major fields in which we operate properties or have a +significant interest. Replacement of any of our leased offices would not result +in material expenditures by us as alternative locations to our leased space are +anticipated to be readily available. +9 +EMPLOYEES +We had 103 employees as of December 31, 2001, none of whom are currently +represented by a union. We believe that we have good relations with our +employees. We employ nine petroleum engineers and eight petroleum geoscientists. +FEDERAL REGULATIONS +SALES OF NATURAL GAS. Effective January 1, 1993, the Natural Gas Wellhead +Decontrol Act deregulated prices for all "first sales" of natural gas. Thus, all +sales of gas by the Company may be made at market prices, subject to applicable +contract provisions. +TRANSPORTATION OF NATURAL GAS. The rates, terms and conditions applicable to the +interstate transportation of natural gas by pipelines are regulated by the +Federal Energy Regulatory Commission ("FERC") under the Natural Gas Act ("NGA"), +as well as under section 311 of the Natural Gas Policy Act ("NGPA"). Since 1985, +the FERC has implemented regulations intended to make natural gas transportation +more accessible to gas buyers and sellers on an open-access, non-discriminatory +basis. +The FERC has announced several important transportation-related policy +statements and rule changes, including a statement of policy and final rule +issued February 25, 2000 concerning alternatives to its traditional +cost-of-service rate-making methodology to establish the rates interstate +pipelines may charge for their services. The final rule revises FERC's pricing +policy and current regulatory framework to improve the efficiency of the market +and further enhance competition in natural gas markets. +With respect to the transportation of natural gas on or across the Outer +Continental Shelf ("OCS"), the FERC requires, as part of its regulation under +the Outer Continental Shelf Lands Act, that all pipelines provide open and +non-discriminatory access to both owner and non-owner shippers. Although to date +the FERC has imposed light-handed regulation on off-shore facilities that meet +its traditional test of gathering status, it has the authority to exercise +jurisdiction under the Outer Continental Shelf Lands Act ("OCSLA") over +gathering facilities, if necessary, to permit non-discriminatory access to +service. For those facilities transporting natural gas across the OCS that are +not considered to be gathering facilities, the rates, terms, and conditions +applicable to this transportation are regulated by FERC under the NGA and NGPA, +as well as the OCSLA. +SALES AND TRANSPORTATION OF CRUDE OIL. Sales of crude oil and condensate can be +made by the Company at market prices not subject at this time to price controls. +The price that the Company receives from the sale of these products will be +affected by the cost of transporting the products to market. The rates, terms, +and conditions applicable to the interstate transportation of oil and related +products by pipelines are regulated by the FERC under the Interstate Commerce +Act. As required by the Energy Policy Act of 1992, the FERC has revised its +regulations governing the rates that may be charged by oil pipelines. The new +rules, which were effective January 1, 1995, provide a simplified, generally +applicable method of regulating such rates by use of an index for setting rate +ceilings. The FERC will also, under defined circumstances, permit alternative +ratemaking methodologies for interstate oil pipelines such as the use of cost of +service rates, settlement rates, and market-based rates. Market-based rates will +be permitted to the extent the pipeline can demonstrate that it lacks +significant market power in the market in which it proposes to charge +market-based rates. The cumulative effect that these rules may have on moving +the Company's production to market cannot yet be determined. +10 +With respect to the transportation of oil and condensate on or across the OCS, +the FERC requires, as part of its regulation under the OCSLA, that all pipelines +provide open and non-discriminatory access to both owner and non-owner shippers. +Accordingly, the FERC has the authority to exercise jurisdiction under the +OCSLA, if necessary, to permit non-discriminatory access to service. +LEGISLATIVE PROPOSALS. In the past, Congress has been very active in the area of +natural gas regulation. There are legislative proposals pending in Congress and +in various state legislatures which, if enacted, could significantly affect the +petroleum industry. At the present time it is impossible to predict what +proposals, if any, might actually be enacted by Congress or the various state +legislatures and what effect, if any, such proposals might have on the Company's +operations. +FEDERAL, STATE OR INDIAN LEASES. In the event the Company conducts operations on +federal, state or Indian oil and gas leases, such operations must comply with +numerous regulatory restrictions, including various nondiscrimination statutes, +royalty and related valuation requirements, and certain of such operations must +be conducted pursuant to certain on-site security regulations and other +appropriate permits issued by the Bureau of Land Management ("BLM") or Minerals +Management Service ("MMS") or other appropriate federal or state agencies. +The Company's OCS leases in federal waters are administered by the MMS and +require compliance with detailed MMS regulations and orders. The MMS has +promulgated regulations implementing restrictions on various production-related +activities, including restricting the flaring or venting of natural gas. Under +certain circumstances, the MMS may require Company operations on federal leases +to be suspended or terminated. Any such suspension or termination could +materially and adversely affect the Company's financial condition and +operations. On March 15, 2000, the MMS issued a final rule effective June 1, +2000 which amends its regulations governing the calculation of royalties and the +valuation of crude oil produced from federal leases. Among other matters, this +rule amends the valuation procedure for the sale of federal royalty oil by +eliminating posted prices as a measure of value and relying instead on arm's +length sales prices and spot market prices as market value indicators. Because +the Company sells its production in the spot market and therefore pays royalties +on production from federal leases, it is not anticipated that this final rule +will have any substantial impact on the Company. +The Mineral Leasing Act of 1920 ("Mineral Act") prohibits direct or indirect +ownership of any interest in federal onshore oil and gas leases by a foreign +citizen of a country that denies "similar or like privileges" to citizens of the +United States. Such restrictions on citizens of a "non-reciprocal" country +include ownership or holding or controlling stock in a corporation that holds a +federal onshore oil and gas lease. If this restriction is violated, the +corporation's lease can be canceled in a proceeding instituted by the United +States Attorney General. Although the regulations of the BLM (which administers +the Mineral Act) provide for agency designations of non-reciprocal countries, +there are presently no such designations in effect. The Company owns interests +in numerous federal onshore oil and gas leases. It is possible that holders of +equity interests in the Company may be citizens of foreign countries, which at +some time in the future might be determined to be non-reciprocal under the +Mineral Act. +STATE REGULATIONS +Most states regulate the production and sale of oil and natural gas, including +requirements for obtaining drilling permits, the method of developing new +fields, the spacing and operation of wells and the prevention of waste of oil +and gas resources. The rate of production may be regulated and the maximum daily +production allowable from both oil and gas wells may be established on a market +demand or conservation basis or both. +11 +The Company may enter into agreements relating to the construction or operation +of a pipeline system for the transportation of natural gas. To the extent that +such gas is produced, transported and consumed wholly within one state, such +operations may, in certain instances, be subject to the jurisdiction of such +state's administrative authority charged with the responsibility of regulating +intrastate pipelines. In such event, the rates which the Company could charge +for gas, the transportation of gas, and the costs of construction and operation +of such pipeline would be impacted by the rules and regulations governing such +matters, if any, of such administrative authority. Further, such a pipeline +system would be subject to various state and/or federal pipeline safety +regulations and requirements, including those of, among others, the Department +of Transportation. Such regulations can increase the cost of planning, +designing, installation and operation of such facilities. The impact of such +pipeline safety regulations would not be any more adverse to the Company than it +would be to other similar owners or operators of such pipeline facilities. +ENVIRONMENTAL REGULATIONS +GENERAL. The Company's activities are subject to federal, state and local laws +and regulations governing environmental quality and pollution control. Although +no assurances can be made, the Company believes that, absent the occurrence of +an extraordinary event, compliance with existing federal, state and local laws, +rules and regulations regulating the release of materials in the environment or +otherwise relating to the protection of the environment will not have a material +effect upon the capital expenditures, earnings or the competitive position of +the Company with respect to its existing assets and operations. The Company +cannot predict what effect additional regulation or legislation, enforcement +policies thereunder, and claims for damages to property, employees, other +persons and the environment resulting from the Company's operations could have +on its activities. +Activities of the Company with respect to natural gas facilities, including the +operation and construction of pipelines, plants and other facilities for +transporting, processing, treating or storing natural gas and other products, +are subject to stringent environmental regulation by state and federal +authorities including the United States Environmental Protection Agency ("EPA"). +Such regulation can increase the cost of planning, designing, installation and +operation of such facilities. In most instances, the regulatory requirements +relate to water and air pollution control measures. Although the Company +believes that compliance with environmental regulations will not have a material +adverse effect on it, risks of substantial costs and liabilities are inherent in +oil and gas production operations, and there can be no assurance that +significant costs and liabilities will not be incurred. Moreover, it is possible +that other developments, such as stricter environmental laws and regulations, +and claims for damages to property or persons resulting from oil and gas +production, would result in substantial costs and liabilities to the Company. +SOLID AND HAZARDOUS WASTE. The Company owns or leases numerous properties that +have been used for production of oil and gas for many years. Although the +Company has utilized operating and disposal practices standard in the industry +at the time, hydrocarbons or other solid wastes may have been disposed or +released on or under these properties. In addition, many of these properties +have been operated by third parties. The Company had no control over such +entities' treatment of hydrocarbons or other solid wastes and the manner in +which such substances may have been disposed or released. State and federal laws +applicable to oil and gas wastes and properties have gradually become stricter +over time. Under these new laws, the Company could be required to remove or +remediate previously disposed wastes (including wastes disposed or released by +prior owners or operators) or property contamination (including groundwater +contamination by prior owners or operators) or to perform remedial plugging +operations to prevent future contamination. +The Company generates wastes, including hazardous wastes, that are subject to +the Federal Resource Conservation and Recovery Act ("RCRA") and comparable state +statutes. The EPA has limited the disposal +12 +options for certain hazardous wastes and is considering the adoption of stricter +disposal standards for nonhazardous wastes. Furthermore, it is possible that +certain wastes currently exempt from treatment as "hazardous wastes" generated +by the Company's oil and gas operations may in the future be designated as +"hazardous wastes" under RCRA or other applicable statutes, and therefore may be +subject to more rigorous and costly disposal requirements. +SUPERFUND. The Comprehensive Environmental Response, Compensation and Liability +Act ("CERCLA"), also known as the "Superfund" law, imposes liability, without +regard to fault or the legality of the original conduct, on certain classes of +persons with respect to the release of a "hazardous substance" into the +environment. These persons include the owner and operator of a site and persons +that disposed or arranged for the disposal of the hazardous substances found at +a site. CERCLA also authorizes the EPA and, in some cases, third parties to take +actions in response to threats to the public health or the environment and to +seek to recover from the responsible classes of persons the costs of such +action. Neither the Company nor its predecessors has been designated as a +potentially responsible party by the EPA under CERCLA with respect to any such +site. +OIL POLLUTION ACT. The Oil Pollution Act of 1990 (the "OPA") and regulations +thereunder impose a variety of regulations on "responsible parties" related to +the prevention of oil spills and liability for damages resulting from such +spills in United States waters. A "responsible party" includes the owner or +operator of a facility or vessel, or the lessee or permittee of the area in +which an offshore facility is located. The OPA assigns liability to each +responsible party for oil removal costs and a variety of public and private +damages. While liability limits apply in some circumstances, a party cannot take +advantage of liability limits if the spill was caused by gross negligence or +willful misconduct or resulted from violation of a federal safety, construction +or operating regulation. If the party fails to report a spill or to cooperate +fully in the cleanup, liability limits likewise do not apply. Few defenses exist +to the liability imposed by the OPA. +The OPA also imposes ongoing requirements on a responsible party, including +proof of financial responsibility to cover at least some costs in a potential +spill. Certain amendments to the OPA that were enacted in 1996 require owners +and operators of offshore facilities that have a worst case oil spill potential +of more than 1,000 barrels to demonstrate financial responsibility in amounts +ranging from $10 million in specified state waters and $35 million in federal +OCS waters, with higher amounts, up to $150 million based upon worst case +oil-spill discharge volume calculations. The Company believes that it currently +has established adequate proof of financial responsibility for its offshore +facilities. +AIR EMISSIONS. The operations of the Company are subject to local, state and +federal regulations for the control of emissions from sources of air pollution. +Administrative enforcement actions for failure to comply strictly with air +regulations or permits are generally resolved by payment of monetary fines and +correction of any identified deficiencies. Alternatively, regulatory agencies +could require the Company to forego construction or operation of certain air +emission sources, although the Company believes that in such case it would have +enough permitted or permittable capacity to continue its operations without a +material adverse effect on any particular producing field. +OSHA. The Company is subject to the requirements of the Federal Occupational +Safety and Health Act ("OSHA") and comparable state statutes. The OSHA hazard +communication standard, the EPA community right-to-know regulations under Title +III of the Federal Superfund Amendment and Reauthorization Act and similar state +statutes require the Company to organize and/or disclose information about +hazardous materials used or produced in its operations. Certain of this +information must be provided to employees, state and local governmental +authorities and local citizens. +13 +Management believes that the Company is in substantial compliance with current +applicable environmental laws and regulations and that continued compliance with +existing requirements would not have a material adverse impact on the Company. \ No newline at end of file diff --git a/raw/filings/0000928022/2001/0000950134-02-003092/item13.txt b/raw/filings/0000928022/2001/0000950134-02-003092/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2001/0000950134-02-003092/item9a.txt b/raw/filings/0000928022/2001/0000950134-02-003092/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2001/0000950134-02-003092/rp_note.txt b/raw/filings/0000928022/2001/0000950134-02-003092/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2001/0000950134-02-003092/rpt_disclosure.txt b/raw/filings/0000928022/2001/0000950134-02-003092/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..bc67dd34e1f12390166612fbb8158eaad0d24de5 --- /dev/null +++ b/raw/filings/0000928022/2001/0000950134-02-003092/rpt_disclosure.txt @@ -0,0 +1,11 @@ +TRANSACTIONS WITH RELATED PERSONS +REGISTRATION RIGHTS. The Callon Family (including John S. Callon and +Fred L. Callon) is party to a Registration Rights Agreement dated September 16, +1994 (the "Registration Rights Agreement"), pursuant to which they are entitled +to require the Company to register Common Stock owned by them with the +Commission for sale to the public in a firm commitment public offering and +generally to include shares owned by them in registration statements filed by +the Company. NOCO and the Company have entered into a similar agreement, which +was subsequently amended to include F.O. Energy. The registration rights +agreement with F.O. Energy also covers Common Stock held by its assignees, +Ganger Rolf and Bonheur. \ No newline at end of file diff --git a/raw/filings/0000928022/2002/0000950134-03-004701/filing.txt b/raw/filings/0000928022/2002/0000950134-03-004701/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..1f3bc53145cdbc7e523b46e5ffc4a5c395a216a2 --- /dev/null +++ b/raw/filings/0000928022/2002/0000950134-03-004701/filing.txt @@ -0,0 +1,3653 @@ +10-K +1 +d04345e10vk.txt +FORM 10-K +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF +THE SECURITIES EXCHANGE ACT OF 1934 +FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002 +COMMISSION FILE NUMBER 001-14039 +CALLON PETROLEUM COMPANY +(Exact name of Registrant as specified in its charter) +DELAWARE 64-0844345 +--------------------------------- -------------------- +(State or other jurisdiction of (I.R.S. Employer +incorporation or organization) Identification No.) +200 NORTH CANAL STREET +NATCHEZ, MISSISSIPPI 39120 (601) 442-1601 +--------------------------------- --------------------------- +(Address of Principal Executive (Registrant's telephone +Offices)(Zip Code) number including area code) +Securities registered pursuant to Section 12(b) of the Act: +TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED +------------------- ----------------------------------- +Convertible Exchangeable Preferred Stock, New York Stock Exchange +Series A, Par Value $.01 Per Share +Common Stock, Par Value $.01 Per Share New York Stock Exchange +Preferred Stock Purchase Rights New York Stock Exchange +11% Senior Subordinated Notes due 2005 New York Stock Exchange +10.25% Senior Subordinated Notes due 2004 New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: NONE +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 if disclosure of delinquent filers pursuant to Item 405 +of Regulation S-K is not contained herein, and will not be contained, to the +best of Registrant's knowledge, in definitive proxy or information statements +incorporated by reference in Part III of this Form 10-K or any amendment to this +Form 10-K. [X] +Indicate by check mark whether the registrant is an accelerated filer (as +defined in Exchange Act Rule 12b-2). Yes No X . +---- --- +The aggregate market value of the voting and non-voting common equity held by +nonaffiliates of the registrant was approximately $53,216,000 as of June 28, +2002, and $46,702,000 as of March 7, 2003 (based on the last reported sale price +of such stock on the New York Stock Exchange on such dates). +As of March 7, 2003, there were 13,919,457 shares of the Registrant's Common +Stock, par value $.01 per share, outstanding. +Document incorporated by reference: Portions of the definitive Proxy Statement +of Callon Petroleum Company (to be filed no later than 120 days after December +31, 2002) relating to the Annual Meeting of Stockholders to be held on May 2, +2003, which is incorporated into Part III of this Form 10-K. +1 +PART I. +ITEM 1 AND 2. BUSINESS AND PROPERTIES +OVERVIEW +Callon Petroleum Company has been engaged in the exploration, development, +acquisition and production of oil and gas properties since 1950. Our properties +are geographically concentrated primarily offshore in the Gulf of Mexico and +onshore in Louisiana and Alabama. The public Company was incorporated under the +laws of the state of Delaware in 1994 through the consolidation of a publicly +traded limited partnership, a joint venture with a consortium of European +institutional investors and an independent energy company owned by certain +members of current management (the "Consolidation"). As used herein, the +"Company," "Callon," "we," "us," and "our" refer to Callon Petroleum Company and +its predecessors and subsidiaries unless the context requires otherwise. +In 1989, we began increasing our reserves through the acquisition of producing +properties that were geologically complex, had (or were analogous to fields +with) an established production history from stacked pay zones and were +candidates for exploitation. We focused on reducing operating costs and +implementing production enhancements through the application of technologically +advanced production and recompletion techniques. +Over the past seven years, we have also placed emphasis on the acquisition of +acreage with exploration and development drilling opportunities in the Gulf of +Mexico Shelf area. We acquired an infrastructure of production platforms, +gathering systems and pipelines to minimize development expenditures of these +drilling opportunities. We also joined with other industry partners, primarily +Murphy Exploration and Production, Inc., ("Murphy"), to explore federal offshore +blocks acquired in the Gulf of Mexico. Our areas of exploration include the Gulf +of Mexico Deepwater area (generally 900 to 5,500 feet of water). +We ended the year 2002 with estimated net proved reserves of 236 billion cubic +feet of natural gas equivalent ("Bcfe"). This represents a decrease of 22% from +2001 year-end estimated net proved reserves of 303 Bcfe. +The major focus of our future operations is expected to continue to be the +exploration for and development of oil and gas properties, primarily in the Gulf +of Mexico. +AVAILABILITY OF REPORTS +All of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current +reports on Form 8-K, and amendments to such reports as well as other filings we +make pursuant to Section 13(a) and 15(d) of the Securities Exchange Act of 1934 +are available free of charge on our Internet website. The address of our +Internet website is www.callon.com. Our SEC filings are available on our website +as soon as they are posted to the EDGAR database on the SEC's website. +BUSINESS STRATEGY +Our goal is to increase shareholder value by increasing our reserves, +production, cash flow and earnings. We seek to achieve these goals through the +following strategies: +o Focus on Gulf of Mexico exploration with a balance between shelf and +deepwater areas using the latest available technology. +o Aggressively explore our existing prospect inventory. +o Replenish our prospect inventory with increasing emphasis on prospect +generation. +2 +o Achieve moderate increases in current production levels through +continued shelf exploration. +o Achieve significant increases in longer-term production levels through +development of deepwater discoveries and ongoing deepwater exploration. +EXPLORATION AND DEVELOPMENT ACTIVITIES +Capital expenditures for exploration and development costs related to oil and +gas properties totaled approximately $61.9 million in 2002. We incurred +approximately $24.4 million in the Gulf of Mexico Shelf area, with approximately +$9.7 million related to the Mobile 952/953/955 acceleration project. The Gulf of +Mexico Deepwater area expenditures ($24.6 million) accounted for the remainder +of the total capital expended, along with $660,000 incurred in leasehold and +seismic acquisition costs and $15.2 million of interest and general and +administrative costs allocable directly to exploration and development projects. +The Gulf of Mexico Deepwater area expenditures were incurred primarily in the +production facility fabrication for our Medusa discovery. +As a result of drilling successes in the Gulf of Mexico Deepwater area, we are +faced with increased costs to develop these significant proved undeveloped +reserves. A large portion of these future development costs will be incurred in +2003 and beyond. While management believes that current availability under our +existing credit facilities along with current cash flows are expected to meet +the needs of these development costs, no assurances can be made that we will be +able to fund these development costs. +SEC REVIEW OF PROVED RESERVES +In October 2002, we received a letter from the SEC requesting supplemental +information concerning our operations in the Gulf of Mexico. We believe that a +similar letter was sent to other oil and gas companies with off-shore +operations. We responded to the SEC's letter on October 18, 2002. +On February 21, 2003, we received another letter from the SEC requesting +additional information about the procedures we used to classify our offshore +reserves as "proved" in our Form 10-K for our fiscal year ended December 31, +2001. The letter also questions the procedures used to classify reserves at our +Boomslang property as proved undeveloped reserves at year end 1998. In 2002, we +drilled a development well which caused us to reduce our estimated reservoir +volumes at our Boomslang property (and record a downward revision of our +estimates of the reserves attributable to such property at December 31, 2002) to +such an extent that the partners determined that the risk of further development +was not economic. The staff of the SEC has asked Callon to restate its financial +statements for fiscal years 2000 and 2001 to remove the reserves attributable to +Boomslang as proved. We responded to the SEC's second letter on March 13, 2003. +We have reviewed the SEC comments with our independent petroleum reserve +engineers, Huddleston & Co., Inc., Houston, Texas. Both Huddleston & Co. and +Callon believe that our proved reserves were properly classified in accordance +with SEC definitions and industry practices. The Company believes the reserve +revision has no effect on prior year financial statements as it represents a +change in estimate. If the SEC requires us to retroactively classify Boomslang +as an unproved property through December, 2002, we would be required to restate +our financial position, results of operations, and supplemental oil and gas +reserve data from 1998 through 2002. +Based on our discussions with others in the oil and gas business, we believe +that the SEC is reviewing generally the procedures used by reserve engineers to +classify oil and gas reserves as proved in the +3 +deepwater areas of the Gulf of Mexico. In particular, the SEC appears to +indicate that it is not appropriate to classify reserves as proved without +conducting a "flow test." It has not been our practice to conduct a flow test on +our deepwater properties prior to classifying the reserves as proved. We +believe, and have been advised by Huddleston & Co., that our procedures for +classifying our deepwater reserves as proved are in accordance with SEC rules +and industry practices. +The SEC has asked us, and we have provided substantial detail, about our proved +reserves, including the detailed reserve report. At this point, we cannot +predict the ultimate outcome of the SEC's review of our proved reserves. With +respect to our deepwater projects other than Boomslang, we believe that the +outcome of the SEC's review of practices in the oil and gas industry for +classifying deepwater reserves as proved should not affect us materially +differently than other similarly situated oil and gas companies with deepwater +projects. With respect to Boomslang, we believe that reserves attributable to +the project were properly classified as proved at year end 1998, 1999, 2000 and +2001, and that no restatement of our financial statements is required as this +revision to our Boomslang reserves in 2002 represented a change in estimates of +our proved reserves. We cannot make any assurances, however, that the SEC will +ultimately agree with this position. +RISK FACTORS +DECREASE IN OIL AND GAS PRICES MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS +AND FINANCIAL CONDITION. Our success is highly dependent on prices for oil and +gas, which are extremely volatile. Any substantial or extended decline in the +price of oil or gas would have a material adverse effect on us. Oil and gas +markets are both seasonal and cyclical. The prices of oil and gas depend on +factors we cannot control such as weather, economic conditions, and levels of +production, actions by OPEC and other countries and government actions. Prices +of oil and gas will affect the following aspects of our business: +o our revenues, cash flows and earnings; +o the amount of oil and gas that we are economically able to produce; +o our ability to attract capital to finance our operations and the cost of +the capital; +o the amount we are allowed to borrow under our senior credit facility; +o the value of our oil and gas properties; and +o the profit or loss we incur in exploring for and developing our +reserves. +UNLESS WE ARE ABLE TO REPLACE RESERVES WHICH WE HAVE PRODUCED, OUR CASH FLOWS +AND PRODUCTION WILL DECREASE OVER TIME. Our future success depends upon our +ability to find, develop and acquire oil and gas reserves that are economically +recoverable. As is generally the case for Gulf properties, our producing +properties usually have high initial production rates, followed by a steep +decline in production. As a result, we must continually locate and develop or +acquire new oil and gas reserves to replace those being depleted by production. +We must do this even during periods of low oil and gas prices when it is +difficult to raise the capital necessary to finance these activities and during +periods of high operating costs when it is expensive to contract for drilling +rigs and other equipment and personnel necessary to explore for oil and gas. +Without successful exploration or acquisition activities, our reserves, +production and revenues will decline rapidly. We cannot assure you that we will +be able to find and develop or acquire additional reserves at an acceptable +cost. +A SIGNIFICANT PART OF THE VALUE OF OUR PRODUCTION AND RESERVES IS CONCENTRATED +IN A SMALL NUMBER OF OFFSHORE PROPERTIES, AND ANY PRODUCTION PROBLEMS OR +INACCURACIES IN RESERVE ESTIMATES RELATED TO THOSE PROPERTIES WOULD ADVERSELY +IMPACT OUR BUSINESS. During 2002, 49% of our daily production came from two of +our properties in the Gulf of Mexico. Moreover, one property accounted for 33% +of our production during this period. If mechanical problems, storms or other +events curtailed a substantial +4 +portion of this production, our results of operations would be adversely +affected. In addition, at December 31, 2002, most of our proved reserves were +located in five fields in the Gulf of Mexico, with approximately 93% of our +total net proved reserves attributable to these properties. If the actual +reserves associated with any one of these producing properties are less than our +estimated reserves, our results of operations and financial condition could be +adversely affected. +OUR FOCUS ON EXPLORATION PROJECTS INCREASES THE RISKS INHERENT IN OUR OIL AND +GAS ACTIVITIES. Our business strategy focuses on replacing reserves through +exploration, where the risks are greater than in acquisitions and development +drilling. Although we have been successful in exploration in the past, we cannot +assure you that we will continue to increase reserves through exploration or at +an acceptable cost. Additionally, we are often uncertain as to the future costs +and timing of drilling, completing and producing wells. Our drilling operations +may be curtailed, delayed or canceled as a result of a variety of factors, +including: +o unexpected drilling conditions; +o pressure or inequalities in formations; +o equipment failures or accidents; +o adverse weather conditions; +o compliance with governmental requirements; and +o shortages or delays in the availability of drilling rigs and the +delivery of equipment. +BECAUSE WE DO NOT CONTROL, AND DO NOT OPERATE, ALL OF OUR PROPERTIES, ESPECIALLY +OUR DEEPWATER PROPERTIES, WE HAVE LIMITED INFLUENCE OVER THEIR DEVELOPMENT. Our +lack of control could result in the following: +o the operator may initiate exploration or development on a faster or +slower pace than we prefer; +o the operator may propose to drill more wells or build more facilities on +a project than we have funds for or that we deem appropriate, which may +mean that we are unable to participate in the project or share in the +revenues generated by the project even though we paid our share of +exploration costs; and +o if an operator refuses to initiate a project, we may be unable to pursue +the project. +Any of these events could materially reduce the value of our properties. +OUR DEEPWATER OPERATIONS HAVE SPECIAL OPERATIONAL RISKS THAT MAY NEGATIVELY +AFFECT THE VALUE OF THOSE ASSETS. Drilling operations in the deepwater area are +by their nature more difficult and costly than drilling operations in shallow +water. Deepwater drilling operations require the application of more advanced +drilling technologies, involving a higher risk of technological failure and +usually have significantly higher drilling costs than shallow water drilling +operations. Deepwater wells are completed using sub sea completion techniques +that require substantial time and the use of advanced remote installation +equipment. These operations involve a high risk of mechanical difficulties and +equipment failures that could result in significant cost overruns. +In deepwater, the time required to commence production following a discovery is +much longer than in shallow water and on-shore. Our deepwater discoveries and +prospects will require the construction of expensive production facilities and +pipelines prior to the beginning of production. We cannot estimate the costs and +timing of the construction of these facilities with certainty, and the accuracy +of our estimates will be affected by a number of factors beyond our control, +including the following: +5 +o decisions made by the operators of our deepwater wells; +o the availability of materials necessary to construct the facilities; +o the proximity of our discoveries to pipelines; and +o the price of oil and natural gas. +Delays and cost overruns in the commencement of production will affect the value +of our deepwater prospects and the discounted present value of reserves +attributable to those prospects. +Competitive industry conditions may negatively affect our ability to conduct +operations. We operate in the highly competitive areas of oil and gas +exploration, development and production. We compete for the purchase of leases +in the Gulf of Mexico from the U. S. government and from other oil and gas +companies. These leases include exploration prospects as well as properties with +proved reserves. Factors that affect our ability to compete in the marketplace +include: +o our access to the capital necessary to drill wells and acquire +properties; +o our ability to acquire and analyze seismic, geological and other +information relating to a property; +o our ability to retain the personnel necessary to properly evaluate +seismic and other information relating to a property; +o the location of, and our ability to access, platforms, pipelines and +other facilities used to produce and transport oil and gas production; +o the standards we establish for the minimum projected return on an +investment of our capital; and +o the availability of alternate fuel sources. +Our competitors include major integrated oil companies, substantial independent +energy companies, and affiliates of major interstate and intrastate pipelines +and national and local gas gatherers, many of which possess greater financial, +technological and other resources than we do. +OUR COMPETITORS MAY USE SUPERIOR TECHNOLOGY, WHICH WE MAY BE UNABLE TO AFFORD OR +WHICH WOULD REQUIRE COSTLY INVESTMENT BY US IN ORDER TO COMPETE. Our industry is +subject to rapid and significant advancements in technology, including the +introduction of new products and services using new technologies. As our +competitors use or develop new technologies, we may be placed at a competitive +disadvantage, and competitive pressures may force us to implement new +technologies at a substantial cost. In addition, our competitors may have +greater financial, technical and personnel resources that allow them to enjoy +technological advantages and may in the future allow them to implement new +technologies before we can. We cannot be certain that we will be able to +implement technologies on a timely basis or at a cost that is acceptable to us. +One or more of the technologies that we currently use or that we may implement +in the future may become obsolete, and we may be adversely affected. For +example, marine seismic acquisition technology has been characterized by rapid +technological advancements in recent years, and further significant +technological developments could substantially impair our 3-D seismic data's +value. +WE MAY NOT BE ABLE TO REPLACE OUR RESERVES OR GENERATE CASH FLOWS IF WE ARE +UNABLE TO RAISE CAPITAL. WE WILL BE REQUIRED TO MAKE SUBSTANTIAL CAPITAL +EXPENDITURES TO DEVELOP OUR EXISTING RESERVES, AND TO DISCOVER NEW OIL AND GAS +RESERVES. Historically, we have financed these expenditures primarily with cash +from operations, proceeds from bank borrowings and proceeds from the sale of +debt and equity securities. See "Management's Discussion and Analysis of +Financial Condition and Results of Operations -- Liquidity and Capital +Resources" for a discussion of our capital budget. We cannot assure you that we +will be able to raise capital in the future. We also make offers to acquire oil +and gas properties in the ordinary course of our business. If these offers are +accepted, our capital needs may increase substantially. +6 +We expect to continue using our senior credit facility to borrow funds to +supplement our available cash. The amount we may borrow under our senior credit +facility may not exceed a borrowing base determined by the lenders based on +their projections of our future production, future production costs, taxes, +commodity prices and any other factors deemed relevant by our lenders. We cannot +control the assumptions the lenders use to calculate our borrowing base. The +lenders may, without our consent, adjust the borrowing base semiannually or in +situations where we purchase or sell assets or issue debt securities. If our +borrowings under the senior credit facility exceed the borrowing base, the +lenders may require that we repay the excess. If this were to occur, we might +have to sell assets or seek financing from other sources. Sales of assets could +further reduce the amount of our borrowing base. We cannot assure you that we +would be successful in selling assets or arranging substitute financing. If we +were not able to repay borrowings under our senior credit facility to reduce the +outstanding amount to less than the borrowing base, we would be in default under +our senior credit facility. For a description of our senior credit facility and +its principal terms and conditions, see "Management's Discussion and Analysis of +Financial Condition and Results of Operations -- Liquidity and Capital +Resources." +7 +OUR RESERVE INFORMATION REPRESENTS ESTIMATES THAT MAY TURN OUT TO BE INCORRECT +IF THE ASSUMPTIONS UPON WHICH THESE ESTIMATES ARE BASED ARE INACCURATE. ANY +MATERIAL INACCURACIES IN THESE RESERVE ESTIMATES OR UNDERLYING ASSUMPTIONS WILL +MATERIALLY AFFECT THE QUANTITIES AND PRESENT VALUE OF OUR RESERVES. The process +of estimating oil and gas reserves is complex. It requires interpretations of +available technical data and various assumptions, including assumptions relating +to economic factors. Any significant inaccuracies in these interpretations or +assumptions could materially affect the estimated quantities and present value +of reserves shown in this annual report. +In order to prepare these estimates, we must project production rates and the +timing of development expenditures. The assumptions regarding the timing and +costs to commence production from our deepwater wells used in preparing our +reserves are often subject to revisions over time as described under "our +deepwater operations have special operational risks that may negatively affect +the value of those assets." We must also analyze available geological, +geophysical, production and engineering data, the extent, quality and +reliability of which can vary. The process also requires economic assumptions, +such as oil and gas prices, drilling and operating expenses, capital +expenditures, taxes and availability of funds. Therefore, estimates of oil and +gas reserves are inherently imprecise. +Actual future production, oil and gas prices, revenues, taxes, development +expenditures, operating expenses and quantities of recoverable oil and gas +reserves most likely will vary from our estimates. Any significant variance +could materially affect the estimated quantities and present value of reserves +shown in this report. In addition, we may adjust estimates of proved reserves to +reflect production history, results of exploration and development, prevailing +oil and gas prices and other factors, many of which are beyond our control. +You should not assume that the present value of future net cash flows from our +proved reserves referred to in this report is the current market value of our +estimated oil and gas reserves. In accordance with SEC requirements, we +generally base the estimated discounted future net cash flows from our proved +reserves on prices and costs on the date of the estimate. Actual future prices +and costs may differ materially from those used in the present value estimate. +Information about reserves constitutes forward-looking information. See +"Forward-Looking Statements" for information regarding forward-looking +information. The discounted present value of our oil and gas reserves is +prepared in accordance with guidelines established by the SEC. A purchaser of +reserves would use numerous other factors to value our reserves. The discounted +present value of reserves, therefore, does not represent the fair market value +of those reserves. +On December 31, 2002, approximately 81.4% of the discounted present value of our +estimated net proved reserves were proved undeveloped. Proved undeveloped oil +volumes represented 96% of total proved oil reserves. Substantially all of these +proved undeveloped reserves were attributable to our deepwater properties. +Development of these properties is subject to additional risks as described +above. +THE SEC MAY REQUIRE US TO BOOK RESERVES AS PROVED IN A MANNER THAT DIFFERS FROM +OUR HISTORICAL PRACTICES AND CURRENT INDUSTRY STANDARDS, AND WHICH MAY RESULT IN +A SIGNIFICANT DOWNWARD REVISION OF OUR PROVED RESERVES. As discussed above, in +October 2002 and February 2003, we received letters from the SEC regarding our +Annual Report on Form 10-K for the year ended December 31, 2001 requesting +supplemental information concerning our operations in the Gulf of Mexico. The +comment letters requested information about the procedures we used to classify +our deepwater reserves as proved and requested that our financials be restated +to reflect the removal of the Boomslang reserves as proved for all prior periods +during which such reserves were reported as proved. We have reviewed the SEC +8 +comments with our independent petroleum reserve engineers, Huddleston & Co., +Inc. of Houston, Texas. Both Huddleston & Co and Callon believe that such +reserves were properly classified as proved. However, if the SEC decides to +question our other deepwater properties and these reserves are ultimately +required to be reclassified as not proved; our proved reserves will be +materially reduced. If the SEC requires us to retroactively classify Boomslang +as an unproved property through December, 2002, we would be required to restate +our financial position, results of operations, and supplemental oil and gas +reserve data from 1998 through 2002. A material reduction in our proved reserves +could have a material adverse effect on our financial condition and results of +operations. +WEATHER, UNEXPECTED SUBSURFACE CONDITIONS, AND OTHER UNFORESEEN OPERATING +HAZARDS MAY ADVERSELY IMPACT OUR ABILITY TO CONDUCT BUSINESS. There are many +operating hazards in exploring for and producing oil and gas, including: +o our drilling operations may encounter unexpected formations or +pressures, which could cause damage to equipment or personal injury; +o we may experience equipment failures which curtail or stop production; +and +o we could experience blowouts or other damages to the productive +formations that may require a well to be re-drilled or other corrective +action to be taken. +In addition, any of the foregoing may result in environmental damages for which +we will be liable. Moreover, a substantial portion of our operations are +offshore and are subject to a variety of risks peculiar to the marine +environment such as capsizing, collisions, hurricanes and other adverse weather +conditions. These conditions can cause substantial damage to facilities and +interrupt production. Offshore operations are also subject to more extensive +governmental regulation. +We cannot assure you that we will be able to maintain adequate insurance at +rates we consider reasonable to cover our possible losses from operating +hazards. The occurrence of a significant event not fully insured or indemnified +against could materially and adversely affect our financial condition and +results of operations. +WE MAY NOT HAVE PRODUCTION TO OFFSET HEDGES; BY HEDGING, WE MAY NOT BENEFIT FROM +PRICE INCREASES. Part of our business strategy is to reduce our exposure to the +volatility of oil and gas prices by hedging a portion of our production. In a +typical hedge transaction, we will have the right to receive from the other +parties to the hedge the excess of the fixed price specified in the hedge over a +floating price based on a market index, multiplied by the quantity hedged. If +the floating price exceeds the fixed price, we are required to pay the other +parties this difference multiplied by the quantity hedged. We are required to +pay the difference between the floating price and the fixed price when the +floating price exceeds the fixed price regardless of whether we have sufficient +production to cover the quantities specified in the hedge. Significant +reductions in production at times when the floating price exceeds the fixed +price could require us to make payments under the hedge agreements even though +such payments are not offset by sales of production. Hedging will also prevent +us from receiving the full advantage of increases in oil or gas prices above the +fixed amount specified in the hedge. See "Quantitative and Qualitative +Disclosures About Market Risks" for a discussion of our hedging practices. +9 +COMPLIANCE WITH ENVIRONMENTAL AND OTHER GOVERNMENT REGULATIONS COULD BE COSTLY +AND COULD NEGATIVELY IMPACT PRODUCTION. Our operations are subject to numerous +laws and regulations governing the operation and maintenance of our facilities +and discharge of materials into the environment or otherwise relating to +environmental protection. For a discussion of the material regulations +applicable to us, see "Federal Regulations," "State Regulations," and +"Environmental Regulations." These laws and regulations may: +o require that we acquire permits before commencing drilling; +o restrict the substances that can be released into the environment in +connection with drilling and production activities; +o limit or prohibit drilling activities on protected areas such as +wetlands or wilderness areas; and +o require remedial measures to mitigate pollution from former operations, +such as dismantling abandoned production facilities. +Under these laws and regulations, we could be liable for personal injury and +clean-up costs and other environmental and property damages, as well as +administrative, civil and criminal penalties. We maintain limited insurance +coverage for sudden and accidental environmental damages. We do not believe that +insurance coverage for environmental damages that occur over time is available +at a reasonable cost. Also, we do not believe that insurance coverage for the +full potential liability that could be caused by sudden and accidental +environmental damages is available at a reasonable cost. Accordingly, we may be +subject to liability or we may be required to cease production from properties +in the event of environmental damages. +FACTORS BEYOND OUR CONTROL AFFECT OUR ABILITY TO MARKET PRODUCTION AND OUR +FINANCIAL RESULTS. The ability to market oil and gas from our wells depends upon +numerous factors beyond our control. These factors include: +o the extent of domestic production and imports of oil and gas; +o the proximity of the gas production to gas pipelines; +o the availability of pipeline capacity; +o the demand for oil and gas by utilities and other end users; +o the availability of alternative fuel sources; +o the effects of inclement weather; +o state and federal regulation of oil and gas marketing; and +o federal regulation of gas sold or transported in interstate commerce. +Because of these factors, we may be unable to market all of the oil or gas we +produce. In addition, we may be unable to obtain favorable prices for the oil +and gas we produce. +IF OIL AND GAS PRICES DECREASE, WE MAY BE REQUIRED TO TAKE WRITEDOWNS. We may be +required to writedown the carrying value of our oil and gas properties when oil +and gas prices are low or if we have substantial downward adjustments to our +estimated net proved reserves, increases in our estimates of development costs +or deterioration in our exploration results. Under the full cost method which we +use to account for our oil and gas properties, the net capitalized costs of our +oil and gas properties may not exceed the present value, discounted at 10%, of +future net cash flows from estimated net proved reserves, using period end oil +and gas prices or prices as of the date of our auditor's report, plus the lower +of cost or fair market value of our unproved properties. If net capitalized +costs of our oil and gas properties exceed this limit, we must charge the amount +of the excess to earnings. This type of charge will not affect our cash flows, +but will reduce the book value of our stockholders' equity. We review the +carrying value of our properties quarterly, based on prices in effect as of the +end of each quarter or at the time of reporting our +10 +results. Once incurred, a writedown of oil and gas properties is not reversible +at a later date, even if prices increase. +FORWARD-LOOKING STATEMENTS +In this report, we have made many forward-looking statements. We cannot assure +you that the plans, intentions or expectations upon which our forward-looking +statements are based will occur. Our forward-looking statements are subject to +risks, uncertainties and assumptions, including those discussed elsewhere in +this report. Forward-looking statements include statements regarding: +o our oil and gas reserve quantities, and the discounted present value of +these reserves; +o the amount and nature of our capital expenditures; +o drilling of wells; +o the timing and amount of future production and operating costs; +o business strategies and plans of management; and +o prospect development and property acquisitions. +Some of the risks, which could affect our future results and could cause results +to differ materially from those expressed in our forward-looking statements +include: +o general economic conditions; +o the volatility of oil and natural gas prices; +o the uncertainty of estimates of oil and natural gas reserves; +o the impact of competition; +o the availability and cost of seismic, drilling and other equipment; +o operating hazards inherent in the exploration for and production of +oil and natural gas; +o difficulties encountered during the exploration for and production +of oil and natural gas; +o difficulties encountered in delivering oil and natural gas to +commercial markets; +o changes in customer demand and producers' supply; +o the uncertainty of our ability to attract capital; +o compliance with, or the effect of changes in, the extensive +governmental regulations regarding the oil and natural gas business; +o actions of operators of our oil and gas properties; and +o weather conditions. +The information contained in this report, including the information set forth +under the heading "Risk Factors," identifies additional factors that could +affect our operating results and performance. We urge you to carefully consider +these factors and the other cautionary statements in this report. Our +forward-looking statements speak only as of the date made, and we have no +obligation to update these forward-looking statements. +CORPORATE OFFICES +Our headquarters are located in Natchez, Mississippi, in approximately 51,500 +square feet of owned space, with a field office in Houston, Texas. We also +maintain owned or leased field offices in the area of the major fields in which +we operate properties or have a significant interest. Replacement of any of our +leased offices would not result in material expenditures by us as alternative +locations to our leased space are anticipated to be readily available. +11 +EMPLOYEES +We had 100 employees as of December 31, 2002, none of whom are currently +represented by a union. We believe that we have good relations with our +employees. We employ nine petroleum engineers and seven petroleum geoscientists. +FEDERAL REGULATIONS +SALES OF NATURAL GAS. Effective January 1, 1993, the Natural Gas Wellhead +Decontrol Act deregulated prices for all "first sales" of natural gas. Thus, all +sales of gas by the Company may be made at market prices, subject to applicable +contract provisions. +TRANSPORTATION OF NATURAL GAS. The rates, terms and conditions applicable to the +interstate transportation of natural gas by pipelines are regulated by the +Federal Energy Regulatory Commission ("FERC") under the Natural Gas Act ("NGA"), +as well as under section 311 of the Natural Gas Policy Act ("NGPA"). Since 1985, +the FERC has implemented regulations intended to make natural gas transportation +more accessible to gas buyers and sellers on an open-access, non-discriminatory +basis. +The FERC has announced several important transportation-related policy +statements and rule changes, including a statement of policy and final rule +issued February 25, 2000 concerning alternatives to its traditional +cost-of-service rate-making methodology to establish the rates interstate +pipelines may charge for their services. The final rule revises FERC's pricing +policy and current regulatory framework to improve the efficiency of the market +and further enhance competition in natural gas markets. +With respect to the transportation of natural gas on or across the Outer +Continental Shelf ("OCS"), the FERC requires, as part of its regulation under +the Outer Continental Shelf Lands Act, that all pipelines provide open and +non-discriminatory access to both owner and non-owner shippers. Although to date +the FERC has imposed light-handed regulation on off-shore facilities that meet +its traditional test of gathering status, it has the authority to exercise +jurisdiction under the Outer Continental Shelf Lands Act ("OCSLA") over +gathering facilities, if necessary, to permit non-discriminatory access to +service. For those facilities transporting natural gas across the OCS that are +not considered to be gathering facilities, the rates, terms, and conditions +applicable to this transportation are regulated by FERC under the NGA and NGPA, +as well as the OCSLA. +SALES AND TRANSPORTATION OF CRUDE OIL. Sales of crude oil and condensate can be +made by the Company at market prices not subject at this time to price controls. +The price that the Company receives from the sale of these products will be +affected by the cost of transporting the products to market. The rates, terms, +and conditions applicable to the interstate transportation of oil and related +products by pipelines are regulated by the FERC under the Interstate Commerce +Act. As required by the Energy Policy Act of 1992, the FERC has revised its +regulations governing the rates that may be charged by oil pipelines. The new +rules, which were effective January 1, 1995, provide a simplified, generally +applicable method of regulating such rates by use of an index for setting rate +ceilings. The FERC will also, under defined circumstances, permit alternative +ratemaking methodologies for interstate oil pipelines such as the use of cost of +service rates, settlement rates, and market-based rates. Market-based rates will +be permitted to the extent the pipeline can demonstrate that it lacks +significant market power in the market in which it proposes to charge +market-based rates. The cumulative effect that these rules may have on moving +the Company's production to market cannot yet be determined. +With respect to the transportation of oil and condensate on or across the OCS, +the FERC requires, as part of its regulation under the OCSLA, that all pipelines +provide open and non-discriminatory access to both owner and non-owner shippers. +Accordingly, the FERC has the authority to exercise jurisdiction under the +OCSLA, if necessary, to permit non-discriminatory access to service. +12 +LEGISLATIVE PROPOSALS. In the past, Congress has been very active in the area of +natural gas regulation. There are legislative proposals pending in Congress and +in various state legislatures which, if enacted, could significantly affect the +petroleum industry. At the present time it is impossible to predict what +proposals, if any, might actually be enacted by Congress or the various state +legislatures and what effect, if any, such proposals might have on the Company's +operations. +FEDERAL, STATE OR INDIAN LEASES. In the event the Company conducts operations on +federal, state or Indian oil and gas leases, such operations must comply with +numerous regulatory restrictions, including various nondiscrimination statutes, +royalty and related valuation requirements, and certain of such operations must +be conducted pursuant to certain on-site security regulations and other +appropriate permits issued by the Bureau of Land Management ("BLM") or Minerals +Management Service ("MMS") or other appropriate federal or state agencies. +The Company's OCS leases in federal waters are administered by the MMS and +require compliance with detailed MMS regulations and orders. The MMS has +promulgated regulations implementing restrictions on various production-related +activities, including restricting the flaring or venting of natural gas. Under +certain circumstances, the MMS may require Company operations on federal leases +to be suspended or terminated. Any such suspension or termination could +materially and adversely affect the Company's financial condition and +operations. On March 15, 2000, the MMS issued a final rule effective June 1, +2000 which amends its regulations governing the calculation of royalties and the +valuation of crude oil produced from federal leases. Among other matters, this +rule amends the valuation procedure for the sale of federal royalty oil by +eliminating posted prices as a measure of value and relying instead on arm's +length sales prices and spot market prices as market value indicators. Because +the Company sells its production in the spot market and therefore pays royalties +on production from federal leases, it is not anticipated that this final rule +will have any substantial impact on the Company. +The Mineral Leasing Act of 1920 ("Mineral Act") prohibits direct or indirect +ownership of any interest in federal onshore oil and gas leases by a foreign +citizen of a country that denies "similar or like privileges" to citizens of the +United States. Such restrictions on citizens of a "non-reciprocal" country +include ownership or holding or controlling stock in a corporation that holds a +federal onshore oil and gas lease. If this restriction is violated, the +corporation's lease can be canceled in a proceeding instituted by the United +States Attorney General. Although the regulations of the BLM (which administers +the Mineral Act) provide for agency designations of non-reciprocal countries, +there are presently no such designations in effect. The Company owns interests +in numerous federal onshore oil and gas leases. It is possible that holders of +equity interests in the Company may be citizens of foreign countries, which at +some time in the future might be determined to be non-reciprocal under the +Mineral Act. +STATE REGULATIONS +Most states regulate the production and sale of oil and natural gas, including +requirements for obtaining drilling permits, the method of developing new +fields, the spacing and operation of wells and the prevention of waste of oil +and gas resources. The rate of production may be regulated and the maximum daily +production allowable from both oil and gas wells may be established on a market +demand or conservation basis or both. +The Company may enter into agreements relating to the construction or operation +of a pipeline system for the transportation of natural gas. To the extent that +such gas is produced, transported and consumed wholly within one state, such +operations may, in certain instances, be subject to the jurisdiction of such +state's administrative authority charged with the responsibility of regulating +intrastate pipelines. In such event, the rates which the Company could charge +for gas, the transportation of gas, and the costs of construction and operation +of such +13 +pipeline would be impacted by the rules and regulations governing such matters, +if any, of such administrative authority. Further, such a pipeline system would +be subject to various state and/or federal pipeline safety regulations and +requirements, including those of, among others, the Department of +Transportation. Such regulations can increase the cost of planning, designing, +installing and operating such facilities. The impact of such pipeline safety +regulations would not be any more adverse to the Company than it would be to +other similar owners or operators of such pipeline facilities. +ENVIRONMENTAL REGULATIONS +GENERAL. The Company's activities are subject to federal, state and local laws +and regulations governing environmental quality and pollution control. Although +no assurances can be made, the Company believes that, absent the occurrence of +an extraordinary event, compliance with existing federal, state and local laws, +rules and regulations regulating the release of materials into the environment +or otherwise relating to the protection of the environment will not have a +material effect upon the capital expenditures, earnings or the competitive +position of the Company with respect to its existing assets and operations. The +Company cannot predict what effect future regulation or legislation, enforcement +policies, and claims for damages to property, employees, other persons and the +environment resulting from the Company's operations could have on its +activities. +Activities of the Company with respect to natural gas facilities, including the +operation and construction of pipelines, plants and other facilities for +transporting, processing, treating or storing natural gas and other products, +are subject to stringent environmental regulation by state and federal +authorities including the United States Environmental Protection Agency ("EPA"). +Such regulation can increase the cost of planning, designing, installing and +operating such facilities. In most instances, the regulatory requirements relate +to water and air pollution control measures. Although the Company believes that +compliance with environmental regulations will not have a material adverse +effect on it, risks of substantial costs and liabilities are inherent in oil and +gas production operations, and there can be no assurance that significant costs +and liabilities will not be incurred. Moreover, it is possible that other +developments, such as stricter environmental laws and regulations, and claims +for damages to property or persons resulting from oil and gas production, would +result in substantial costs and liabilities to the Company. +SOLID AND HAZARDOUS WASTE. The Company currently owns or leases, and in the past +owned or leased, properties that have been used for the exploration and +production of oil and gas for many years. Although the Company has utilized +operating and disposal practices that were standard in the industry at the time, +hydrocarbons or other solid wastes may have been disposed or released on or +under the properties owned or leased by the Company or on or under locations +where such wastes have been taken for disposal. In addition, many of these +properties have been operated by third parties. The Company has no control over +such entities' treatment of hydrocarbons or other solid wastes and the manner in +which such substances may have been disposed or released. State and federal laws +applicable to oil and gas wastes and properties have gradually become stricter +over time. Under new laws, the Company could be required to remediate property, +including groundwater, containing or impacted by previously disposed wastes +(including wastes disposed or released by prior owners or operators, or property +contamination, including groundwater contamination by prior owners or operators) +or to perform remedial plugging operations to prevent future or mitigate +existing contamination. +The Company generates wastes, including hazardous wastes that are subject to the +federal Resource Conservation and Recovery Act ("RCRA") and comparable state +statutes. The Environmental Protection Agency ("EPA") and various state agencies +have limited the disposal options for certain wastes, including wastes +designated as hazardous under the RCRA and similar state statutes ("Hazardous +Wastes"). Furthermore, it is possible that certain wastes generated by the +Company's oil and gas operations that are (currently exempt from +14 +treatment as) Hazardous Wastes may in the future be designated as Hazardous +Wastes under RCRA or other applicable statutes and, therefore, may be subject to +more rigorous and costly disposal requirements. +SUPERFUND. The federal Comprehensive Environmental Response, Compensation and +Liability Act ("CERCLA"), also known as the "Superfund" law, generally imposes +joint and several liability for costs of investigation and remediation and for +natural resource damages, without regard to fault or the legality of the +original conduct, on certain classes of persons with respect to the release into +the environment of substances designated under CERCLA as hazardous substances +("Hazardous Substances"). These classes of persons, or so-called potentially +responsible parties ("PRPs"), include the current and certain past owners and +operators of a facility where there has been a release or threat of release of a +Hazardous Substance and persons who disposed of or arranged for the disposal of +Hazardous Substances found at a site. CERCLA also authorizes the EPA and, in +some cases, third parties to take actions in response to threats to the public +health or the environment and to seek to recover from the PRPs the costs of such +action. Although CERCLA generally exempts "petroleum" from the definition of +Hazardous Substance, in the course of its operations, the Company has generated +and will generate wastes that may fall within CERCLA's definition of Hazardous +Substance. The Company may also be the owner or operator of sites on which +Hazardous Substances have been released. To its knowledge, neither the Company +nor its predecessors have been designated as a PRP by the EPA under CERCLA; the +Company also does not know of any prior owners or operators of its properties +that are named as PRPs related to their ownership or operation of such +properties. +CLEAN WATER ACT. The Clean Water Act ("CWA") imposes restrictions and strict +controls regarding the discharge of wastes including produced waters and other +oil and natural gas wastes, into waters of the United States, a term broadly +defined. These controls have become more stringent over the years, and it is +probable that additional restrictions will be imposed in the future. Permits +must be obtained to discharge pollutants into federal waters. The CWA provides +for civil, criminal and administrative penalties for unauthorized discharges of +oil and hazardous substances and of other pollutants. It imposes substantial +potential liability for the costs of removal or remediation associated with +discharges of oil or hazardous substances and other pollutants. State laws +governing discharges to water also provide varying civil, criminal and +administrative penalties and impose liabilities in the case of a discharge of +petroleum or its derivatives, or other hazardous substances, into state waters. +In addition, the EPA has promulgated regulations that may require us to obtain +permits to discharge storm water runoff, including discharges associated with +construction activities. In the event of an unauthorized discharge of wastes, +the Company may be liable for penalties and costs. +OIL POLLUTION ACT. The Oil Pollution Act of 1990 ("OPA"), which amends and +augments oil spill provisions of CWA, imposes certain duties and liabilities on +certain "responsible parties" related to the prevention of oil spills and +damages resulting from such spills in or threatening United States waters or +adjoining shorelines. A liable "responsible party" includes the owner or +operator of a facility, vessel or pipeline that is a source of an oil discharge +or that poses the substantial threat of discharge, or the lessee or permittee of +the area in which a discharging facility is located. OPA assigns joint and +several liability, without regard to fault, to each liable party for oil removal +costs and a variety of public and private damages. Although defenses and +limitations exist to the liability imposed by OPA, they are limited. In the +event of an oil discharge or substantial threat of discharge, the Company may be +liable for costs and damages. +The OPA also imposes ongoing requirements on a responsible party, including +proof of financial responsibility to cover at least some costs in a potential +spill. Certain amendments to the OPA that were enacted in 1996 require owners +and operators of offshore facilities that have a worst case oil spill potential +of more than 1,000 barrels to demonstrate financial responsibility in amounts +ranging from $10 million in specified state waters and $35 million in federal +outer continental shelf ("OCS") waters, with higher amounts, up to $150 million +based upon worst +15 +case oil-spill discharge volume calculations. The Company believes that it has +established adequate proof of financial responsibility for its offshore +facilities. +AIR EMISSIONS. The Company's operations are subject to local, state and federal +regulations for the control of emissions from sources of air pollution. Federal +and state laws require new and modified sources of air pollutants to obtain +permits prior to commencing construction. Major sources of air pollutants are +subject to more stringent, federally imposed requirements including additional +permits. Federal and state laws designed to control hazardous (toxic) air +pollutants, might require installation of additional controls. Administrative +enforcement actions for failure to comply strictly with air pollution +regulations or permits are generally resolved by payment of monetary fines and +correction of any identified deficiencies. Alternatively, regulatory agencies +could bring lawsuits for civil penalties or require the Company to forego +construction, modification or operation of certain air emission sources. +COASTAL COORDINATION. There are various federal and state programs that regulate +the conservation and development of coastal resources. The federal Coastal Zone +Management Act ("CZMA") was passed in 1972 to preserve and, where possible, +restore the natural resources of the Nation's coastal zone. The CZMA provides +for federal grants for state management PROGRAMS that regulate land use, water +use and coastal development. +Various states, such as Alabama, Louisiana and Texas, also have coastal +management programs, which provide for, among other things, the coordination +among local and state authorities to protect coastal resources through +regulating land use, water, and coastal development. Coastal management programs +also may provide for the review of state and federal agency rules and agency +actions for consistency with the goals and policies of the state coastal +management plan. This review may impact agency permitting and review activities +and add an additional layer of review to certain activities undertaken by the +Company. +OSHA AND OTHER REGULATIONS. The Company is subject to the requirements of the +federal Occupational Safety and Health Act ("OSHA") and comparable state +statutes. The OSHA hazard communication standard, the EPA community +right-to-know regulations under Title III of CERCLA and similar state statutes +require the Company to organize and/or disclose information about hazardous +materials used or produced in its operations. +Management believes that the Company is in substantial compliance with current +applicable environmental laws and regulations and that continued compliance with +existing requirements would not have a material adverse impact on the Company. +PROPERTY SUMMARY +We are engaged in the exploration, development, acquisition and production of +oil and gas properties and natural gas transmission and provide oil and gas +property management services for other investors. Our properties are +concentrated offshore in the Gulf of Mexico and onshore, primarily, in Louisiana +and Alabama. We have historically grown our reserves and production by focusing +primarily on low to moderate risk exploration and acquisition opportunities in +the Gulf of Mexico Shelf area. Over the last several years, we have expanded our +area of exploration to include the Gulf of Mexico Deepwater area. As of December +31, 2002, our estimated net proved reserves totaled 24.0 million barrels of oil +("MBbl") and 91.5 billion cubic feet of natural gas ("Bcf"), with a pre-tax +present value, discounted at 10%, of the estimated future net revenues based on +constant prices in effect at year-end ("Discounted Cash Flow") of $623.9 +million. Gas constitutes approximately 39% of our total estimated proved +reserves and approximately 17% of our total estimated proved reserves are proved +producing reserves. +16 +Our Medusa (Mississippi Canyon Blocks 538/582) discovery and Habanero (Garden +Banks Block 341) discovery are projected to begin production late in the third +quarter of 2003. Construction of a production facility, subsea completions and +flowlines are projected to be completed by the fall of 2003. These two deepwater +discoveries are expected to increase our projected production from our existing +producing properties by 58% in the second half of 2003. A detail discussion of +each of these properties is provided in the Significant Properties section of +this report. +SIGNIFICANT PROPERTIES +The following table shows discounted cash flows and estimated net proved oil and +gas reserves by major field, within the focus area, for our seven largest fields +and for all other properties combined at December 31, 2002. +ESTIMATED NET PROVED RESERVES PRE-TAX +------------------------------------------ DISCOUNTED +OIL GAS TOTAL RESENT VALUE +OPERATOR (MBbls) (MMcf) (MMcfe) ($000) +------------ ------------ ------------ ------------ ------------- +(a) +GULF OF MEXICO DEEPWATER: +Mississippi Canyon Blocks 538/582 +"Medusa" Murphy 10,479 8,460 71,336 $ 226,810 +Garden Banks Block 341 +"Habanero" Shell 4,736 11,280 39,696 103,589 +Garden Banks Blocks 738/782/826/827 +"Entrada" BP Amoco 7,772 29,126 75,761 164,272 +17 +GULF OF MEXICO SHELF: +Mobile Blocks 863/864/907/908 Callon -- 9,991 9,991 27,866 +Mobile Blocks 952/953/955 Callon -- 23,117 23,117 76,382 +Ship Shoal Blocks 28/35 Callon 12 1,141 1,210 3,722 +ONSHORE AND OTHER: +Big Escambia Creek Exxon 353 1,298 3,414 8,199 +Other Various 691 7,126 11,274 13,106 +------------ ------------ ------------ ------------ +TOTAL NET PROVED RESERVES 24,043 91,539 235,799 $ 623,946 +============ ============ ============ ============ +(a) Represents the present value of future net cash flows before deduction +of federal income taxes, discounted at 10%, attributable to estimated +net proved reserves as of December 31, 2002, as set forth in the +Company's reserve reports prepared by its independent petroleum reserve +engineers, Huddleston & Co., Inc. of Houston, Texas. +GULF OF MEXICO DEEPWATER +Medusa, Mississippi Canyon Blocks 538/582 +Medusa was our third deepwater discovery and was announced in September 1999. We +drilled the initial test well in 2,235 feet of water to a total depth of 16,241 +feet and encountered over 120 feet of pay in two intervals. We performed +subsequent sidetrack drilling from the well bore to determine the extent of the +discovery. We drilled a second successful well in the first quarter of 2000 to +further delineate the extent of the pay intervals. We own a 15% working +interest, Murphy, the operator, owns a 60% interest and Agip Ventures, formerly +British-Borneo Petroleum, Inc., owns the remaining 25% interest. +In 2001 a drilling program began which included four development wells and one +sidetrack. The program included production casing being set on six wells which +will provide initial production take-points. The program was completed in the +first half of 2002. Also in 2001, the operator submitted an Authorization +18 +for Expenditure for a floating production system at Medusa and awarded the +contract to J. Ray McDermott, Inc. The spar was barged to the Mississippi Canyon +Block 582 in January 2003 and installed. The topside deck and production +facilities should be delivered and lifted into place atop the spar during the +second quarter of 2003. Initial production is scheduled to commence in the third +quarter of 2003 as the six wells are individually completed and tied into the +spar and production facilities. Once all six wells are tied in, it is estimated +that the production facility will have the capacity to handle up to 40,000 +barrels of crude oil and 110 million cubic feet of natural gas per day. +Habanero, Garden Banks Block 341 +During February 1999 the initial test well on our Habanero prospect encountered +over 200 feet of net pay in two zones. Located in 2,000 feet of water, the well +was drilled to a measured depth of 21,158 feet. This discovery was our second +deepwater success. We own an 11.25% working interest in the well. It is operated +by Shell Deepwater Development Inc., which owns a 55% working interest, with the +remaining working interest being owned by Murphy. +Current development plans include sub-sea completion and tie back to an existing +production facility in the area that is operated by Shell. A field delineation +program began in mid-year 2001, which included sidetracking the discovery well +with three sidetracks. Production casing was set on this well through one of the +sidetracks to the Hab 52 oil sand and the Hab 55 gas sand. Initial production +will be from the Hab55 gas sand and future recompletions are scheduled up-hole +to the Hab 52 oil sand for this well. Also, a development well is scheduled to +be drilled in the summer of 2003 and will provide a take-point for production +from the Hab 52 oil sand. The operator has submitted to the co-owners a +development schedule which estimates initial production to commence in late +summer 2003. +Entrada, Garden Banks Blocks 738/782/826/827 +The Entrada discovery is located in approximately 4,500 feet of water in the +Gulf of Mexico. Two wells and seven sidetracks have been drilled to date on +Garden Banks 782 on a northwest plunging salt ridge along the southern edge of +the Entrada Basin. Multiple stacked amplitudes trapped against a salt or fault +interface characterize the Entrada Area. We own a 20% working interest in this +discovery with BP Amoco, the operator, holding the remaining working interest. +The owners of an adjacent discovery have announced their plans to construct +production facilities to enable them to be a regional off-take point in +Southeastern Garden Banks. These plans include handling third party tie-ins, +which we expect to include Entrada. First production from their discovery is +expected in late 2004. Information obtained in a data swap with the adjacent +owners, is being incorporated into the Entrada development plans. An integrated +project team was formed by the working interest owners during 2002 to begin +planning the development of the field. +Boomslang, Ewing Bank Block 994 +A major revision to reserves in 2002 was at our Boomslang discovery. The initial +exploratory well drilled at this location in 1998 encountered 185 feet of pay. +The first well was drilled with significant mechanical problems and was +subsequently determined not to be a viable well for completion and production of +the estimated proved reserves encountered in this initial well. A second well, +to serve as a production take point, was drilled in the fourth quarter of 2002 +in a down dip direction from the first well targeting what was anticipated to be +a better sand development in the three separate reservoirs found in the first +well, but still up dip of the lowest known hydrocarbons in the first well. +Reservoir sand quality changed dramatically, reducing the estimated reservoir +volumes found and booked as estimated proved reserves by the first well +19 +to an extent that the partners determined that the risk of development was not +economic. Callon had a 40% working interest. The Company's proved reserves in +the prior year included 7.2 million barrels of oil and 13 billion cubic feet of +natural gas attributable to Boomslang. +GULF OF MEXICO SHELF +Mobile Blocks 863/864/ 907/908 +We own an average 67.9% working interest in these blocks and we are the +operator. The Mobile 864 unit, in which we have a 66.4% working interest, has +three producing wells, unit production facilities and covers portions of these +four blocks. In addition, there are two other wells located on the blocks in +which we own a 100% and 66.4% working interest. These wells produce through the +unit facilities. During 2002 the unit and the other two wells produced an +average of 7.1 MMcf per day net to us. +Mobile Blocks 952/953/955 +We own a 100% working interest in these three blocks and we are the operator. In +the fourth quarter of 2001, we initiated a production acceleration program for +Mobile Blocks 952, 953 and 955, which were being produced through the Mobile +Block 864 unit facilities. Plans included an acceleration well, which was +successfully drilled in the fourth quarter of 2001. Stand-alone production +facilities were installed and production flow lines were rerouted to the new +facilities. Production commenced through the new facilities in April 2002. This +program offset normal production declines curves from existing field wells and +added an annual increase of 3.8 MMcf per day net to us over 2001 production +levels of 10.1 MMcf per day. From May 1, 2002 to December 31, 2002 the wells +produced 18.6 MMcf per day net to us. +Ship Shoal Blocks 28/35 +We successfully drilled an exploratory well on our prospect at Ship Shoal Blocks +28 and 35 during the third quarter of 2002. The well was drilled to a measured +depth of 15,237 feet (12,295 feet of true vertical depth) and encountered 140 +feet of net natural gas pay. The well is being completed as a single producer in +the deepest of three productive intervals and is scheduled for first production +during the second quarter of 2003. We operate and own a 22% working interest. +ONSHORE AND OTHER +Big Escambia Creek +This gas field in south Alabama produces from the Smackover formation at depths +ranging from 15,100 to 15,600 and is operated by Exxon/Mobil. We own an average +working interest of 4.9% (5.5% net revenue interest), in six wells and a 2.2% +average royalty interest in another five wells. This field produced 1.0 MMcfe +per day to our interest in 2002. The field has an estimated reserve life in +excess of ten years given current production rates. +Other +20 +We own various royalty and working interest in numerous onshore areas and the +Gulf of Mexico other than the fields discussed above. +OIL AND GAS RESERVES +The following table sets forth certain information about our estimated proved +reserves as of the dates set forth below. +YEARS ENDED DECEMBER 31, +------------------------------------------ +2002 2001(a) 2000(a) +------------ ------------ ------------ +(IN THOUSANDS) +Proved developed: +Oil (Bbls) 1,056 885 2,192 +Gas (Mcf) 37,631 52,375 67,463 +Proved undeveloped: +Oil (Bbls) 22,988 29,324 31,190 +Gas (Mcf) 53,908 69,078 65,940 +Total proved: +Oil (Bbls) 24,043 30,209 33,382 +Gas (Mcf) 91,539 121,453 133,403 +Estimated pre-tax future net cash flows $ 970,198 $ 473,896 $ 1,610,320 +============ ============ ============ +Pre-tax discounted present value $ 623,946 $ 272,053 $ 939,325 +============ ============ ============ +Standardized measure of discounted future +net cash flows $ 556,046 $ 254,857 $ 671,197 +============ ============ ============ +(a) The estimates include reserve volumes of approximately 3.5 Bcf, $31.8 +million of pre-tax future net cash flows and $29.5 million of pre-tax discounted +present value in 2000, 1.2 Bcf, $2.9 million of pre-tax discounted present value +in 2001, attributable to a volumetric production payment. Standardized measure +of discounted future net cash flows does not include any volumes or cash flows +associated with the volumetric production payment. +Our independent reserve engineers, Huddleston & Co., Inc. prepared the estimates +of the proved reserves and the future net cash flows and present value thereof +attributable to such proved reserves. Reserves were estimated using oil and gas +prices and production and development costs in effect on December 31 of each +such year, without escalation, and were otherwise prepared in accordance with +Securities and Exchange Commission regulations regarding disclosure of oil and +gas reserve information. +There are numerous uncertainties inherent in estimating quantities of proved +reserves, including many factors beyond our control or the control of the +reserve engineers. Reserve engineering is a subjective process of estimating +underground accumulations of oil and gas that cannot be measured in an exact +manner. The accuracy of any reserve or cash flow estimate is a function of the +quality of available data and of engineering and geological interpretation and +judgment. Estimates by different engineers often vary, sometimes significantly. +In addition, physical factors, such as the results of drilling, testing and +production subsequent to the date of an +21 +estimate, as well as economic factors, such as an increase or decrease in +product prices that renders production of such reserves more or less economic, +may justify revision of such estimates. Accordingly, reserve estimates could be +different from the quantities of oil and gas that are ultimately recovered. +We have not filed any reports with other federal agencies which contain an +estimate of total proved net oil and gas reserves during our last fiscal year. +PRESENT ACTIVITIES AND PRODUCTIVE WELLS +The following table sets forth the wells we have drilled and completed during +the periods indicated. All such wells were drilled in the continental United +States primarily in federal and state waters in the Gulf of Mexico. +YEARS ENDED DECEMBER 31, +------------------------ +2002 2001 2000 +---- ---- ---- +GROSS NET GROSS NET GROSS NET +------ ------ ------ ------ ------ ------ +Development: +Oil 2 .30 6 .45 2 .35 +Gas -- -- 4 3.17 -- -- +Non-productive 1 .40 -- -- -- -- +------ ------ ------ ------ ------ ------ +Total 3 .70 10 3.62 2 .35 +====== ====== ====== ====== ====== ====== +Exploration: +Oil -- -- -- -- 1 .20 +Gas 1 .22 3 2.00 2 2.00 +Non-productive 1 .50 12 5.77 6 2.29 +------ ------ ------ ------ ------ ------ +Total 2 .72 15 7.77 9 4.49 +====== ====== ====== ====== ====== ====== +The following table sets forth our productive wells as of December 31, 2002: +WELLS +----- +GROSS NET +-------- -------- +Oil: +Working interest 39.00 3.07 +Royalty interest 220.00 3.40 +-------- -------- +Total 259.00 6.47 +Gas: +Working interest 45.00 21.25 +Royalty interest 243.00 1.51 +-------- -------- +Total 288.00 22.76 +A well is categorized as an oil well or a natural gas well based upon the ratio +of oil to gas reserves on a Mcfe basis. However, some of our wells produce both +oil and gas. At December 31, 2002, we had no wells with multiple completions. At +December 31, 2002, we had 1 gross (1.0 net) exploratory gas well in progress. +22 +LEASEHOLD ACREAGE +The following table shows our approximate developed and undeveloped (gross and +net) leasehold acreage as of December 31, 2002. +LEASEHOLD ACREAGE +----------------- +DEVELOPED UNDEVELOPED +--------- ----------- +LOCATION GROSS NET GROSS NET +------------------ ---------- ---------- ---------- ---------- +Louisiana 7,862 4,835 3,801 1,237 +Other States 1,500 740 879 689 +Federal Waters 116,566 82,442 300,475 98,231 +---------- ---------- ---------- ---------- +Total 125,928 88,017 305,155 100,157 +========== ========== ========== ========== +As of December 31, 2002, we owned various royalty and overriding royalty +interests in 1,336 net developed and 6,862 net undeveloped acres. In addition, +we owned 5,181 developed and 120,819 undeveloped mineral acres. +MAJOR CUSTOMERS +Our production is sold generally on month-to-month contracts at prevailing +prices. The following table identifies customers to whom we sold a significant +percentage of our total oil and gas production during each of the twelve-month +periods ended: +DECEMBER 31, +------------ +2002 2001 2000 +------ ------ ------ +Adams Resources Marketing, Ltd. -- -- 14% +Petrocom Energy Group, Ltd. 4% -- -- +Dynegy 7% 8% -- +Prior Energy Corporation -- 20% -- +Reliant Energy Services 70% 49% 37% +Unocal Exploration Corporation -- -- 8% +Because alternative purchasers of oil and gas are readily available, we believe +that the loss of any of these purchasers would not result in a material adverse +effect on our ability to market future oil and gas production. +23 +TITLE TO PROPERTIES +We believe that the title to our oil and gas properties is good and defensible +in accordance with standards generally accepted in the oil and gas industry, +subject to such exceptions which, in our opinion are not so material as to +detract substantially from the use or value of such properties. Our properties +are typically subject, in one degree or another, to one or more of the +following: royalties and other burdens and obligations, express or implied, +under oil and gas leases; overriding royalties and other burdens created by us +or our predecessors in title; a variety of contractual obligations (including, +in some cases, development obligations) arising under operating agreements, +farmout agreements, production sales contracts and other agreements that may +affect the properties or their titles; back-ins and reversionary interests +existing under purchase agreements and leasehold assignments; liens that arise +in the normal course of operations, such as those for unpaid taxes, statutory +liens securing obligations to unpaid suppliers and contractors and contractual +liens under operating agreements; pooling, unitization and communitization +agreements, declarations and orders; and easements, restrictions, rights-of-way +and other matters that commonly affect property. To the extent that such burdens +and obligations affect our rights to production revenues, they have been taken +into account in calculating our net revenue interests and in estimating the size +and value of our reserves. We believe that the burdens and obligations affecting +our properties are conventional in the industry for properties of the kind owned +by us. +ITEM 3. LEGAL PROCEEDINGS +We are a defendant in various legal proceedings and claims, which arise in the +ordinary course of our business. We do not believe the ultimate resolution of +any such actions will have a material affect on our financial position or +results of operations. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +There were no matters submitted to a vote of security holders during the fourth +quarter of 2002. +PART II. +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS +Our common stock trades on the New York Stock Exchange under the symbol "CPE". +The following table sets forth the high and low sale prices per share as +reported for the periods indicated. +QUARTER ENDED HIGH LOW +-------------------- -------- -------- +2001: +First quarter $ 16.69 $ 10.00 +Second quarter 13.22 10.65 +Third quarter 11.82 5.90 +Fourth quarter 7.20 5.35 +2002: +First quarter $ 9.40 $ 3.97 +Second quarter 8.39 4.50 +Third quarter 5.15 3.20 +Fourth quarter 6.25 3.35 +As of March 7, 2003, there were approximately 4,896 common stockholders of +record. +We have never paid dividends on our common stock and intend to retain our cash +flow from operations, net of preferred stock dividends, for the future operation +and development of our business. In addition, our primary credit facility and +the terms of our outstanding subordinated debt restrict payments of dividends on +our common stock. +24 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth, as of the dates and for the periods indicated, +selected financial information about us. The financial information for each of +the five years in the period ended December 31, 2002 has been derived from our +audited Consolidated Financial Statements for such periods. The information +should be read in conjunction with "Management's Discussion and Analysis of +Financial Condition and Results of Operations" and the Consolidated Financial +Statements and Notes thereto. The following information is not necessarily +indicative of our future results. +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) +YEARS ENDED DECEMBER 31, +------------------------------------------------------------------------- +2002 2001 2000 1999 1998 +------------ ------------ ------------ ------------ ------------ +STATEMENT OF OPERATIONS DATA: +Revenues: +Oil and gas sales $ 61,171 $ 60,010 $ 56,310 $ 37,140 $ 35,624 +Interest and other 1,004 1,742 1,767 1,853 2,094 +Gain on sale of pipeline 2,454 -- -- -- -- +Gain on sale of Enron derivatives 2,479 -- -- -- -- +------------ ------------ ------------ ------------ ------------ +Total revenues 67,108 61,752 58,077 38,993 37,718 +------------ ------------ ------------ ------------ ------------ +Costs and expenses: +Lease operating expenses 11,030 11,252 9,339 7,536 7,817 +Depreciation, depletion and amortization 27,096 21,081 17,153 16,727 19,284 +General and administrative 4,705 4,635 4,155 4,575 5,285 +Writedown of Enron derivatives -- 9,186 -- -- -- +Loss on mark-to-market commodity derivative contracts 708 -- -- -- -- +Interest 26,140 12,805 8,420 6,175 1,925 +Accelerated vesting and retirement benefits -- -- -- -- 5,761 +Impairment of oil and gas properties -- -- -- -- 43,500 +------------ ------------ ------------ ------------ ------------ +Total costs and expenses 69,679 58,959 39,067 35,013 83,572 +------------ ------------ ------------ ------------ ------------ +Income (loss) from operations (2,571) 2,793 19,010 3,980 (45,854) +Income tax expense (benefit) (900) 977 6,463 1,353 (15,100) +------------ ------------ ------------ ------------ ------------ +Net income (loss) (1,671) 1,816 12,547 2,627 (30,754) +Preferred stock dividends 1,277 1,277 2,403 2,497 2,779 +------------ ------------ ------------ ------------ ------------ +Net income (loss) available to common shares $ (2,948) $ 539 $ 10,144 $ 130 $ (33,533) +============ ============ ============ ============ ============ +Net income (loss) per common share: +Basic $ (.22) $ .04 $ .82 $ .01 $ (4.17) +Diluted $ (.22) $ .04 $ .80 $ .01 $ (4.17) +Shares used in computing net income (loss) per +common share: +Basic 13,387 13,273 12,420 8,976 8,034 +Diluted 13,387 13,366 12,745 9,075 8,034 +BALANCE SHEET DATA (END OF PERIOD): +Oil and gas properties, net $ 377,661 $ 343,158 $ 258,613 $ 194,365 $ 141,905 +Total assets $ 410,613 $ 372,095 $ 301,569 $ 259,877 $ 181,652 +Long-term debt, less current portion $ 248,269 $ 161,733 $ 134,000 $ 100,250 $ 78,250 +Stockholders' equity $ 140,960 $ 147,224 $ 136,328 $ 124,380 $ 84,484 +------------- +We use the full-cost method of accounting. Under this method of accounting, our +net capitalized costs to acquire, explore and develop oil and gas properties may +not exceed the standardized measure of our proved reserves. If these capitalized +costs exceed a ceiling amount, the excess is charged to expense. As a result of +the significant decline in oil and gas prices, we recorded a non-cash impairment +expense related to our oil and gas properties in the amount of $43.5 million +during the fourth quarter of 1998. +ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS +OF OPERATIONS +The following discussion is intended to assist in an understanding of our +financial condition and results of operations. Our Financial Statements and +Notes thereto contain detailed information that should be referred to in +conjunction with the following discussion. See Item 8. "Financial Statements and +Supplementary Data." +GENERAL +Callon Petroleum Company has been engaged in the exploration, development, +acquisition and production of oil and gas properties since 1950. Our revenues, +profitability and future growth and the carrying value of our oil and gas +properties are substantially dependent on prevailing prices of oil and gas and +our ability to find, develop and acquire additional oil and gas reserves that +are economically recoverable. Our ability to maintain or increase our borrowing +capacity and to obtain additional capital on attractive terms is also influenced +by oil and gas prices. +25 +Our estimated net proved oil and gas reserves decreased at December 31, 2002 to +236 billion cubic feet of natural gas equivalent (Bcfe). This represents a +decrease of 22% over previous year-end 2001 estimated proved reserves of 303 +Bcfe. +A major revision to reserves in 2002 was at our Boomslang discovery. The initial +exploratory well drilled at this location in 1998 encountered 185 feet of pay. +The well was drilled with mechanical problems and was subsequently determined +not to be a viable well for completion and production of the estimated proved +reserves encountered in this initial well. A second well, drilled in the fourth +quarter of 2002, to serve as a production take point, was drilled in a down dip +direction from the first well targeting what was anticipated to be a better sand +development in the three separate reservoirs found in the first well, but still +up dip of the lowest known hydrocarbons in the first well. Reservoir sand +quality changed dramatically, reducing the estimated reservoir volumes found and +booked as estimated proved reserves by the first well to an extent that the +partners determined that the risk of development was not economic. Callon had a +40% working interest. The Company's proved reserves in the prior year included +7.2 million barrels of oil and 13 billion cubic feet of natural gas attributable +to Boomslang. +Prices for oil and gas are subject to large fluctuations in response to +relatively minor changes in the supply of and demand for oil and gas, market +uncertainty and a variety of additional factors beyond our control. These +factors include weather conditions in the United States, the condition of the +United States economy, the actions of the Organization of Petroleum Exporting +Countries, governmental regulation, political stability in the Middle East and +elsewhere, the foreign supply of crude oil and natural gas, the price of foreign +imports and the availability of alternate fuel sources. Any substantial and +extended decline in the price of crude oil or natural gas would have an adverse +effect on our carrying value of our proved reserves, borrowing capacity, +revenues, profitability and cash flows from operations. We use derivative +financial instruments (see Note 6 and Item 7A. "Quantitative and Qualitative +Disclosures About Market Risks") for price protection purposes on a limited +amount of our future production and do not use them for trading purposes. On a +Mcfe basis, natural gas represents 65% of the budgeted 2003 production and 39% +of proved reserves at year-end 2002. +Inflation has not had a material impact on us and is not expected to have a +material impact on us in the future. +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +RECENT ACCOUNTING PRONOUNCEMENTS. In June 1998, the Financial Accounting +Standards Board issued Statement of Financial Accounting Standards No. 133 +("SFAS 133"), Accounting for Derivative Instruments and Hedging Activities. The +Statement establishes accounting and reporting standards requiring that every +derivative instrument, including certain derivative instruments embedded in +other contracts, be recorded in the balance sheet as either an asset or +liability measured at its fair value. SFAS 133 requires the Company to report +changes in the fair value of our derivative financial instruments that qualify +as cash flow hedges in other comprehensive income, a component of stockholders' +equity, until realized. We adopted SFAS 133 effective January 1, 2001. +In June 2001, the Financial Accounting Standards Board approved Statement of +Accounting Standards No. 143, Asset Retirement Obligations ("SFAS 143"). SFAS +143 addresses financial accounting and reporting for obligations associated with +the retirement of tangible long-lived assets and the associated asset retirement +costs. We will record the fair value of these obligations on January 1, 2003, as +well as the related additional assets. The net difference between our previously +recorded abandonment liability and the amounts estimated under SFAS 143, after +taxes, is expected to total a gain of approximately $180,000, which will +26 +be recognized as a cumulative effect of a change in accounting principle and an +expected abandonment liability for retirement obligations of approximately $26 +million. +In December 2002, the Financial Accounting Standards Board issued Statement of +Financial Accounting Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based +Compensation-Transition and Disclosure -an amendment of SFAS No. 123." SFAS 148 +amends SFAS 123 to provide alternative methods of transition for a voluntary +change to the fair value based method of accounting for stock-based employee +compensation. In addition, this statement amends the disclosure requirements of +SFAS 123 to require disclosures in both annual and interim financial statements +about the method of accounting for stock-based employee compensation and the +effect of the method used on the reported results. SFAS 148 is effective for the +year ended December 31, 2002 and for interim financial statements commencing in +2003. The adoption of this pronouncement by the Company did not have an impact +on our financial condition or results of operations. +PROPERTY AND EQUIPMENT. We follow the full-cost method of accounting for oil and +gas properties whereby all costs incurred in connection with the acquisition, +exploration and development of oil and gas reserves, including certain overhead +costs, are capitalized into the "full cost pool." The amounts we capitalize into +the full cost pool are depleted (charged against earnings) using the +unit-of-production method. The full cost method of accounting for our proved oil +and gas properties requires that we make estimates based on assumptions as to +future events which could change. These estimates are described below. +Depreciation, Depletion and Amortization (DD&A) of Oil and Gas Properties. We +calculate depletion by using the capitalized costs in our full cost pool plus +future development and abandonment costs (combined, the depletable base) and our +estimated net proved reserve quantities. Capitalized costs added to the full +cost pool and other costs added to the depletable base include the following: +o The cost of drilling and equipping productive wells, dry hole costs, +acquisition costs of properties with proved reserves, delay rentals and +other costs related to exploration and development of our oil and gas +properties; +o Our payroll and general and administrative costs and costs related +fringe benefits paid to employees directly engaged in the acquisition, +exploration and/or development of oil and gas properties as well as +other directly identifiable general and administrative costs associated +with such activities. Such capitalized costs do not include any costs +related to our production of oil and gas or our general corporate +overhead; +o Costs associated with properties that do not have proved reserves +attributed to them are excluded from the full cost pool. These +unevaluated property costs are added to the full cost pool at such time +as wells are completed on the properties, the properties are sold or we +determine these costs have been impaired. Our determination that a +property has or has not been impaired (which is discussed below) +requires that we make assumptions about future events. +o Our estimates of future costs to develop proved properties are added to +the full cost pool for purposes of the DD&A computation. We use +assumptions based on the latest geologic, engineering, regulatory and +cost data available to us to estimate these amounts. However, the +estimates we make are subjective and may change over time. Our +estimates of future development costs are periodically updated as +additional information becomes available. +o Estimated costs to dismantle, abandon and restore a proved property are +added to the full cost pool for the purposes of DD&A. Such cost +estimates are periodically updated as additional information becomes +available. As discussed above under Accounting Pronouncements, +specifically FAS 143, beginning January 1, 2003, we will change the +method for which we account for such costs +27 +Capitalized costs included in the full cost pool are depleted and charged +against earnings using the unit of production method. Under this method, we +estimate our quantity of proved reserves at the beginning of each accounting +period. For each barrel of oil equivalent produced during the period, we record +a depletion charge equal to the amount included in the depletable base (net of +accumulated depreciation, depletion and amortization) divided by our estimated +net proved reserve quantities. +Because we use estimates and assumptions to calculate proved reserves (as +discussed below) and the amounts included in the full cost pool, our depletion +calculations will change as the estimates and assumptions are not realized. Such +changes may be material. +Ceiling Test. Under the full cost accounting rules, capitalized costs included +in the full cost pool, net of accumulated depreciation, depletion and +amortization (DD&A) and deferred income taxes, may not exceed the present value +of our estimated future net cash flows from proved oil and gas reserves, +discounted at 10 percent, plus the lower of cost or fair value of unproved +properties included in the costs being amortized, net of related tax effects. +These rules generally require that, in estimating future net cash flow, we +assume that future oil and gas production will be sold at the unescalated market +price for oil and gas received at the end of each fiscal quarter and that future +costs to produce oil and gas will remain constant at the prices in effect at the +end of the fiscal quarter. We are required to write-down and charge to earnings +the amount, if any, by which these costs exceed the discounted future net cash +flows, unless prices recover sufficiently before the date of our financial +statements. Given the volatility of oil and gas prices, it is likely that our +estimates of discounted future net cash flows from proved oil and gas reserves +will change in the near term. If oil and gas prices decline significantly, even +if only for a short period of time, it is possible that writedowns of oil and +gas properties could occur in the future. +Estimating Reserves and Present Values. Our estimates of quantities of proved +oil and gas reserves and the discounted present value of such reserves at the +end of each quarter are based on numerous assumptions which are likely to change +over time. These assumptions include: +o The prices at which we can sell our oil and gas production in the +future. Oil and gas process are volatile, but we are generally required +to assume that they will not change from the prices in effect at the +end of the quarter. In general, higher oil and gas prices will increase +quantities of proved reserves and the present value of such reserves, +while lower prices will decrease these amounts. Because our properties +have relatively short productive lives, changes in prices will affect +the present value more than quantities of oil and gas reserves. +o The costs to develop and produce our reserves and the costs to +dismantle our production facilities when reserves are depleted. These +costs are likely to change over time, but we are required to assume +that costs in effect at the end of the quarter will not change. +Increases in costs will reduce oil and gas quantities and present +values, while decreases in costs will increase such amounts. Because +our properties have relatively short productive lives, changes in costs +will affect the present value more than quantities of oil and gas +reserves. +In addition, the process of estimating proved oil and gas reserves requires that +our independent and internal reserve engineers exercise judgment based on +available geological, geophysical and technical information. We have described +the risks associated with reserve estimation and the volatility of oil and gas +prices, under "Risk Factors." +Unproved Properties. Costs associated with properties that do not have proved +reserves, including capitalized interest, are excluded from the full cost pool. +These unproved properties are included in the line item "Unevaluated properties +excluded from amortization." Unproved property costs are transferred to the full +cost pool when wells are completed on the properties or the properties are sold. +In addition, we are required to +28 +determine whether our unproved properties are impaired and, if so, add the costs +of such properties to the full cost pool. We determine whether an unproved +property should be impaired by periodically reviewing our exploration program on +a property by property basis. This determination may require the exercise of +substantial judgment by our management. +DERIVATIVES. We use derivative financial instruments for price protection +purposes on a limited amount of our future production and do not use them for +trading purposes. Such derivatives were accounted for in years prior to 2001 as +hedges and have been recognized as an adjustment to oil and gas sales in the +period in which they are related. Current accounting treatment is under SFAS +133. +LIQUIDITY AND CAPITAL RESOURCES +Our primary sources of capital are cash flows from operations, borrowings from +financial institutions and the sale of debt and equity securities. Net cash and +cash equivalents decreased during 2002 by $1.1 million. Cash provided from +operating activities during 2002 totaled $12.2 million. Dividends paid on +preferred stock were $1.3 million. Average debt outstanding was $246.0 million +during 2002 compared to $164.9 million in 2001. At December 31, 2002, we had +working capital of $.6 million. +In early July of 2001, we closed a $95 million multiple advance term loan +("Senior Notes") with a private lender. We drew $45 million on July 3, 2001 and +paid down our revolving Credit Facility. We drew the remaining $50 million in +December 2001. Under the terms of the agreement, we also issued warrants for the +purchase, at a nominal exercise price, of 265,210 shares of our common stock to +the lender and conveyed an overriding royalty interest equal to 2% of our net +interest in four of our deepwater discoveries. The warrants and the overriding +royalty interest were earned by the lender based on the ratio of the amount of +the loan proceeds advanced to the total loan facility amount. This senior debt +will mature March 31, 2005 and contains restrictions on certain types of future +indebtedness and dividends on common stock. +Effective October 31, 2000, we entered into a $75 million Credit Facility with +First Union National Bank. Borrowings under the Credit Facility are secured by +mortgages covering substantially all of our producing oil and gas properties and +guaranteed by our subsidiaries. On June 30, 2002, the lenders under the +Company's Credit Facility agreed to increase availability under the revolving +borrowing base from $50 million to $75 million. +The Credit Facility, the Senior Notes and our subordinated debt contain various +covenants including restrictions on additional indebtedness and payment of cash +dividends as well as maintenance of certain financial ratios. We are in +compliance with these covenants at December 31, 2002. +The holders of $22.9 million of the $36.0 million of the Company's 10.125% +Senior Subordinated Notes (the "Notes") consented to an extension of such Notes +until July 31, 2004. The Company granted 274,980 warrants with a fair market +value of approximately $1.3 million to purchase Common Stock of the Company and +paid consent fees in the amount of $2.3 million to the holders of the Notes that +granted the extensions. The holders of the Notes that did not consent to the +extension were paid on the maturity date of the Notes in September 2002. +Subsequent to September 2002, the holders of the Notes exercised approximately +116,000 warrants that were granted as a result of the extension of the Notes. +Our plans for 2003 include non-discretionary capital expenditures of $51.2 +million. Approximately $8.6 million of this amount is allocated to the +completion of the Medusa deepwater discovery, currently scheduled to begin +production in the third quarter of 2003. +29 +Following Medusa, the Habanero deepwater discovery is scheduled for development +with projected capital expenditures in 2003 of approximately $17.2 million and +is projected to begin initial production in the second half of 2003. Once +producing, this deepwater discovery is projected to have the same positive +impact on borrowing capacity as Medusa. Habanero will be produced through a +sidetrack of the initial discovery well and the additional development well to +be drilled in the summer of 2003. A sub sea completion will be routed into one +of the operator's existing facilities and initial production is expected in late +third quarter of 2003. +The Company anticipates that cash flow generated during 2003 and current +availability under the Credit Facility will provide necessary capital to enable +the Company to continue its operational activities until such time as production +from Medusa and Habanero begins. At that time, the Company anticipates that the +Medusa and Habanero reserves and production will be integrated into the +borrowing base of the Company's Credit Facility and will provide additional +available borrowing capacity. This increase in borrowing capacity as well as +significant additional cash flow from the new production will provide funds for +future discretionary capital expenditures. +The completion of the Company's deepwater discoveries will require the +construction of expensive production facilities and pipelines, including the +transportation and installation of production facilities and the use of sub sea +completion techniques. The Company cannot estimate the timing of the +construction of these facilities with certainty. The operators completing these +discoveries will possibly face inclement weather and other unfavorable +environmental conditions, delays in fabrication and delivery of necessary +equipment, and other unforeseen circumstances that may delay completion of these +properties. Long-term delays in the completion of these deepwater projects that +prevent the commencement of production from such discoveries could have a +material adverse effect on the Company's financial position and result of +operations. Such a delay would require the Company to reduce future anticipated +capital expenditures or seek additional sources of liquidity to finance capital +expenditures, which may not be available. +The following table describes our outstanding contractual obligations (in +thousands) as of December 31, 2002: +CONTRACTUAL LESS THAN ONE-THREE FOUR-FIVE AFTER-FIVE +OBLIGATIONS TOTAL ONE YEAR YEARS YEARS YEARS +------------------------------------------ -------- -------- -------- ---------- ---------- +Credit Facility $ 65,000 $ -- $ 65,000 $ -- $ -- +Senior Notes 95,000 -- 95,000 -- -- +10.125% Senior +Subordinated Debt 22,915 -- 22,915 -- -- +10.25% Senior Subordinated Debt 40,000 -- 40,000 -- -- +11% Senior Subordinated Debt 33,000 -- 33,000 -- -- +Capital lease (future minimum payments) 6,419 1,998 2,712 787 923 +RESULTS OF OPERATIONS +The following table sets forth certain operating information with respect to our +oil and gas operations for each of the three years in the period ended December +31, 2002. +30 +DECEMBER 31, +------------------------------------------ +2002(a)(b) 2001(a)(b) 2000(a)(b) +------------ ------------ ------------ +Production: +Oil (MBbls) 226 273 232 +Gas (MMcf) 14,215 13,566 13,943 +Total production (MMcfe) 15,571 15,206 15,334 +Average daily production (MMcfe) 42.7 41.7 41.9 +Average sales price: +Oil (per Bbl) $ 23.11 $ 22.95 $ 27.88 +Gas (per Mcf) $ 3.94 $ 3.96 $ 3.57 +Total production (per Mcfe) $ 3.93 $ 3.95 $ 3.67 +Average costs (per Mcfe): +Lease operating expenses $ .71 $ .73 $ .61 +Depletion $ 1.73 $ 1.37 $ 1.10 +General and administrative (net of management fees) $ .30 $ .30 $ .27 +(a) Includes hedging gains and losses. +(b) Includes volumes of 1,200 MMcf for the year 2002 and 2,300 MMcf for each of +the years 2001 and 2000, at an average price of $2.08 per Mcf associated with a +volumetric production payment. +PENDING SEC REVIEW OF RESERVE INFORMATION +In October 2002 and February 2003, we received letters from the SEC regarding +our Annual Report on Form 10-K for the year ended December 31, 2001 requesting +supplemental information concerning our operations in the Gulf of Mexico. The +comment letters requested information about the procedures we used to classify +our deepwater reserves as proved and requested that our financials be restated +to reflect the removal of the Boomslang reserves as proved for all prior periods +during which such reserves were reported as proved. We have reviewed the SEC +comments with our independent petroleum reserve engineers, Huddleston & Co., +Inc. of Houston, Texas. Both Huddleston & Co and Callon believe that such +deepwater reserves are properly classified as proved. +COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2002 AND +2001 +OIL AND GAS REVENUES +Oil and gas revenues for 2002 were $61.2 million, a 2% increase from the 2001 +amount of $60.0 million. 2002 oil and gas production of 15,571 MMcfe increased +as well from the 2001 amount of 15,206 MMcfe. +Oil production decreased from 273,000 barrels in 2001 to 226,000 barrels in 2002 +but the average sales price increased from $22.95 in 2001 to $23.11 in 2002. As +a result, oil revenues dropped from $6.3 million in 2001 to $5.2 million in +2002. The production decrease was primarily due to older properties' normal and +expected decline in production. +Gas revenues for 2002 were $55.9 million based on sales of 14.2 Bcf at an +average sales price of $3.94 per Mcf. For 2001, gas revenues were $53.7 million +based on production of 13.6 Bcf sold at an average sales price of $3.96 per Mcf. +Our gas production in 2002 increased when compared to last year due primarily to +the acceleration program at Mobile Blocks 952/953/955 area initiated in the +fourth quarter of 2001. +31 +LEASE OPERATING EXPENSES +Lease operating expenses remained relatively stable at $11.3 million ($.73 per +Mcfe) in 2001 compared to $11.0 million ($.71 per Mcfe) in 2002. +DEPRECIATION, DEPLETION AND AMORTIZATION +Depreciation, depletion and amortization increased by 28% due in large part to +the downward reserve revisions at Boomslang. This decrease in estimated proved +reserves, over which depletable costs are amortized, increased the per unit +depletion rate, while production remained relatively constant between years. +Total charges increased from $21.1 million or $1.39 per Mcfe in 2001, to $27.1 +million, or $1.74 per Mcfe in 2002. +GENERAL AND ADMINISTRATIVE +General and administrative expenses for 2002 were $4.7 million, or $.30 per +Mcfe, compared to $4.6 million, or $.30 per Mcfe, in 2001. +INTEREST EXPENSE +Interest expense for 2002 was $26.1 million increasing from $12.8 million in +2001. This is a result of an increase in our long-term debt as well as higher +interest rates associated with additional debt incurred in 2002. +INCOME TAXES +Our 2002 results include a deferred income tax benefit of $900,000. We evaluated +the deferred income tax asset in light of our reserve quantity estimates, our +long-term outlook for oil and gas prices and our expected level of future +revenues and expenses. We believe it is more likely than not, based upon this +evaluation, that we will realize the recorded deferred income tax asset. +However, there is no assurance that such asset will ultimately be realized. +COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2001 AND +2000 +OIL AND GAS REVENUES +Oil and gas revenues for 2001 were $60.0 million, a 7% increase from the 2000 +amount of $56.3 million. However, 2001 oil and gas production of 15,206 MMcfe +decreased slightly from the 2000 amount of 15,334 MMcfe. +Oil production increased from 232,000 barrels in 2000 to 273,000 barrels in 2001 +but the average sales price decreased from $27.88 in 2000 to $22.95 in 2001. As +a result, oil revenues dropped from $6.5 million in 2000 to $6.3 million in +2001. The production increase was primarily from increased oil production at +South Marsh Island 261 offset by older properties' normal and expected decline +in production. The slight decrease in oil revenue was due to the decline in +average oil prices received in 2001. +Gas revenues for 2001 were $53.7 million based on sales of 13.6 Bcf at an +average sales price of $3.96 per Mcf. For 2000, gas revenues were $49.8 million +based on production of 13.9 Bcf sold at an average sales price of $3.57 per Mcf. +Our gas production in 2001 decreased when compared to last year as a result of +32 +production declines at East Cameron 275 and South Marsh Island 261, offset by +increases in production at Mobile Block 864 and Chandeleur Block 40. The +production declines at East Cameron 275 and South Marsh Island 261 were normal +and expected as the 2000 rates were indicative of higher initial production. The +Mobile Block 864 Area increased production due to a well stimulation program as +well additions to production through exploratory and developmental drilling on +the property. Gas revenue increased due to higher prices received for production +in 2001. +LEASE OPERATING EXPENSES +Lease operating expenses increased from $9.3 million ($.61 per Mcfe) in 2000 to +$11.3 million ($.73 per Mcfe) in 2001. The increase was attributable to higher +operating costs at South Marsh Island 261 and at Mobile Block 864. Also, +production declines related to older properties that have relatively fixed +operating costs contributed to the higher per Mcf costs with lower production +levels for those properties in 2001. +WRITEDOWN OF ENRON DERIVATIVES +In April of 2001, we entered into derivative contracts for 2002 production with +Enron North America Corp. Enron North America Corp. filed for protection under +the bankruptcy laws in late 2001. As a result of the credit risk associated with +the derivatives with Enron North America Corp., hedge accounting was not +available due to ineffectiveness as of September 30, 2001 and the contracts at +December 31, 2001 were marked to the market. In the fourth quarter of 2001, we +charged to expense (non-cash) $9.2 million related to these Enron North America +Corp. derivatives. We have no other contracts with Enron or their related +subsidiaries. +DEPRECIATION, DEPLETION AND AMORTIZATION +Depreciation, depletion and amortization increased by 23% due to a combination +of an increase in the amortization base due to higher drilling costs with +reserve additions being less than expected from exploration efforts in 2001 and +downward reserve revisions in 2000 as a result of a field delineation program at +Habanero. +Total charges increased from $17.2 million, or $1.12 per Mcfe in 2000 to $21.1 +million, or $1.39 per Mcfe in 2001. +GENERAL AND ADMINISTRATIVE +General and administrative expenses for 2001 were $4.6 million, or $.30 per +Mcfe, compared to $4.2 million, or $.27 per Mcfe, in 2000. This increase was due +primarily to expenses incurred in the second quarter of 2001 related to our +withdrawn debt offering. +INTEREST EXPENSE +Interest expense for 2001 was $12.8 million increasing from $8.4 million in +2000. This is a result of an increase in our long-term debt as well as higher +interest rates associated with additional debt incurred in 2001. +INCOME TAXES +Our 2001 results include a deferred income tax expense of $977,000. We evaluated +the deferred income tax asset in light of our reserve quantity estimates, our +long-term outlook for oil and gas prices and our expected level of future +revenues and expenses. We believe it is more likely than not, based upon this +evaluation, that we will realize the recorded deferred income tax asset. +However, there is no assurance that such asset will ultimately be realized. +33 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS +The Company's revenues are derived from the sale of its crude oil and natural +gas production. In recent months, the prices for oil and gas have increased; +however, they remain extremely volatile and sometimes experience large +fluctuations as a result of relatively small changes in supplies, weather +conditions, economic conditions and government actions. The Company enters into +derivative financial instruments to hedge oil and gas price risks for the +production volumes to which the hedge relates. The derivatives reduce the +Company's exposure on the hedged volumes to decreases in commodity prices and +limit the benefit the Company might otherwise have received from any increases +in commodity prices on the hedged volumes. +The Company also enters into price "collars" to reduce the risk of changes in +oil and gas prices. Under these arrangements, no payments are due by either +party so long as the market price is above the floor price set in the collar and +below the ceiling. If the price falls below the floor, the counter-party to the +collar pays the difference to the Company and if the price is above the ceiling, +the counter-party receives the difference from the Company. The Company enters +into these various agreements to reduce the effects of volatile oil and gas +prices and does not enter into hedge transactions for speculative purposes. See +Note 6 to the Consolidated Financial Statements for a description of the +Company's hedged position at December 31, 2002. There have been no significant +changes in market risks faced by the Company since the end of 2002. +Based on projected annual sales volumes for 2003 (excluding forecast production +increases over 2002), a 10% decline in the prices we receive for our crude oil +and natural gas production would have an approximate $6.5 million impact on our +revenues. +34 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +---------- +Report of Independent Auditors 36 and 37 +Consolidated Balance Sheets as of December 31, 2002 and 2001 38 +Consolidated Statements of Operations for Each of the Three Years +in the Period Ended December 31, 2002 39 +Consolidated Statements of Stockholders' Equity for Each of the Three Years in +the Period Ended December 31, 2002 40 +Consolidated Statements of Cash Flows for Each of the Three Years in the Period +Ended December 31, 2002 41 +Notes to Consolidated Financial Statements 42 +35 +REPORT OF INDEPENDENT AUDITORS +The Stockholders and Board of Directors +Callon Petroleum Company: +We have audited the accompanying consolidated balance sheet of Callon +Petroleum Company as of December 31, 2002, and the related consolidated +statements of operations, stockholders' equity and cash flows for the year then +ended. These financial statements are the responsibility of the Company's +management. Our responsibility is to express an opinion on these financial +statements based on our audit. The financial statements of Callon Petroleum +Company as of December 31, 2001 and for each of the two years in the period then +ended, were audited by other auditors who have ceased operations and whose +report dated March 29, 2002, expressed an unqualified opinion on those +statements and included an explanatory paragraph that disclosed the change in +the Company's method of accounting for derivative instruments and hedging +activities discussed in Note 2 to those financial statements. +We conducted our audit in accordance with auditing standards generally +accepted in the United States. Those standards require that we plan and perform +the audit to obtain reasonable assurance about whether the financial statements +are free of material misstatement. An audit includes examining, on a test basis, +evidence supporting the amounts and disclosures in the financial statements. An +audit also includes assessing the accounting principles used and significant +estimates made by management, as well as evaluating the overall financial +statement presentation. We believe that our audit provides a reasonable basis +for our opinion. +In our opinion, the financial statements referred to above present fairly, +in all material respects, the consolidated financial position of Callon +Petroleum Company as of December 31, 2002, and the results of its operations and +its cash flows for the year then ended in conformity with accounting principles +generally accepted in the United States. +ERNST & YOUNG LLP +New Orleans, Louisiana +February 28, 2003 +36 +The following report is a copy of the audit report previously issued by Arthur +Andersen LLP in connection with Callon Petroleum Company's annual report on Form +10-K for the year ended December 31, 2001. This audit report has not been +reissued by Arthur Andersen LLP in connection with this filing on form 10-K for +the year ended December 31, 2002. The consolidated balance sheet as of December +31, 2000 and the consolidated statements of operations, stockholders' equity and +cash flows for the year ended December 31, 1999, mentioned in the report, are +not required in the Company's annual report for 2002 and are therefore not +presented among the financial statements in this annual report. +REPORT OF INDEPENDENT AUDITORS +To the Stockholders and Board of Directors of Callon Petroleum Company: +We have audited the accompanying consolidated balance sheets of Callon +Petroleum Company (a Delaware corporation) and subsidiaries as of December 31, +2001 and 2000, and the related consolidated statements of operations, +stockholders' equity and cash flows for each of the three years in the period +ended December 31, 2001. These financial statements are the responsibility of +the Company's management. Our responsibility is to express an opinion on these +financial statements based on our audits. +We conducted our audits in accordance with auditing standards generally +accepted in the United States. Those standards require that we plan and perform +the audit to obtain reasonable assurance about whether the financial statements +are free of material misstatement. An audit includes examining, on a test basis, +evidence supporting the amounts and disclosures in the financial statements. An +audit also includes assessing the accounting principles used and significant +estimates made by management, as well as evaluating the overall financial +statement presentation. We believe that our audits provide a reasonable basis +for our opinion. +In our opinion, the financial statements referred to above present +fairly, in all material respects, the financial position of Callon Petroleum +Company and subsidiaries, as of December 31, 2001 and 2000, and the results of +their operations and their cash flows for each of the three years in the period +ended December 31, 2001, in conformity with accounting principles generally +accepted in the United States. +As discussed in Note 2 to the consolidated financial statements +effective January 1, 2001, the Company adopted SFAS 133, "Accounting for +Derivative Instruments and Hedging Activities." +ARTHUR ANDERSEN LLP +New Orleans, Louisiana +March 29, 2002 +37 +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(IN THOUSANDS, EXCEPT SHARE DATA) +DECEMBER 31, +---------------------------- +2002 2001 +------------ ------------ +ASSETS +Current assets: +Cash and cash equivalents $ 5,807 $ 6,887 +Accounts receivable 10,875 5,908 +Other current assets 570 209 +------------ ------------ +Total current assets 17,252 13,004 +------------ ------------ +Oil and gas properties, full-cost accounting method: +Evaluated properties 762,918 704,937 +Less accumulated depreciation, depletion and amortization (426,254) (399,339) +------------ ------------ +336,664 305,598 +Unevaluated properties excluded from amortization 40,997 37,560 +------------ ------------ +Total oil and gas properties 377,661 343,158 +------------ ------------ +Pipeline and other facilities, net 853 5,364 +Other property and equipment, net 1,890 2,455 +Deferred tax asset 8,767 4,399 +Long-term gas balancing receivable 761 473 +Other assets, net 3,429 3,242 +------------ ------------ +Total assets $ 410,613 $ 372,095 +============ ============ +LIABILITIES AND STOCKHOLDERS' EQUITY +Current liabilities: +Accounts payable and accrued liabilities $ 12,498 $ 9,985 +Undistributed oil and gas revenues 1,109 1,131 +Accrued net profits interest payable 1,707 1,501 +Accounts payable and accrued liabilities to be refinanced -- 9,558 +Current maturities of long-term debt 1,320 37,345 +------------ ------------ +Total current liabilities 16,634 59,520 +------------ ------------ +Long-term debt-excluding current maturities 248,269 161,733 +Accounts payable and accrued liabilities to be refinanced 3,861 -- +Deferred revenue on sale of production payment -- 2,406 +Accrued retirement benefits 204 137 +Long-term gas balancing payable 685 1,075 +------------ ------------ +Total liabilities 269,653 224,871 +------------ ------------ +Stockholders' equity: +Preferred Stock, $.01 par value; 2,500,000 shares +authorized; 600,861 shares of Convertible +Exchangeable Preferred Stock, Series A issued +and outstanding at December 31, 2002 +with a liquidation preference of $15,021,525 6 6 +Common Stock, $.01 par value; 20,000,000 shares +authorized; 13,900,466 shares and 13,397,706 shares +outstanding at December 31, 2002 and 2001, respectively 139 134 +Capital in excess of par value 158,370 154,425 +Unearned restricted stock compensation (826) -- +Accumulated other comprehensive income (loss) (469) 5,971 +Retained earnings (deficit) (16,260) (13,312) +------------ ------------ +Total stockholders' equity 140,960 147,224 +------------ ------------ +Total liabilities and stockholders' equity $ 410,613 $ 372,095 +============ ============ +The accompanying notes are an integral part of these financial statements. +38 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF OPERATIONS +FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 +(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) +2002 2001 2000 +------------ ------------ ------------ +Revenues: +Oil and gas sales $ 61,171 $ 60,010 $ 56,310 +Interest and other 1,004 1,742 1,767 +Gain on sale of pipeline 2,454 -- -- +Gain on sale of Enron derivatives 2,479 -- -- +------------ ------------ ------------ +Total revenues 67,108 61,752 58,077 +------------ ------------ ------------ +Costs and expenses: +Lease operating expenses 11,030 11,252 9,339 +Depreciation, depletion and amortization 27,096 21,081 17,153 +General and administrative 4,705 4,635 4,155 +Writedown of Enron derivatives -- 9,186 -- +Loss on mark-to-market commodity derivative contracts 708 -- -- +Interest 26,140 12,805 8,420 +------------ ------------ ------------ +Total costs and expenses 69,679 58,959 39,067 +------------ ------------ ------------ +Income (loss) from operations (2,571) +2,793 19,010 +Income tax expense (benefit) (900) 977 6,463 +------------ ------------ ------------ +Net income (loss) (1,671) 1,816 12,547 +Preferred stock dividends 1,277 1,277 2,403 +------------ ------------ ------------ +Net income (loss) available to common shares $ (2,948) $ 539 $ 10,144 +============ ============ ============ +Net income (loss) per common share: +Basic $ (.22) $ .04 $ .82 +============ ============ ============ +Diluted $ (.22) $ .04 $ .80 +============ ============ ============ +Shares used in computing net income (loss) per common share: +Basic 13,387 13,273 12,420 +============ ============ ============ +Diluted 13,387 13,366 12,745 +============ ============ ============ +The accompanying notes are an integral part of these financial statements. +39 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY +(IN THOUSANDS) +Unearned Accumulated Total +Restricted Capital in Other Retained Stock- +Preferred Common Stock Excess of Comprehensive Earnings holders' +Stock Stock Compensation Par Value Income (Loss) (Deficit) Equity +---------- ---------- ------------ ---------- ------------- --------- ---------- +Balances, December 31, 1999 $ 11 $ 122 $ -- $ 148,242 $ -- $ (23,995) $ 124,380 +---------- ---------- ---------- ---------- ---------- --------- ---------- +Net income -- -- -- -- -- 12,547 12,547 +Preferred stock dividends -- -- -- -- -- (1,978) (1,978) +Shares issued pursuant to employee +benefit and option plan -- -- -- 1,069 -- -- 1,069 +Employee stock purchase plan -- -- -- 269 -- -- 269 +Tax benefits related to stock +compensation plans -- -- -- 41 -- -- 41 +Conversion of preferred shares +to common stock (5) 11 -- 419 -- (425) -- +---------- ---------- ---------- ---------- ---------- --------- ---------- +Balances, December 31, 2000 6 133 -- 150,040 -- (13,851) 136,328 +---------- ---------- ---------- ---------- ---------- --------- ---------- +Comprehensive income: +Net income -- -- -- -- -- 1,816 +Other comprehensive income -- -- -- -- 5,971 -- +---------- +Total comprehensive income 7,787 +Preferred stock dividend -- -- -- -- -- (1,277) (1,277) +Shares issued pursuant to employee +benefit and option plan -- 1 -- 942 -- -- 943 +Employee stock purchase plan -- -- -- 357 -- -- 357 +Tax benefits related to stock +compensation plans -- -- -- 18 -- -- 18 +Warrants -- -- -- 3,068 -- -- 3,068 +---------- ---------- ---------- ---------- ---------- --------- ---------- +Balances, December 31, 2001 6 134 -- 154,425 5,971 (13,312) 147,224 +---------- ---------- ---------- ---------- ---------- --------- ---------- +Comprehensive income: +Net loss -- -- -- -- -- (1,671) +Other comprehensive loss -- -- -- -- (6,440) -- +---------- +Total comprehensive loss (8,111) +Preferred stock dividends -- -- -- -- -- (1,277) (1,277) +Shares issued pursuant to employee +benefit and option plan -- 1 -- 770 -- -- 771 +Employee stock purchase plan -- -- -- 79 -- -- 79 +Tax benefits related to stock +compensation plans -- -- -- (29) -- -- (29) +Restricted stock -- 3 (826) 1,849 -- -- 1,026 +Warrants -- 1 -- 1,276 -- -- 1,277 +---------- ---------- ---------- ---------- ---------- --------- ---------- +Balances, December 31, 2002 $ 6 $ 139 $ (826) $ 158,370 $ (469) $ (16,260) $ 140,960 +========== ========== ========== ========== ========== ========= ========== +The accompanying notes are an integral part of these financial statements. +40 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 +(IN THOUSANDS) +2002 2001 2000 +------------ ------------ ------------ +Cash flows from operating activities: +Net income (loss) $ (1,671) $ 1,816 $ 12,547 +Adjustments to reconcile net income (loss) to +cash provided by operating activities: +Depreciation, depletion and amortization 27,774 21,709 17,598 +Gain on sale of pipeline (2,454) -- -- +Amortization of deferred costs 5,521 2,485 1,034 +Non-cash derivative income (9,186) -- -- +Mark-to-market commodity derivative contracts 708 -- -- +Amortization of deferred production payment revenue (2,406) (4,830) (4,844) +Writedown of Enron derivatives -- 9,186 -- +Deferred income tax expense (benefit) (900) 977 6,463 +Non-cash charge related to compensation plans 1,267 942 1,069 +Changes in current assets and liabilities: +Accounts receivable (4,967) 3,336 (3,882) +Advance to operators (98) 1,131 (1,131) +Other current assets (6) (2) (18) +Investment in derivative contracts (1,687) -- -- +Current liabilities 3,198 (8,782) 1,077 +Increase in accounts payable and accrued liabilities to be +refinanced -- 9,558 -- +Change in gas balancing receivable (288) 170 (400) +Change in gas balancing payable (390) 355 204 +Change in other long-term liabilities 67 (1,749) (221) +Change in other assets, net (2,315) (1,071) (751) +------------ ------------ ------------ +Cash provided (used) by operating activities 12,167 35,231 28,745 +------------ ------------ ------------ +Cash flows from investing activities: +Capital expenditures (66,023) (113,833) (81,849) +Proceeds from sale of pipeline 6,784 -- -- +Cash proceeds from sale of mineral interests 4,492 1,195 -- +------------ ------------ ------------ +Cash provided (used) by investing activities (54,747) (112,638) (81,849) +------------ ------------ ------------ +Cash flows from financing activities: +Decrease in accounts payable and accrued liability to be refinanced (5,697) -- -- +Equity issued related to employee stock plans 79 357 269 +Payment on debt (58,085) (84,900) (29,250) +Increase in debt 109,900 155,000 63,000 +Debt issuance costs (2,291) (2,374) (1,496) +Capital lease (1,129) 5,612 -- +Cash dividends on preferred stock (1,277) (1,277) (2,214) +------------ ------------ ------------ +Cash provided (used) by financing activities 41,500 72,418 30,309 +------------ ------------ ------------ +Net increase (decrease) in cash and cash equivalents (1,080) (4,989) (22,795) +Cash and cash equivalents: +Balance, beginning of period 6,887 11,876 34,671 +------------ ------------ ------------ +Balance, end of period $ 5,807 $ 6,887 $ 11,876 +============ ============ ============ +The accompanying notes are an integral part of these financial statements. +41 +CALLON PETROLEUM COMPANY +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +GENERAL +Callon Petroleum Company ("Company") was organized under the laws of the state +of Delaware in March 1994 to serve as the surviving entity in the consolidation +and combination of several related entities (referred to herein collectively as +the "Constituent Entities"). The combination of the businesses and properties of +the Constituent Entities with the Company was completed on September 16, 1994 +("Consolidation"). +As a result of the Consolidation, all of the businesses and properties of the +Constituent Entities are owned (directly or indirectly) by the Company. Certain +registration rights were granted to the stockholders of certain of the +Constituent Entities. See Note 7. +The Company and its predecessors have been engaged in the acquisition, +development and exploration of crude oil and natural gas since 1950. The +Company's properties are geographically concentrated in Louisiana, Alabama, +Texas and offshore Gulf of Mexico. +LIQUIDITY AND CAPITAL RESOURCES +In 2002, the lenders under the Company's Credit Facility agreed to increase +availability under the revolving borrowing base from $50 million to $75 million. +In addition, the holders of $22.9 million of the $36.0 million of the Company's +10.125% Senior Subordinated Notes ("Notes") consented to an extension of such +Notes until July 31, 2004. The Company granted 274,980 warrants with a fair +market value of approximately $1.3 million to purchase Common Stock of the +Company for $.01 per share and paid consent fees in the amount of $2.3 million +to the holders of the Notes that granted the extensions. The holders of the +Notes that did not consent to the extension were paid on the maturity date of +the Notes in September 2002. Subsequent to September 2002, the holders of the +Notes exercised approximately 116,000 warrants that were granted as a result of +the extension of the Notes. +Non-discretionary capital expenditures include completion of the Medusa +deepwater discovery, currently scheduled to begin production in the late summer +of 2003. The Company anticipates that cash flow generated during 2003 and +current availability under the Credit Facility will provide necessary capital to +enable the Company to continue its operational activities until such time as +production from the Medusa discovery begins. At that time, the Company +anticipates that the Medusa reserves and production will be integrated into the +borrowing base of the Company's Credit Facility and will provide additional +available borrowing capacity. This increase in borrowing capacity as well as +significant additional cash flow expected from the new production will provide +funds for future discretionary capital expenditures. +Following Medusa, the Habanero deepwater discovery is scheduled for development +and is projected to begin initial production in the second half of 2003. Once +producing, this deepwater discovery is projected to have the same positive +impact on borrowing capacity as Medusa. Habanero will be produced by the +42 +existing delineation well and an additional well to be drilled in the summer of +2003. A sub sea completion will be routed into one of the operator's existing +facilities and initial production is expected in late third quarter of 2003. +The completion of the Company's deepwater discoveries will require the +construction of expensive production facilities and pipelines, including the +transportation and installation of production facilities and the use of sub sea +completion techniques. The Company cannot estimate the timing of the +construction of these facilities with certainty. The operators completing these +discoveries will possibly face inclement weather and other unfavorable +environmental conditions, delays in fabrication and delivery of necessary +equipment, and other unforeseen circumstances that may delay completion of these +properties. Long-term delays in the completion of these deepwater projects that +prevent the commencement of production from such discoveries could have a +material adverse effect on the Company's financial position and result of +operations. Such a delay would require the Company to reduce future anticipated +capital expenditures or seek additional sources of liquidity to finance capital +expenditures, which may not be available. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +PRINCIPLES OF CONSOLIDATION AND REPORTING +The Consolidated Financial Statements include the accounts of the Company, and +its subsidiary, Callon Petroleum Operating Company ("CPOC"). CPOC also has +subsidiaries, namely Callon Offshore Production, Inc. and Mississippi Marketing, +Inc. All intercompany accounts and transactions have been eliminated. Certain +prior year amounts have been reclassified to conform to presentation in the +current year. +USE OF ESTIMATES +The preparation of financial statements in conformity with generally accepted +accounting principles requires management to make estimates and assumptions that +affect the reported amounts of assets and liabilities and disclosure of +contingent assets and liabilities at the date of the financial statements and +the reported amounts of revenues and expenses during the reporting period. +Actual results could differ from those estimates. +ACCOUNTING PRONOUNCEMENTS +In June 1998, the Financial Accounting Standards Board issued Statement of +Financial Accounting Standards No. 133 ("SFAS 133"), Accounting for Derivative +Instruments and Hedging Activities. The Statement establishes accounting and +reporting standards requiring that every derivative instrument, including +certain derivative instruments embedded in other contracts, be recorded in the +balance sheet as either an asset or liability measured at its fair value. The +Company adopted SFAS 133 effective January 1, 2001. The cumulative effect of the +accounting change, net of tax, recorded as other comprehensive loss was $3.8 +million. +SFAS 133 requires the Company to report changes in the fair value of our +derivative financial instruments that qualify as cash flow hedges in other +comprehensive income, a component of stockholders' equity, until realized. See +Note 6 for a discussion of our derivative financial instruments. +In June 2001, the Financial Accounting Standards Board approved Statement of +Accounting Standards No. 143, Asset Retirement Obligations ("SFAS 143"). SFAS +143 addresses financial accounting and reporting for obligations associated with +the retirement of tangible long-lived assets and the associated asset retirement +costs. We will record the fair value of these obligations on January 1, 2003, as +well as the related additional +43 +assets. The net difference between our previously recorded abandonment liability +and the amounts estimated under SFAS 143, after taxes, is expected to total a +gain of approximately $180,000, which will be recognized as a cumulative effect +of a change in accounting principle and an expected abandonment liability for +retirement obligations of approximately $26 million. +In December 2002, the Financial Accounting Standards Board issued Statement of +Financial Accounting Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based +Compensation-Transition and Disclosure--an amendment of SFAS No. 123." SFAS 148 +amends SFAS 123 to provide alternative methods of transition for a voluntary +change to the fair value based method of accounting for stock-based employee +compensation. In addition, this statement amends the disclosure requirements of +SFAS 123 to require disclosures in both annual and interim financial statements +about the method of accounting for stock-based employee compensation and the +effect of the method used on the reported results. SFAS 148 is effective for the +year ended December 31, 2002 and for interim financial statements commencing in +2003. The adoption of this pronouncement by the Company did not have an impact +on our financial condition or results of operations. +PROPERTY AND EQUIPMENT +The Company follows the full cost method of accounting for oil and gas +properties whereby all costs incurred in connection with the acquisition, +exploration and development of oil and gas reserves, including certain overhead +costs, are capitalized. Such amounts include the cost of drilling and equipping +productive wells, dry hole costs, lease acquisition costs, delay rentals, +interest capitalized on unevaluated leases and other costs related to +exploration and development activities. Payroll and general and administrative +costs capitalized include salaries and related fringe benefits paid to employees +directly engaged in the acquisition, exploration and/or development of oil and +gas properties as well as other directly identifiable general and administrative +costs associated with such activities. Such capitalized costs ($9.6 million in +2002, $10.0 million in 2001 and $7.4 million in 2000) do not include any costs +related to production or general corporate overhead. Costs associated with +unevaluated properties, including capitalized interest on such costs, are +excluded from amortization. Unevaluated property costs are transferred to +evaluated property costs at such time as wells are completed on the properties, +the properties are sold or management determines these costs have been impaired. +Costs of properties, including future development and net future site +restoration, dismantlement and abandonment costs, which have proved reserves and +those which have been determined to be worthless, are depleted using the +unit-of-production method based on proved reserves. If the total capitalized +costs of oil and gas properties, net of amortization, exceed the sum of (1) the +estimated future net revenues from proved reserves at current prices and +discounted at 10% and (2) the lower of cost or market of unevaluated properties +(the full cost ceiling amount), net of tax effects, then such excess is charged +to expense during the period in which the excess occurs. See Note 8. +Upon the acquisition or discovery of oil and gas properties, management +estimates the future net costs to be incurred to dismantle, abandon and restore +the property using geological, engineering and regulatory data available. Such +cost estimates are periodically updated for changes in conditions and +requirements. Such estimated amounts are considered as part of the full cost +pool subject to amortization upon acquisition or discovery. Such costs are +capitalized as oil and gas properties as the actual restoration, dismantlement +and abandonment activities take place. As discussed above under Accounting +Pronouncements, beginning January 1, 2003, the Company will change the method +for which we account for such cost as described by FAS 143. +44 +Depreciation of other property and equipment is provided using the straight-line +method over estimated lives of three to 20 years. Depreciation of pipeline and +other facilities is provided using the straight-line method over estimated lives +of 15 to 27 years. +SALE OF PRODUCTION PAYMENT INTEREST +In June 1999, the Company acquired a working interest in the Mobile Block 864 +Area where the Company already owned an interest. Concurrent with this +acquisition, the seller received a volumetric production payment, valued at +approximately $14.8 million, from production attributable to a portion of the +Company's interest in the area over a 39-month period. The Company recorded a +liability associated with the sale of this production payment interest because a +substantial obligation for future performance existed. Under the terms of the +sale, the Company was obligated to deliver the production volumes free and clear +of royalties, lease operating expenses, production taxes and all capital costs. +The production payment was amortized, beginning in June 1999, to oil and gas +sales on the units-of-production method as associated hydrocarbons were +delivered, and expired in July 2002. +NATURAL GAS IMBALANCES +The Company follows an entitlement method of accounting for its proportionate +share of gas production on a well-by-well basis, recording a receivable to the +extent that a well is in an "undertake" position and conversely recording a +liability to the extent that a well is in an "overtake" position. Imbalance +positions are not significant at December 31, 2002. +DERIVATIVES +The Company uses derivative financial instruments for price protection purposes +on a limited amount of its future production and does not use them for trading +purposes. Such derivatives were accounted for, prior to adoption of SFAS 133, as +hedges and have been recognized as an adjustment to oil and gas sales in the +period in which they are related. Current accounting treatment is under SFAS 133 +(see Note 6). +ACCOUNTS RECEIVABLE +Accounts receivable consists primarily of accrued oil and gas production +receivables. The balance in the reserve for doubtful accounts included in +accounts receivable was $143,000 and $68,000 at December 31, 2002 and 2001, +respectively. Net recoveries were $75,000 in 2002 and net charge offs were +$10,000 in 2001. There were no provisions to expense in the three-year period +ended December 31, 2002. +ACCOUNTS PAYABLE AND ACCRUED LIABILITIES TO BE REFINANCED +These amounts included in the Balance Sheet represent capital expenditures in +accounts payable and accrued liabilities that were refinanced with the +availability under the Credit Facility subsequent to December 31, 2002. Amounts +in 2001 were classified as short term because of the maturity of the Credit +Facility at December 31, 2001. See Footnote 5 for a discussion of the amendment +to the Credit Facility in June of 2001. +45 +STOCK BASED COMPENSATION +The Company accounts for its stock based compensation plans under the +recognition and measurement principles of APB Opinion No. 25, Accounting for +Stock Issued to Employees, and related Interpretations. See Footnote 10 for +descriptions and additional disclosures related to the plans. +MAJOR CUSTOMERS +Our production is sold generally on month-to-month contracts at prevailing +prices. The following table identifies customers to whom we sold a significant +percentage of our total oil and gas production during each of the twelve-month +periods ended: +DECEMBER 31, +------------ +2002 2001 2000 +---- ---- ---- +Adams Resources Marketing, Ltd. -- -- 14% +Petrocom Energy Group, Ltd. 4% -- -- +Dynegy 7% 8% -- +Prior Energy Corporation -- 20% -- +Reliant Energy Services 70% 49% 37% +Unocal Exploration Corporation -- -- 8% +Because alternative purchasers of oil and gas are readily available, we believe +that the loss of any of these purchasers would not result in a material adverse +effect on our ability to market future oil and gas production. +STATEMENTS OF CASH FLOWS +For purposes of the Consolidated Financial Statements, the Company considers all +highly liquid investments purchased with an original maturity of three months or +less to be cash equivalents. +The Company paid no federal income taxes for the three years ended December 31, +2002. During the years ended December 31, 2002, 2001 and 2000, the Company made +cash payments for interest of $25,507,000, $16,441,000 and $11,449,000 +respectively. +PER SHARE AMOUNTS +Basic income or loss per common share was computed by dividing net income or +loss by the weighted average number of shares of common stock outstanding during +the year. Diluted income or loss per common share was determined on a weighted +average basis using common shares issued and outstanding adjusted for the effect +of stock options considered common stock equivalents computed using the treasury +stock method. The conversion of the preferred stock was not included in any +annual calculation due to its antidilutive effect on diluted income or loss per +common share. +46 +A reconciliation of the basic and diluted per share computation is as follows +(in thousands, except per share amounts): +2002 2001 2000 +---------- ---------- ---------- +(a) Net income (loss) available for common stock $ (2,948) $ 539 $ 10,144 +Preferred dividends assuming conversion of +preferred stock (if dilutive) -- -- -- +(b) Income (loss) available for common stock assuming +conversion of preferred stock (if dilutive) $ (2,948) $ 539 $ 10,144 +(c) Weighted average shares outstanding 13,387 13,273 12,420 +Dilutive impact of stock options -- 27 325 +Dilutive impact of warrants -- 66 -- +Convertible preferred stock (if dilutive) -- -- -- +(d) Total diluted shares 13,387 13,366 12,745 +Stock options and warrants excluded due to +antidilutive impact 2,945 1,438 150 +Basic income (loss) per share (a/c) $ (.22) $ .04 $ .82 +Diluted income (loss) per share (b/d) $ (.22) $ .04 $ .80 +FAIR VALUE OF FINANCIAL INSTRUMENTS +Fair value of cash, cash equivalents, accounts receivable, accounts payable, the +capital lease and the Credit Facility approximates book value at December 31, +2002 and 2001. Fair value of long-term debt (specifically, the 10.125%, the +10.25%, the 11% Senior Subordinated Notes and the 12% Senior Notes) have an +estimated fair value of between 84% and 86% of face value at December 31, 2002. +3. INCOME TAXES +The Company follows the asset and liability method of accounting for deferred +income taxes prescribed by Statement of Financial Accounting Standards No. 109 +("SFAS 109") "Accounting for Income Taxes". The statement provides for the +recognition of a deferred tax asset for deductible temporary timing differences, +capital and operating loss carryforwards, statutory depletion carryforward and +tax credit carryforwards, net of a "valuation allowance". The valuation +allowance is provided for that portion of the asset, for which it is deemed more +likely than not, that it will not be realized. The Company's management +determined that no valuation allowance was required in 2002 or 2001. +Accordingly, the Company has recorded a deferred tax asset at December 31, 2002 +and 2001 as follows: +47 +DECEMBER 31, +------------ +2002 2001 +---------- ---------- +(IN THOUSANDS) +Federal net operating loss carryforwards $ 42,464 $ 29,723 +Statutory depletion carryforward 4,251 4,184 +Temporary differences: +Oil and gas properties (39,159) (28,685) +Pipeline and other facilities (299) (1,822) +Non-oil and gas property (30) (62) +Other 1,540 1,061 +---------- ---------- +Total tax asset 8,767 4,399 +Valuation allowance -- -- +---------- ---------- +Net tax asset $ 8,767 $ 4,399 +========== ========== +At December 31, 2002, the Company had, for federal tax reporting purposes, net +operating loss carryforwards of $121.3 million, which expire in 2003 through +2017. Net operating loss carryforwards includes approximately $1.4 million of +the total that will expire within the next five years including approximately $1 +million in 2003. Additionally, the Company had available for tax reporting +purposes $12.0 million in statutory depletion deductions, which can be carried +forward for an indefinite period. No valuation allowance has been provided +against these carryforwards because management believes that it is more likely +than not they will be realized. However, realization is not assured. +The Company has significant state net operating loss carryforwards that are not +included in the deferred tax asset above, as the Company does not anticipate +generating taxable state income in the states in which these loss carryforwards +apply. The Company has very limited state taxable income as primarily all of its +revenue is generated in federal waters not subject to state income taxes. +The provision for income taxes at the Company's effective tax rate approximated +the provision for income taxes at the statutory rate. +4. OTHER COMPREHENSIVE INCOME +The Company did not have any items of other comprehensive income prior to 2001. +A recap of the Company's 2002 and 2001 comprehensive income (net of tax) is +shown below (in thousands): +YEARS ENDED DECEMBER, +------------------------ +2002 2001 +---------- ---------- +Other comprehensive income (loss): +Cumulative effect of change in +accounting principle $ -- $ (3,764) +Change in unrealized derivatives' +fair value (469) 9,735 +Amortization of Enron derivatives (5,971) -- +---------- ---------- +Total other comprehensive income (loss) $ (6,440) $ 5,971 +========== ========== +48 +5. LONG-TERM DEBT +Long-term debt consisted of the following at: +DECEMBER 31, +------------ +2002 2001 +------------ ------------ +(IN THOUSANDS) +Credit Facility $ 65,000 $ 100 +Senior Notes, net of discount 87,020 84,366 +10.125% Senior Subordinated Notes (due 2004), +net of discount 20,086 36,000 +10.25% Senior Subordinated Notes (due 2004) 40,000 40,000 +11% Senior Subordinated Notes (due 2005) 33,000 33,000 +Capital lease 4,483 5,612 +------------ ------------ +249,589 199,078 +Less: current portion 1,320 37,345 +------------ ------------ +$ 248,269 $ 161,733 +============ ============ +The Company negotiated its Credit Facility effective October 31, 2000 with First +Union National Bank. Borrowings under the Credit Facility are secured by +mortgages covering substantially all of the Company's producing oil and gas +properties. On June 30, 2002, the Company amended the Credit Facility to +increase availability under the revolving borrowing base from $50 million to $75 +million under a dual tranche loan. The Tranche A revolver bears interest at +0.25% to 0.75% above a defined base rate depending on utilization of the +borrowing base or, at the option of the Company, LIBOR plus 2% to 2.5% based on +utilization of the borrowing base and has a maximum aggregate credit amount of +$45 million. The range of interest rates on the Tranche A revolver was 3.36% to +5.25% for the twelve months ended December 31, 2002. The Tranche B part of the +facility will bear interest at 15% and has an aggregate maximum credit amount of +$30 million. The amended Credit Facility contains substantially the same +covenants as the original Credit Facility. The weighted average interest rate +for the Credit Facility debt outstanding at December 31, 2002 and 2001 was 9.00% +and 4.75%, respectively. Under the Credit Facility, a commitment fee of 0.25% or +0.375% per annum, depending on the amount of the unused portion of the borrowing +base, is payable quarterly. The maturity date of the Credit Facility is June 30, +2004 and the $75 million borrowing base is subject to semi-annual +re-determinations in April and October of each year. +On September 15, 2002, $36 million of the Company's 10.125% Senior Subordinated +Notes ("Notes")that were issued on July 31, 1997, were due. The holders of $22.9 +million of the Notes consented to an extension of such Notes until July 31, +2004. The Company granted 274,980 warrants (with a fair market value of +approximately $1.3 million) to purchase Common Stock of the Company and paid +consent fees in the amount of $2.3 million to the holders of the Notes that +granted the extensions. The warrants have a term of five years and an exercise +price of $0.01. The holders of the Notes had exercised approximately 116,000 +warrants as of December 31, 2002. The holders of the Notes that did not consent +to the extension were paid on the maturity date in September 2002. Interest on +the Notes is payable quarterly, on March 15, June 15, September 15, and December +15 of each year. +The Company accounted for the extension of the $22.9 million in Notes described +above as an extinguishment of the Notes and the issuance of new securities +recorded at a fair value of $19.3 million. +49 +The net loss on extinguishment, including the warrants and fees paid described +above was not significant. Costs deferred with the extensions will be amortized +through July 2004. +On July 15, 1999, the Company completed the sale of $40 million of Senior +Subordinated Notes due 2004 at 10.25%. The net proceeds of approximately $38.2 +million were used to pay down the Credit Facility at that time. These notes are +not entitled to any mandatory sinking fund payments and are subject to +redemption at the Company's option at par plus unpaid interest at any time after +March 15, 2001. The notes are listed on the New York Stock Exchange under the +symbol "CPE 04" and are subject to a change of control clause that obligates the +Company to repurchase the notes for 101% of par should a change of control +occur. Interest is paid quarterly. +The Company completed the sale of $33 million of 11% Senior Subordinated Notes +due 2005, on October 26, 2000. The Company netted $31.5 million from the +offering after deducting the underwriters' discount and offering expenses. +Approximately $20.8 million of the net proceeds from the offering were used to +purchase a portion of the Company's outstanding 10% Senior Subordinated Notes +due 2001 in conjunction with a tender offer. The Company redeemed the remaining +$3.4 million of its 10% Senior Subordinated Notes due 2001 not tendered in the +offer. +In July 2001, the Company entered into a $95 million multiple advance term loan +("Senior Notes") with a private lender. The Company issued $45 million of 12% +Senior Notes upon closing of the loan and issued the remaining $50 million of +Senior Notes in December 2001. Under the terms of the agreement Callon also +issued warrants to purchase, at a nominal exercise price, 265,210 shares of its +common stock (fair value of $3.1 million) and conveyed an overriding royalty +interest equal to 2% of the Company's net interest in four existing deepwater +discoveries (fair value of $5.9 million). The warrants and the overriding +royalty interest were earned by the lender based on the ratio of the amount of +the loan proceeds advanced to the total loan facility amount. The Senior Notes +will mature March 31, 2005, have an effective interest rate of approximately 16% +and contain restrictions on certain types of future indebtedness. +In December 2001, the Company entered into a ten-year gas processing agreement +associated with a production facility on Callon's Mobile 952 field with Hanover +Compression Limited Partnership, which is being accounted for as a capital +lease. Total minimum obligations are $8.4 million with interest representing +approximately $2.8 million and the present value minimum obligations were $5.6 +million ($1.2 million current). +Future minimum lease payments and debt maturities (in thousands) are as follows: +CAPITAL LEASE +YEAR PAYMENTS DEBT +---------------- ------------- ------------ +2003 $ 1,998 $ -- +2004 1,890 128,000 +2005 822 128,000 +2006 439 -- +2007 348 -- +Thereafter 923 -- +The Credit Facility, the subordinated debt and the Senior Notes contain various +covenants including restrictions on additional indebtedness and payment of cash +dividends as well as maintenance of certain financial ratios. The Company is in +compliance with these covenants at December 31, 2002. +50 +6. DERIVATIVES +The Company periodically uses derivative financial instruments to manage oil and +gas price risk. Settlements of gains and losses on commodity price contracts are +generally based upon the difference between the contract price or prices +specified in the derivative instrument and a NYMEX price or other cash or +futures index price. As a result of these contracts, there was no effect on oil +and gas revenue during 2002 and in 2001, $1,371,000 was recognized as additional +oil and gas revenue. +In 2002, the Company purchased and sold various put options and call options and +elected not to designate these derivative financial instruments as accounting +hedges and accordingly, accounted for these contracts under mark-to-market +accounting. Year-to-date charges to income were $708,000. +During 2002, the Company entered into no-cost natural gas collar contracts in +effect for February 2003 through October 2003. These agreements are for volumes +of 275,000 Mcf per month with an average ceiling price of $4.79 and a floor +price of $3.52. These contracts are accounted for as cash flow hedges under SFAS +133. The fair value of these collar contracts at December 31, 2002, recorded on +the balance sheet is $721,350 and $468,878 (net of tax) as other comprehensive +income. +In April 2001, the Company entered into derivative contracts for 2002 production +with Enron North America Corp. These agreements are for average gas volumes of +approximately 600,000 Mcf per month in 2002 with a weighted average ceiling +price of $6.09 and floor price of $4.11. Enron North America Corp. filed for +protection under the bankruptcy laws in late 2001. As a result of the credit +risk associated with the derivatives with Enron North America Corp., hedge +accounting was not available due to ineffectiveness as of September 30, 2001 and +the contracts at December 31, 2001 were marked to the market. In the fourth +quarter of 2001, the Company charged to expense (non-cash) $9.2 million related +to these Enron North America Corp. derivatives. The Company has no other +contracts with Enron or its subsidiaries. +The $5,971,000 (net of tax) recorded in other comprehensive income at December +31, 2001 is related to the fair value as of September 30, 2001 of the natural +gas collar contracts with Enron North America Corp., which matured in 2002. As +the contracts matured, the Company recorded non-cash revenue each month, +offsetting the amounts in other comprehensive income related to the derivatives. +The Company recorded approximately $1.7 million related to these Enron +derivatives in the fourth quarter of 2002 and $9.2 million for the year ended +December 31, 2002 as oil and gas revenue. +In the second quarter of 2002, the Company completed the sale of its claim +against Enron for hedging transactions for $2.5 million in cash. As a result of +the sale, the Company reported a pre-tax gain of $2.5 million in the second +quarter of 2002. +The Company has no other derivative contracts. +51 +7. COMMITMENTS AND CONTINGENCIES +As described in Note 9, abandonment trusts (the "Trusts") have been established +for future abandonment obligations of those oil and gas properties of the +Company burdened by a net profits interest. The management of the Company +believes the Trusts will be sufficient to offset those future abandonment +liabilities; however, the Company is responsible for any abandonment expenses in +excess of the Trusts' balances. As of December 31, 2002, total estimated site +restoration, dismantlement and abandonment costs were approximately $6,896,000, +net of expected salvage value. Substantially all such costs are expected to be +funded through the Trusts' funds, all of which will be accessible to the Company +when abandonment work begins. In addition, as a working interest owner and/or +operator of oil and gas properties, the Company is responsible for the cost of +abandonment of such properties. See Note 2. +From time to time, the Company, as part of the Consolidation and other capital +transactions, entered into Registration Rights Agreements whereby certain +parties to the transactions are entitled to require the Company to register +Common Stock of the Company owned by them with the Securities and Exchange +Commission for sale to the public in firm commitment public offerings and +generally to include shares owned by them, at no cost, in registration +statements filed by the Company. Costs of the offering will not include broker's +discounts and commissions, which will be paid by the respective sellers of the +Common Stock. +The Company is involved in various claims and lawsuits incidental to its +business. In the opinion of management, the ultimate liability thereunder, if +any, will not have a material adverse effect on the financial position or +results of operations of the Company. +The Company's activities are subject to federal, state and local laws and +regulations governing environmental quality and pollution control. Although no +assurances can be made, the Company believes that, absent the occurrence of an +extraordinary event, compliance with existing federal, state and local laws, +rules and regulating the release of materials in the environment or otherwise +relating to the protection of the environment will not have a material effect +upon the capital expenditures, earnings or the competitive position of the +Company with respect to its existing assets and operations. The Company cannot +predict what effect additional regulation or legislation, enforcement polices +thereunder, and claims for damages to property, employees, other persons and the +environment resulting from the Company's operations could have on its +activities. +52 +8. OIL AND GAS PROPERTIES +The following table discloses certain financial data relating to the Company's +oil and gas activities, all of which are located in the United States. +YEARS ENDED DECEMBER 31, +------------------------ +2002 2001 2000 +---------- ---------- ---------- +(IN THOUSANDS) +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance $ 704,937 $ 589,549 $ 511,689 +Property acquisition costs 1,471 1,713 3,211 +Exploration costs 17,851 85,782 51,837 +Development costs 43,151 34,980 25,242 +Sale of mineral interests (4,492) (7,087) (2,430) +---------- ---------- ---------- +End of period balance $ 762,918 $ 704,937 $ 589,549 +========== ========== ========== +Unevaluated Properties (excluded from +amortization) - +Beginning of period balance $ 37,560 $ 47,653 $ 44,434 +Additions 5,802 8,760 9,417 +Capitalized interest 5,289 4,879 4,548 +Transfers to evaluated (7,654) (23,732) (10,746) +---------- ---------- ---------- +End of period balance $ 40,997 $ 37,560 $ 47,653 +========== ========== ========== +Accumulated depreciation, depletion +and amortization +Beginning of period balance $ 399,339 $ 378,589 $ 361,758 +Provision charged to expense 26,915 20,750 16,831 +---------- ---------- ---------- +End of period balance $ 426,254 $ 399,339 $ 378,589 +========== ========== ========== +Unevaluated property costs, primarily lease acquisition costs incurred at +federal lease sales, unevaluated drilling costs, capitalized interest and +general and administrative costs being excluded from the amortizable evaluated +property base consisted of $9.4 million incurred in 2002, $7.5 million incurred +in 2001 and $24.1 million incurred in 2000 and prior. These costs are directly +related to the acquisition and evaluation of unproved properties and major +development projects. The excluded costs and related reserves are included in +the amortization base as the properties are evaluated and proved reserves are +established or impairment is determined. The Company expects that the majority +of these costs will be evaluated over the next three to five year period. +Depletion per unit-of-production (thousand cubic feet of gas equivalent) +amounted to $1.73, $1.37 and $1.10 for the years ended December 31, 2002, 2001, +and 2000, respectively. +Under the full cost accounting rules of the SEC, the Company reviews the +carrying value of its proved oil and gas properties each quarter. Under these +rules, capitalized costs of proved oil and gas properties net of accumulated +depreciation, depletion and amortization (DD&A) and deferred income taxes, may +not exceed the present value of estimated future net cash flows from proved oil +and gas reserves, discounted at 10 percent, plus the lower of cost or fair value +of unproved properties included in the costs being amortized, net of related tax +effects. These rules generally require pricing future oil and gas production at +the unescalated market price for oil and gas at the end of each fiscal quarter +and require a write-down if the "ceiling" is exceeded, unless prices recover +sufficiently before the date of the auditor's report. Given the volatility of +oil and gas prices, it is reasonably possible that the Company's estimate of +discounted future net cash flows from proved oil and gas reserves could change +in the near term. If oil and gas priced decline significantly, even if only for +a short period of time, it is possible that writedowns of oil and gas properties +could occur in the future. +53 +9. NET PROFITS INTEREST +From 1989 through 1994, the Constituent Entities entered into separate +agreements to purchase certain oil and gas properties with gross contract +acquisition prices of $170,000,000 ($150,000,000 net as of closing dates) and in +simultaneous transactions, entered into agreements to sell overriding royalty +interests ("ORRI") in the acquired properties. These ORRI are in the form of net +profits interests ("NPI") equal to a significant percentage of the excess of +gross proceeds over production costs, as defined, from the acquired oil and gas +properties. A net deficit incurred in any month can be carried forward to +subsequent months until such deficit is fully recovered. The Company has the +right to abandon the purchased oil and gas properties if it deems the properties +to be uneconomical. +The Company has, pursuant to the purchase agreements, created abandonment trusts +whereby funds are provided out of gross production proceeds from the properties +for the estimated amount of future abandonment obligations related to the +working interests owned by the Company. The Trusts are administered by unrelated +third party trustees for the benefit of the Company's working interest in each +property. The Trust agreements limit their funds to be disbursed for the +satisfaction of abandonment obligations. Any funds remaining in the Trusts after +all restoration, dismantlement and abandonment obligations have been met will be +distributed to the owners of the properties in the same ratio as contributions +to the Trusts. The Trusts' assets are excluded from the Consolidated Balance +Sheets of the Company because the Company does not control the Trusts. Estimated +future revenues and costs associated with the NPI and the Trusts are also +excluded from the oil and gas reserve disclosures at Note 12. As of December 31, +2002 and 2001, the Trusts' assets (all cash and investments) totaled $6,896,000 +and $6,567,000 respectively, all of which will be available to the Company to +pay its portion, as working interest owner, of the restoration, dismantlement +and abandonment costs discussed at Note 7. FAS 143, discussed in Footnote 2, +will require the Abandonment Trusts' assets and the associated abandonment +liability to be recorded in the balance sheet effective January 1, 2003. The +Company does not expect to record any income or loss associated with the Trust +asset or abandonment liability as a result of adoption of FAS 143. +At the time of acquisition of properties by the Company, the property owners +estimated the future costs to be incurred for site restoration, dismantlement +and abandonment, net of salvage value. A portion of the amounts necessary to pay +such estimated costs was deposited in the Trusts upon acquisition of the +properties, and the remainder is deposited from time to time out of the proceeds +from production. The determination of the amount deposited upon the acquisition +of the properties and the amount to be deposited as proceeds from production was +based on numerous factors, including the estimated reserves of the properties. +The amounts deposited in the Trusts upon acquisition of the properties were +capitalized by the Company as oil and gas properties. +As operator, the Company receives all of the revenues and incurs all of the +production costs for the purchased oil and gas properties but retains only that +portion applicable to its net ownership share. As a result, the payables and +receivables associated with operating the properties included in the Company's +Consolidated Balance Sheets include both the Company's and all other outside +owners' shares. However, revenues and production costs associated with the +acquired properties reflected in the accompanying Consolidated Statements of +Operations represent only the Company's share, after reduction for the NPI. +10. EMPLOYEE BENEFIT PLANS +The Company has adopted a series of incentive compensation plans designed to +align the interest of the executives and employees with those of its +stockholders. The following is a brief description of each plan: +The Savings and Protection Plan provides employees with the option to +defer receipt of a portion of their compensation and the Company may, +at its discretion, match a portion of the +54 +employee's deferral with cash and Company Common Stock. The Company may +also elect, at its discretion, to contribute a non-matching amount in +cash and Company Common Stock to employees. The amounts held under the +Savings and Protection Plan are invested in various funds maintained by +a third party in accordance with the directions of each employee. An +employee is fully vested, including Company discretionary +contributions, immediately upon participation in the Savings and +Protection Plan. The total amounts contributed by the Company, +including the value of the common stock contributed, were $611,000, +$595,000 and $500,000 in the years 2002, 2001 and 2000, respectively. +The 1994 Stock Incentive Plan (the "1994 Plan"), approved by the +shareholder's in 1994, provides for 600,000 shares of Common Stock to +be reserved for issuance pursuant to such plan. Under the 1994 Plan, +the Company may grant both stock options qualifying under Section 422 +of the Internal Revenue Code and options that are not qualified as +incentive stock options, as well as performance shares. These options +have an expiration date 10 years from date of grant. +On August 23, 1996, the Board of Directors of the Company approved and +adopted the Callon Petroleum Company 1996 Stock Incentive Plan (the +"1996 Plan"). The 1996 Plan was approved by the shareholders in 1997 +and provides for the same types of awards as the 1994 Plan and is +limited to a maximum of 1,200,000 shares (as amended from the original +900,000 shares) of common stock that may be subject to outstanding +awards. Unvested options are subject to forfeiture upon certain +termination of employment events and expire 10 years from date of +grant. +The Company granted 533,000 stock options to employees on March 23, +2000 and 120,000 stock options to directors on July 25, 2000 at $10.50 +per share. The March 23, 2000 grant was subject to shareholder approval +of an amendment to the 1996 Stock Incentive Plan. The amendment, which +was approved on May 9, 2000 at the Annual Meeting of Shareholders, +increased the number of shares reserved for issuance under the 1996 +plan to 2,200,000 shares. The excess of the market price over the +exercise price on the approval date of the amendment is amortized over +the three-year vesting period of the options. Compensation costs of +$416,000, $611,000 and $801,000 were recognized in 2002, 2001 and 2000 +respectively related to these options. +On February 14, 2002, the Board of Directors of the Company approved +and adopted the 2002 Stock Incentive Plan (the "2002 Plan"). Pursuant +to the 2002 Plan, 350,000 shares of common stock shall be reserved for +issuance upon the exercise of options or for grants of stock options, +stock appreciation rights or units, bonus stock, or performance shares +or units. This Plan qualifies as a "broadly based" plan under the +provisions of the New York Stock Exchanges rules and regulations and +therefore did not require shareholder approval. Because the 2002 Plan +is a broadly based plan, the aggregate number of shares underlying +awards granted to officer and directors cannot exceed 50% of the total +number of shares underlying the awards granted to all employees during +any three-year period. +In 2002, the Company awarded 300,000 shares of restricted stock from +the 1996 and the 2002 Plan and 70,500 from treasury shares to be issued +as vested. The issuance of the restricted stock using treasury shares +did not require shareholder approval pursuant to the New York Stock +Exchange's rules and regulations, and therefore shareholder approval +was not sought. These shares will generally vest to the recipients over +a three-year period (one-third in each year) +55 +beginning in November 2002. The deferred compensation portion of this +grant will be amortized to expense over the vesting period. The +non-cash amortization expense in 2002 was $496,000. +In 1997, the Board of Directors authorized the implementation of the +Callon Petroleum Company 1997 Employee Stock Purchase Plan (the "1997 +Purchase Plan"), which was approved by the Company's shareholders at +the 1997 Annual Meeting. The Plan provides eligible employees of the +Company with the opportunity to acquire a proprietary interest in the +Company through participation in a payroll deduction-based employee +stock purchase plan. An aggregate of 250,000 shares of Common Stock +have been reserved for issuance over the ten-year term of the 1997 +Purchase Plan. The purchase price per share at which Common Stock will +be purchased on the participant's behalf on each purchase date within +an offering period is equal to eighty-five percent of the fair market +value per share of Common Stock. +The Company accounts for the options issued pursuant to the stock incentive +plans under APB Opinion No. 25, under which no compensation cost has been +recognized unless the exercise price is less than the market price at the +measurement date. Had compensation cost for these plans been determined +consistent with Statement of Financial Accounting Standards No. 123 ("SFAS +123"), "Accounting for Stock-Based Compensation", the Company's net income and +earnings per common share would have been reduced to the following pro forma +amounts: +2002 2001 2000 +-------- ------- --------- +(IN THOUSANDS, EXCEPT PER SHARE DATA) +Net income (loss), as reported $ (2,948) $ 539 $ 10,144 +Deduct total stock-based employee +Compensation expense under fair +value based method, net of tax 637 1,378 1,726 +Pro forma net income (loss) (3,585) (839) 8,418 +Basic earnings (loss) per share: As Reported (.22) .04 .82 +Pro Forma (.27) (.06) .68 +Diluted earnings (loss) per share: As Reported (.22) .04 .80 +Pro Forma (.27) (.06) .66 +56 +A summary of the status of the Company's stock option plans for the three most +recent years and changes during the years then ended is presented in the table +and narrative below: +2002 2001 2000 +--------------------------- --------------------------- ---------------------------- +WTD AVG WTD AVG WTD AVG +SHARES EX PRICE SHARES EX PRICE SHARES EX PRICE +------------ ------------ ------------ ------------ ------------ ------------ +Outstanding, beginning of year 2,332,667 $ 10.84 2,304,167 $ 10.83 1,536,500 $ 10.60 +Granted (at market) 310,000 4.45 30,000 11.61 135,000 14.73 +Granted (below market) -- -- -- -- 653,000 10.50 +Exercised -- -- (1,500) 9.00 (20,333) 9.00 +Forfeited (122,250) 14.10 -- -- -- -- +Expired -- -- -- -- -- -- +------------ ------------ ------------ ------------ ------------ ------------ +Outstanding, end of year 2,520,417 $ 9.90 2,332,667 $ 10.84 2,304,167 $ 10.83 +============ ============ ============ ============ ============ ============ +Exercisable, end of year 2,224,334 $ 10.57 2,057,977 $ 10.80 1,647,657 $ 10.71 +============ ============ ============ ============ ============ ============ +Weighted average fair value of +options granted (at market) $ 2.44 $ 5.80 $ 7.68 +============ ============ ============ +Weighted average fair value of +options granted (below market) N/A N/A $ 7.90 +============ +The following table sets forth additional information regarding options +outstanding at December 31, 2002. Contractual life and exercise prices represent +weighted averages for options outstanding and options exercisable. +Options Outstanding Options Exercisable +------------------------------------------ -------------------------- +Range of Number Contractual Exercise Number Exercise +exercise prices Outstanding Life (years) Price Exercisable Price +-------------------- ----------- ------------- -------- ----------- --------- +$ 3.70 to $ 6.41 297,750 9.6 $ 4.38 31,667 $ 6.07 +$ 9.00 to $ 12.28 2,157,667 4.9 $ 10.53 2,127,667 $ 10.53 +$ 13.56 to $ 15.31 65,000 5.3 $ 14.16 65,000 $ 14.16 +The fair value of each option grant is estimated on the date of grant using the +Black-Scholes option pricing model with the following weighted average +assumptions used for options granted during the years presented are as follows: +2002 2001 2000 +------ ------ ------ +Risk free interest rate 3.7% 4.5% 6.3% +Expected life (years) 5.0 5.0 5.0 +Expected volatility 61.0% 43.9% 52.1% +Expected dividends -- -- -- +11. EQUITY TRANSACTIONS +In November 1995, the Company sold 1,315,500 shares of $2.125 Convertible +Exchangeable Preferred Stock, Series A (the "Preferred Stock") for net proceeds +of $30.9 million. Annual dividends are $2.125 per share and are cumulative. The +net proceeds of the $.01 par value stock after underwriters discount and expense +was $30,899,000. Each share has a liquidation preference of $25.00, plus accrued +and unpaid dividends. Dividends on the Preferred Stock are cumulative from the +date of issuance and are payable quarterly, commencing January 15, 1996. The +Preferred Stock is convertible at any time, at the option of +57 +the holders thereof, unless previously redeemed, into shares of Common Stock of +the Company at an initial conversion price of $11 per share of Common Stock, +subject to adjustments under certain conditions. +The Preferred Stock is redeemable at any time on or after December 31, 1998, in +whole or in part at the option of the Company at a redemption price of $26.488 +per share beginning at December 31, 1998 and at premiums declining to the $25.00 +liquidation preference by the year 2005 and thereafter, plus accrued and unpaid +dividends. The Preferred Stock is also exchangeable, in whole, but not in part, +at the option of the Company on or after January 15, 1998 for the Company's 8.5% +Convertible Subordinated Debentures due 2010 (the "Debentures") at a rate of +$25.00 principal amount of Debentures for each share of Preferred Stock. The +Debentures will be convertible into Common Stock of the Company on the same +terms as the Preferred Stock and will pay interest semi-annually. +In a December 1998 private transaction, a preferred stockholder elected to +convert 59,689 shares of Preferred Stock into 136,867 shares of the Company's +Common Stock. In 1999 certain other preferred stockholders, through private +transactions, agreed to convert 210,350 shares of Preferred Stock into 502,637 +shares of the Company's Common Stock under similar terms. Likewise in 2000, +444,600 shares of Preferred Stock were converted into 1,036,098 shares of the +Company's Common Stock. Any non-cash premium negotiated in excess of the +conversion rate was recorded as additional preferred stock dividends and +excluded from the Consolidated Statements of Cash Flows. +In November of 1999, the Company sold 3,680,000 shares of Common Stock in a +public offering at a price to the public of $11.875 per share. Cash proceeds +received by the Company were $41.1 million net of underwriting discount and +offering costs. +In 2001, under the terms of the $95 million multiple advance loans, the Company +issued warrants to purchase, at a nominal exercise price, 265,210 shares of its +common stock. See Note 5. +The Company adopted a stockholder rights plan on March 30, 2000, designed to +assure that the Company's stockholders receive fair and equal treatment in the +event of any proposed takeover of the Company and to guard against partial +tender offers, squeeze-outs, open market accumulations, and other abusive +tactics to gain control without paying all stockholders a fair price. The rights +plan was not adopted in response to any specific takeover proposal. Under the +rights plan, the Company declared a dividend of one right ("Right") on each +share of the Company's Common Stock. Each Right will entitle the holder to +purchase one one-thousandth of a share of a Series B Preferred Stock, par value +$0.01 per share, at an exercise price of $90 per one one-thousandth of a share. +The Rights are not currently exercisable and will become exercisable only in the +event a person or group acquires, or engages in a tender or exchange offer to +acquire, beneficial ownership of 15 percent or more (one existing stockholder +was granted an exception for up to 21 percent) of the Company's Common Stock. +After the Rights become exercisable, each Right will also entitle its holder to +purchase a number of common shares of the Company having a market value of twice +the exercise price. The dividend distribution was made to stockholders of record +at the close of business on April 10, 2000. The Rights will expire on March 30, +2010. +58 +12. SUPPLEMENTAL OIL AND GAS RESERVE DATA (UNAUDITED) +The Company's proved oil and gas reserves at December 31, 2002, 2001 and 2000 +have been estimated by independent petroleum consultants in accordance with +guidelines established by the Securities and Exchange Commission ("SEC"). +Accordingly, the following reserve estimates are based upon existing economic +and operating conditions. These estimates have been adjusted (per SEC +guidelines) to exclude the volumetric production payment described in Note 2. +There are numerous uncertainties inherent in establishing quantities of proved +reserves. The following reserve data represent estimates only and should not be +construed as being exact. In addition, the standard measure of discounted future +net cash flows should not be construed as the current market value of the +Company's oil and gas properties or the cost that would be incurred to obtain +equivalent reserves. +In October 2002, we received a letter from the SEC regarding our Annual Report +on Form 10-K for the year ended December 31, 2001 requesting supplemental +information concerning our operations in the Gulf of Mexico. The comment letters +requested information about the procedures we used to classify our deepwater +reserves as proved and requested that our financials be restated to reflect the +removal of the Boomslang reserves as proved for all prior periods during which +such reserves were reported as proved. We have reviewed the SEC comments with +our independent petroleum reserve engineers, Huddleston & Co., Inc. of Houston, +Texas. Both Huddleston & Co. and Callon believe that such deepwater reserves are +properly classified as proved. If the SEC requires us to retroactively classify +Boomslang as an unproved property through December, 2002, we would be required +to restate our financial position, results of operations, and supplemental oil +and gas reserve data from 1998 through 2002. +59 +ESTIMATED RESERVES +Changes in the estimated net quantities of crude oil and natural gas reserves, +all of which are located onshore and offshore in the continental United States, +are as follows: +RESERVE QUANTITIES +YEARS ENDED DECEMBER 31, +-------------------------------------------- +2002 2001 2000 +------------ ------------ ------------ +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period 30,209 33,382 23,834 +Revisions to previous estimates (5,951) (2,290) 85 +Purchase of reserves in place -- -- -- +Sales of reserves in place -- (624) -- +Extensions and discoveries 11 14 9,695 +Production (226) (273) (232) +------------ ------------ ------------ +End of period 24,043 30,209 33,382 +============ ============ ============ +Natural Gas (MMcf): +Beginning of period 120,299 129,922 110,621 +Revisions to previous estimates (17,279) (4,578) (4,817) +Purchase of reserves in place -- -- 347 +Sales of reserves in place -- (1,296) -- +Extensions and discoveries 1,579 7,483 35,387 +Production (13,060) (11,232) (11,616) +------------ ------------ ------------ +End of period 91,539 120,299 129,922 +============ ============ ============ +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period 885 2,192 1,376 +============ ============ ============ +End of period 1,056 885 2,192 +============ ============ ============ +Natural Gas (MMcf): +Beginning of period 51,221 63,982 76,295 +============ ============ ============ +End of period 37,631 51,221 63,982 +============ ============ ============ +STANDARDIZED MEASURE +The following tables present the Company's standardized measure of discounted +future net cash flows and changes therein relating to proved oil and gas +reserves and were computed using reserve valuations based on regulations +prescribed by the SEC. These regulations provide that the oil, condensate and +gas price structure utilized to project future net cash flows reflects current +prices (approximately $4.80 per Mcf for natural gas and $34.22 per Bbl for oil +for the 2002 disclosures, $2.58 per Mcf and $20.10 per Bbl for 2001 disclosures, +and $9.14 per Mcf and $26.71 per Bbl for 2000 disclosures) at each date +presented and have not been escalated. Future production, development and net +abandonment costs are based on current costs +60 +without escalation. The resulting net future cash flows have been discounted to +their present values based on a 10% annual discount factor. +STANDARDIZED MEASURE +YEARS ENDED DECEMBER 31, +------------------------ +2002 2001 2000 +-------------- -------------- -------------- +Future cash inflows $ 1,261,571 $ 883,145 $ 2,080,680 +Future costs - +Production (165,559) (220,857) (284,667) +Development and net abandonment (125,813) (191,369) (217,507) +-------------- -------------- -------------- +Future net inflows before income taxes 970,199 470,919 1,578,506 +Future income taxes (119,020) (30,315) (472,637) +-------------- -------------- -------------- +Future net cash flows 851,179 440,604 1,105,869 +10% discount factor (295,133) (185,747) (434,672) +-------------- -------------- -------------- +Standardized measure of discounted +future net cash flows $ 556,046 $ 254,857 $ 671,197 +============== ============== ============== +CHANGES IN STANDARDIZED MEASURE +YEARS ENDED DECEMBER 31, +------------------------ +2002 2001 2000 +------------ ------------ ------------ +(IN THOUSANDS) +Standardized measure - beginning of period $ 254,857 $ 671,197 $ 256,322 +Sales and transfers, net of production costs (38,375) (45,672) (42,132) +Net change in sales and transfer prices, +net of production costs 401,837 (604,391) 361,179 +Exchange and sale of in place reserves -- (5,850) -- +Purchases, extensions, discoveries, and improved +recovery, net of future production and +development costs incurred 8,456 9,358 276,770 +Revisions of quantity estimates (103,452) (23,314) (12,399) +Accretion of discount 26,915 90,978 28,581 +Net change in income taxes (53,608) 224,290 (209,090) +Changes in production rates, timing and other 59,416 (61,739) 11,966 +------------ ------------ ------------ +Standardized measure - end of period $ 556,046 $ 254,857 $ 671,197 +============ ============ ============ +61 +13. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) +FIRST SECOND THIRD FOURTH +QUARTER QUARTER QUARTER QUARTER +------------ ------------ ------------ ------------ +(IN THOUSANDS, EXCEPT PER SHARE DATA) +2002 +---- +Total revenues $ 11,624 $ 20,489 $ 15,786 $ 19,209 +Total costs and expenses 15,399 16,888 17,786 19,606 +Income tax expense (benefit) (1,321) 1,260 (700) (139) +Net income (loss) (2,454) 2,341 (1,300) (258) +Net income per share-basic (0.21) 0.15 (0.12) (0.04) +Net income per share-diluted (0.21) 0.15 (0.12) (0.04) +2001 +---- +Total revenues $ 20,812 $ 17,712 $ 12,715 $ 10,513 +Total costs and expenses 11,314 12,398 12,311 22,936 +Income tax expense (benefit) 3,324 1,860 142 (4,349) +Net income 6,174 3,454 262 (8,074) +Net income per share-basic 0.44 0.24 0.00 (0.63) +Net income per share-diluted 0.41 0.23 0.00 (0.63) +62 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND +FINANCIAL DISCLOSURE +As reported in our Current Report on Form 8-K dated June 28, 2002, in June 2002, +the Board of Directors of the company approved the engagement of Ernst & Young +LLP as its independent auditors for the fiscal year ending December 31, 2002 to +replace Arthur Andersen LLP, who were dismissed as auditors of the company +effective June 28, 2002. The audit committee of the Board of Directors approved +the change in auditors and recommended this change to the Board of Directors. +The letter of concurrence was filed as an exhibit to the Form 8-K. No +disagreements were cited. +There have been no disagreements with the independent auditors on any matters of +accounting principles or practices, financial statement disclosure, or auditing +scope or procedures. +63 +PART III. +ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. +For information concerning Item 10, see the definitive proxy statement of Callon +Petroleum Company relating to the Annual Meeting of Stockholders on May 2, 2003 +which will be filed with the Securities and Exchange Commission and is +incorporated herein by reference. +ITEM 11. EXECUTIVE COMPENSATION. +For information concerning Item 11, see the definitive proxy statement of Callon +Petroleum Company relating to the Annual Meeting of Stockholders on May 2, 2003 +which will be filed with the Securities and Exchange Commission and is +incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND +RELATED STOCKHOLDER MATTERS. +For information concerning the security ownership of certain beneficial owners +and management, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders on May 2, 2003 which will be +filed with the Securities and Exchange Commission and is incorporated herein by +reference. +64 +EQUITY COMPENSATION PLAN INFORMATION +The following table provides information as of December 31, 2002 regarding the +number of shares of Common Stock that may be issued under the Company's equity +compensation plans. +Plan Category Number of securities to be Weighted-average Number of securities +issued upon exercise of exercise price of remaining available for +outstanding options, outstanding options, future issuance under +warrants and rights warrants and rights equity compensation +plans (excluding +securities reflected +in column (a) +(a) (b) (c) +-------------------------- -------------------- ----------------------- +Equity compensation +plans approved by +security holders(1) 2,351,667 $ 10.31 186,493 +Equity compensation +plans not approved by +security holders (2) 168,750 $ 4.16 181,250 +-------------- -------------- -------------- +Total 2,520,417 $ 9.90 367,743 +============== ============== ============== +(1) Represents the Callon Petroleum Company 1994 and the 1996 Stock +Incentive Plans which were approved by the shareholders in prior +years. Remaining shares available for future issuance listed in +column (c) does not include 168,000 shares of restricted stock +awarded in 2002 which have not yet vested. +(2) Represents the Callon Petroleum Company 2002 Stock Incentive Plan +adopted by the Company on February 14, 2002. The plan qualifies as +a "broadly based" plan under the provisions of the New York Stock +Exchange rules and regulations and therefore did not require +shareholder approval. Remaining shares available for future +issuance listed in column (c) does not include 124,300 shares of +restricted stock awarded in 2002 which have not yet vested. +See Note 10 to the Consolidated Financial Statements for a description of the +material provisions of each equity compensation plan under which our equity +securities are authorized for issuance that was adopted without the approval of +shareholders. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +For information concerning Item 13, see the definitive proxy statement of Callon +Petroleum Company relating to the Annual Meeting of Stockholders on May 2, 2003 +which will be filed with the Securities and Exchange Commission and is +incorporated herein by reference. +65 +ITEM 14. CONTROLS AND PROCEDURES. +(a) Evaluation of Disclosure Controls and Procedures. Based on their +evaluation as of a date within 90 days of the filing date of this Annual Report +on Form 10-K, the Company's principal executive officer and principal financial +officer have concluded that the Company's disclosure controls and procedures (as +defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of +1934 (the "Exchange Act") are effective to ensure that information required to +be disclosed by the Company in reports that it files or submits under the +Exchange Act is recorded, processed, summarized and reported within the time +periods specified in the rules and forms of the Securities and Exchange +Commission. +(b) Changes in Internal Controls. There were no significant changes in +the Company's internal controls or in other factors that could significantly +affect these controls subsequent to the date of their evaluation, including any +corrective actions with regard to significant deficiencies and material +weaknesses. +66 +PART IV. +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K +(a) 1. The following is an index to the financial statements and financial +statement schedules that are filed as part of this Form 10-K on pages 37 through +63. +Report of Independent Auditors +Consolidated Balance Sheets as of the Years Ended December 31, 2002 and +2001 +Consolidated Statements of Operations for the Three Years in the Period +Ended December 31, 2002 +Consolidated Statements of Stockholders' Equity for the Three Years in +the Period Ended December 31, 2002 +Consolidated Statements of Cash Flows for the Three Years in the Period +Ended December 31, 2002 +Notes to Consolidated Financial Statements +(a) 2. Schedules other than those listed above are omitted because they are not +required, not applicable or the required information is included in the +financial statements or notes thereto. +(a) 3. Exhibits: +2. Plan of acquisition, reorganization, arrangement, liquidation or +succession* +3. Articles of Incorporation and Bylaws +3.1 Certificate of Incorporation of the Company, as amended +(incorporated by reference from Exhibit 3.1 of the Company's +Registration Statement on Form S-4, filed August 4, 1994, Reg. No. +33-82408) +3.2 Certificate of Merger of Callon Consolidated Partners, L. P. with +and into the Company dated September 16, 1994 (incorporated by +reference from Exhibit 3.2 of the Company's Report on Form 10-K +for the fiscal year ended December 31, 1994, File No. 000-25192) +3.3 Bylaws of the Company (incorporated by reference from Exhibit 3.2 +of the Company's Registration Statement on Form S-4, filed August +4, 1994, Reg. No. 33-82408) +4. Instruments defining the rights of security holders, including +indentures +4.1 Specimen Common Stock Certificate (incorporated by reference from +Exhibit 4.1 of the Company's Registration Statement on Form S-4, +filed August 4, 1994, Reg. No. 33-82408) +67 +4.2 Specimen Preferred Stock Certificate (incorporated by reference +from Exhibit 4.2 of the Company's Registration Statement on Form +S-1, filed November 13, 1995, Reg. No. 33-96700) +4.3 Designation for Convertible, Exchangeable Preferred Stock, Series +A (incorporated by reference from Exhibit 4.3 of the Company's +Registration Statement on Form S-1, filed November 13, 1995, Reg. +No. 33-96700) +4.4 Indenture for Convertible Debentures (incorporated by reference +from Exhibit 4.4 of the Company's Registration Statement on Form +S-1, filed November 13, 1995, Reg. No. 33-96700) +4.5 Certificate of Correction on Designation of Series A Preferred +Stock (incorporated by reference from Exhibit 4.4 of the Company's +Registration Statement on Form S-1, filed November 22, 1996, Reg. +No. 333-15501) +4.6 Indenture for the Company's 10.125% Senior Subordinated Notes due +2002 dated as of July 31, 1997 (incorporated by reference from +Exhibit 4.1 of the Company's Registration Statement on Form S-4, +filed September 25, 1997, Reg. No. 333-36395) +4.7 Form of Note Indenture for the Company's 10.25% Senior +Subordinated Notes due 2004 (incorporated by reference from +Exhibit 4.10 of the Company's Registration Statement on Form S-2, +filed June 14, 1999, Reg. No. 333-80579) +4.8 Rights Agreement between Callon Petroleum Company and American +Stock Transfer & Trust Company, Rights Agent, dated March 30, 2000 +(incorporated by reference from Exhibit 99.1 of the Company's +Registration Statement on Form 8-A, filed April 6, 2000, File No. +001-14039) +4.9 Subordinated Indenture for the Company dated October 26, 2000 +(incorporated by reference from Exhibit 4.1 of the Company's +Current Report on Form 8-K dated October 24, 2000, File No. +001-14039) +4.10 Supplemental Indenture for the Company's 11% Senior Subordinated +Notes due 2005 (incorporated by reference from Exhibit 4.2 of the +Company's Current Report on Form 8-K dated October 24, 2000, File +No. 001-14039) +4.11 Warrant dated as of June 29, 2001 entitling Duke Capital Partners, +LLC to purchase common stock from the Company. (incorporated by +reference to Exhibit 4.11 of the Company's Quarterly Report on +Form 10-Q for the period ended June 30, 2001, File No. 001-14039) +4.12 First Supplemental Indenture, dated June 26, 2002, to Indenture +between Callon Petroleum Company and American Stock Transfer & +Trust Company dated July 31, 1997. (incorporated by reference to +Exhibit 4.1 of the Company's Current Report on Form 8-K dated June +26, 2002, File No. 001-14039) +4.13 Form of Warrant entitling certain holders of the Company's 10.125% +Senior Subordinated Notes due 2002 to purchase common stock from +the Company (incorporated by reference to +68 +Exhibit 4.13 of the Company's Form 10-Q for the period ended +June 30, 2002, File No. 001- 14039) +4.14 Second Supplemental Indenture, dated September 16, 2002, to +Indenture between Callon Petroleum Company and American Stock +Transfer & Trust Company dated July 31, 1997. (incorporated by +reference to Exhibit 4.1 of the Company's Current Report on Form +8-K dated September 16, 2002, File No. 001-14039) +9. Voting trust agreement +None. +10. Material contracts +10.1 Registration Rights Agreement dated September 16, 1994 between the +Company and NOCO Enterprises, L. P. (incorporated by reference +from Exhibit 10.2 of the Company's Registration Statement on Form +8-B filed October 3, 1994) +10.2 Counterpart to Registration Rights Agreement by and between the +Company, Ganger Rolf ASA and Bonheur ASA. (incorporated by +reference from Exhibit 10.2 of the Company's Report on Form 10-K +for the fiscal year ended December 31, 2000, File No. 001-14039) +10.3 Registration Rights Agreement dated September 16, 1994 between the +Company and Callon Stockholders (incorporated by reference from +Exhibit 10.3 of the Company's Registration Statement on Form 8-B +filed October 3, 1994) +10.4 Callon Petroleum Company 1994 Stock Incentive Plan (incorporated +by reference from Exhibit 10.5 of the Company's Registration +Statement on Form 8-B filed October 3, 1994) +10.5 Consulting Agreement between the Company and John S. Callon dated +June 19, 1996 (incorporated by reference from Exhibit 10.10 of the +Company's Registration Statement on Form S-1, filed November 5, +1996, Reg. No. 333-15501) +10.6 Callon Petroleum Company Amended 1996 Stock Incentive Plan +(incorporated by reference from Exhibit 4.4 of the Post-Effective +Amendment No. 1 to the Company's Registration Statement on Form +S-8, filed February 5, 1999, Reg No. 333-29537) +10.7 Purchase and Sale Agreement between Callon Petroleum Operating +Company and Murphy Exploration Company, dated May 26, 1999 +(incorporated by reference from Exhibit 10.11 on Form S-2, filed +June 14, 1999, Reg. No. 333-80579) +10.8 Callon Petroleum Company 1996 Stock Incentive Plan as amended on +May 9, 2000 (incorporated by reference from Appendix I of the +Company's Definitive Proxy Statement of Schedule 14A filed March +28, 2000) +69 +10.9 Credit Agreement dated as of October 30, 2000 between the Company +and First Union National Bank, as administrative agent for the +lenders (incorporated by reference from Exhibit 10.2 of the +Company's Quarterly Report on Form 10-Q for the period ended +September 30, 2000, File No. 001-14039) +10.10 Credit Agreement dated as of June 29, 2001 between the Company and +Duke Capital Partners, LLC, as Administrative Agent (incorporated +by reference to Exhibit 10.01 of the Company's Quarterly Report on +Form 10-Q for the period ended June 30, 2001, File No. 001-14039) +10.11 Second Amendment to Credit Agreement by and among the Company and +First Union National Bank, as Administrative Agent, effective as +of June 29, 2001 (incorporated by reference to Exhibit 10.01 of +the Company's Quarterly Report on Form 10-Q for the period ended +June 30, 2001, File No. 001-14039) +10.12 Conveyance of Overriding Royalty Interest from the Company to Duke +Capital Partners, LLC, dated June 29, 2001 (incorporated by +reference to Exhibit 10.03 of the Company's Quarterly Report on +Form 10-Q for the period ended June 30, 2001, File No. 001-14039) +10.13 Callon Petroleum Company 2002 Stock Incentive Plan (incorporated +by reference to Exhibit 10.13 of the Company's Annual Report on +Form 10-K for the year ended December 31, 2001, File No. +001-14039). +10.14 Change of Control Severance Compensation Agreement by and between +Callon Petroleum and John S. Weatherly dated January 1, 2002 +(incorporated by reference to Exhibit 10.14 of the Company's +Annual Report on Form 10-K for the year ended December 31, 2001, +File No. 001-14039) +10.15 Change of Control Severance Compensation Agreement by and between +Callon Petroleum Company and Fred L. Callon, dated January 1, 2002 +(incorporated by reference to Exhibit 10.15 of the Company's +Annual Report on Form 10-K for the year ended December 31, 2001, +File No. 001-14039) +10.16 Change of Control Severance Compensation Agreement by and between +Callon Petroleum Company and Dennis W. Christian, dated January 1, +2002 (incorporated by reference to Exhibit 10.16 of the Company's +Annual Report on Form 10-K for the year ended December 31, 2001, +File No. 001-14039) +10.17 First Amended and Restated Credit Agreement dated as of June 30, +2002, among Callon Petroleum Company, each of the lenders that is +a signatory thereto, Wachovia Bank National Association, as +administrative agent, and Union Bank of California, N.A., as +documentation agent (incorporated by reference to Exhibit 10.1 of +the Company's Form 10-Q for the period ended June 30, 2002, File +No. 001-14039) +11. Statement re computation of per share earnings* +12. Statements re computation of ratios* +70 +13. Annual Report to security holders, Form 10-Q or quarterly reports* +16. Letter re change in certifying accountant* +18. Letter re change in accounting principles* +21. Subsidiaries of the Company +21.1 Subsidiaries of the Company (incorporated by reference from +Exhibit 21.1 of the Company's Registration Statement on Form 8-B +filed October 3, 1994) +22. Published report regarding matters submitted to vote of security +holders* +23. Consents of experts and counsel +23.1 Consent of Ernst & Young LLP +24. Power of attorney* +99. Additional Exhibits +99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. +Section 1350, as adopted pursuant to Section 906 of the +Sarbanes-Oxley Act of 2002 +99.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. +Section 1350, as adopted pursuant to Section 906 of the +Sarbanes-Oxley Act of 2002 +---------------------------- +*Inapplicable to this filing. +(b) Reports on Form 8-K. +Current Report dated June 26, 2002, reporting Item 5. Other Events +Current Report dated June 28, 2002, reporting Item 4. Change in Registrant's +Certifying Accounts +Current Report dated August 14, 2002, reporting Item 9. Regulation FD +Disclosure +Current Report dated September 16, 2002, reporting Item 5. Other Events +Current Report dated October 1, 2002, reporting Item 9. Regulation FD +Disclosure +Current Report dated December 12, 2002, reporting Item 9. Regulation FD +Disclosure +71 +SIGNATURES +Pursuant to the requirements of the Securities Exchange Act of 1934, this report +has been signed below by the following persons on behalf of the registrant and +in the capacities and on the dates indicated. +CALLON PETROLEUM COMPANY +Date: March 27, 2003 /s/ Fred L. Callon +-------------- ------------------------------------------------------ +Fred L. Callon (principal executive officer, director) +Date: March 27, 2003 /s/ John S. Weatherly +-------------- ------------------------------------------------------ +John S. Weatherly (principal financial officer) +Date: March 27, 2003 /s/ James O. Bassi +-------------- ------------------------------------------------------- +James O. Bassi (principal accounting officer) +Date: March 27, 2003 /s/John S. Callon +-------------- ------------------------------------------------------ +John S. Callon (director) +Date: March 27, 2003 /s/Dennis W. Christian +-------------- ------------------------------------------------------ +Dennis W. Christian (director) +Date: March 27, 2003 /s/B. F. Weatherly +-------------- ------------------------------------------------------ +B. F. Weatherly (director) +Date: March 27, 2003 /s/Robert A. Stanger +-------------- ------------------------------------------------------- +Robert A. Stanger (director) +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange +Act of 1934, the registrant has duly caused this report to be signed on its +behalf by the undersigned, thereunto duly authorized. +CALLON PETROLEUM COMPANY +Date: March 27, 2003 By: /s/ John S. Weatherly +---------------------------------------------- +John S. Weatherly, Senior Vice President and +Chief Financial Officer +72 +CERTIFICATIONS +I, Fred L. Callon, certify that: +1. I have reviewed this annual report on Form 10-K of Callon Petroleum +Company; +2. Based on my knowledge, this annual report does not contain any +untrue statement of a material fact or omit to state a material fact necessary +to make the statements made, in light of the circumstances under which such +statements were made, not misleading with respect to the period covered by this +annual report; +3. Based on my knowledge, the financial statements, and other financial +information included in this annual report, fairly present in all material +respects the financial condition, results of operations and cash flows of the +registrant as of, and for, the periods presented in this annual report; +4. The registrant's other certifying officers and I are responsible for +establishing and maintaining disclosure controls and procedures (as defined in +Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: +(a) Designed such disclosure controls and procedures to ensure that +material information relating to the registrant, including its +consolidated subsidiaries, is made known to us by others within those +entities, particularly during the period in which this annual report is +being prepared; +(b) Evaluated the effectiveness of the registrant's disclosure controls +and procedures as of a date within 90 days prior to the filing date of +this annual report (the "Evaluation Date"); and +(c) Presented in this annual report our conclusions about the +effectiveness of the disclosure controls and procedures based on our +evaluation as of the Evaluation Date; +5. The registrant's other certifying officers and I have disclosed, +based on our most recent evaluation, to the registrant's auditors and the audit +committee of registrant's board of directors (or persons performing the +equivalent function): +(a) All significant deficiencies in the design or operation of internal +controls which could adversely affect the registrant's ability to +record, process, summarize and report financial data and have +identified for the registrant's auditors any material weaknesses in +internal controls; and +(b) Any fraud, whether or not material, that involves management or +other employees who have a significant role in the registrant's +internal controls; and +6. The registrant's other certifying officers and I have indicated in +this annual report whether or not there were significant changes in internal +controls or in other factors that could significantly affect internal controls +subsequent to the date of our most recent evaluation, including any corrective +actions with regard to significant deficiencies and material weaknesses. +Date: March 27, 2003 +By: /s/ Fred L. Callon +------------------------------------------------------- +Fred L. Callon, President and Chief Executive Officer +(Principal Executive Officer) +73 +CERTIFICATIONS +I, John S. Weatherly, certify that: +2. Based on my knowledge, this annual report does not contain any +untrue statement of a material fact or omit to state a material fact necessary +to make the statements made, in light of the circumstances under which such +statements were made, not misleading with respect to the period covered by this +annual report; +3. Based on my knowledge, the financial statements, and other financial +information included in this annual report, fairly present in all material +respects the financial condition, results of operations and cash flows of the +registrant as of, and for, the periods presented in this annual report; +4. The registrant's other certifying officers and I are responsible for +establishing and maintaining disclosure controls and procedures (as defined in +Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: +(a) Designed such disclosure controls and procedures to ensure that +material information relating to the registrant, including its +consolidated subsidiaries, is made known to us by others within those +entities, particularly during the period in which this annual report is +being prepared; +(b) Evaluated the effectiveness of the registrant's disclosure controls +and procedures as of a date within 90 days prior to the filing date of +this annual report (the "Evaluation Date"); and +(c) Presented in this annual report our conclusions about the +effectiveness of the disclosure controls and procedures based on our +evaluation as of the Evaluation Date; +5. The registrant's other certifying officers and I have disclosed, +based on our most recent evaluation, to the registrant's auditors and the audit +committee of registrant's board of directors (or persons performing the +equivalent function): +(a) All significant deficiencies in the design or operation of internal +controls which could adversely affect the registrant's ability to +record, process, summarize and report financial data and have +identified for the registrant's auditors any material weaknesses in +internal controls; and +(b) Any fraud, whether or not material, that involves management or +other employees who have a significant role in the registrant's +internal controls; and +6. The registrant's other certifying officers and I have indicated in +this annual report whether or not there were significant changes in internal +controls or in other factors that could significantly affect internal controls +subsequent to the date of our most recent evaluation, including any corrective +actions with regard to significant deficiencies and material weaknesses. +Date: March 27, 2003 +By: /s/ John S. Weatherly +--------------------------------------------------------- +John S. Weatherly, Senior Vice President +and Chief Financial Officer (Principal Financial Officer) +74 +EXHIBIT INDEX +2. Plan of acquisition, reorganization, arrangement, liquidation or +succession* +3. Articles of Incorporation and Bylaws +3.1 Certificate of Incorporation of the Company, as amended +(incorporated by reference from Exhibit 3.1 of the Company's +Registration Statement on Form S-4, filed August 4, 1994, Reg. No. +33-82408) +3.2 Certificate of Merger of Callon Consolidated Partners, L. P. with +and into the Company dated September 16, 1994 (incorporated by +reference from Exhibit 3.2 of the Company's Report on Form 10-K +for the fiscal year ended December 31, 1994, File No. 000-25192) +3.3 Bylaws of the Company (incorporated by reference from Exhibit 3.2 +of the Company's Registration Statement on Form S-4, filed August +4, 1994, Reg. No. 33-82408) +4. Instruments defining the rights of security holders, including +indentures +4.1 Specimen Common Stock Certificate (incorporated by reference from +Exhibit 4.1 of the Company's Registration Statement on Form S-4, +filed August 4, 1994, Reg. No. 33-82408) +4.2 Specimen Preferred Stock Certificate (incorporated by reference +from Exhibit 4.2 of the Company's Registration Statement on Form +S-1, filed November 13, 1995, Reg. No. 33-96700) +4.3 Designation for Convertible, Exchangeable Preferred Stock, Series +A (incorporated by reference from Exhibit 4.3 of the Company's +Registration Statement on Form S-1, filed November 13, 1995, Reg. +No. 33-96700) +4.4 Indenture for Convertible Debentures (incorporated by reference +from Exhibit 4.4 of the Company's Registration Statement on Form +S-1, filed November 13, 1995, Reg. No. 33-96700) +4.5 Certificate of Correction on Designation of Series A Preferred +Stock (incorporated by reference from Exhibit 4.4 of the Company's +Registration Statement on Form S-1, filed November 22, 1996, Reg. +No. 333-15501) +4.6 Indenture for the Company's 10.125% Senior Subordinated Notes due +2002 dated as of July 31, 1997 (incorporated by reference from +Exhibit 4.1 of the Company's Registration Statement on Form S-4, +filed September 25, 1997, Reg. No. 333-36395) +4.7 Form of Note Indenture for the Company's 10.25% Senior +Subordinated Notes due 2004 (incorporated by reference from +Exhibit 4.10 of the Company's Registration Statement on Form S-2, +filed June 14, 1999, Reg. No. 333-80579) +4.8 Rights Agreement between Callon Petroleum Company and American +Stock Transfer & Trust Company, Rights Agent, dated March 30, 2000 +(incorporated by reference from Exhibit 99.1 of the Company's +Registration Statement on Form 8-A, filed April 6, 2000, File No. +001-14039) +4.9 Subordinated Indenture for the Company dated October 26, 2000 +(incorporated by reference from Exhibit 4.1 of the Company's +Current Report on Form 8-K dated October 24, 2000, File No. +001-14039) +4.10 Supplemental Indenture for the Company's 11% Senior Subordinated +Notes due 2005 (incorporated by reference from Exhibit 4.2 of the +Company's Current Report on Form 8-K dated October 24, 2000, File +No. 001-14039) +4.11 Warrant dated as of June 29, 2001 entitling Duke Capital Partners, +LLC to purchase common stock from the Company. (incorporated by +reference to Exhibit 4.11 of the Company's Quarterly Report on +Form 10-Q for the period ended June 30, 2001, File No. 001-14039) +4.12 First Supplemental Indenture, dated June 26, 2002, to Indenture +between Callon Petroleum Company and American Stock Transfer & +Trust Company dated July 31, 1997. (incorporated by reference to +Exhibit 4.1 of the Company's Current Report on Form 8-K dated June +26, 2002, File No. 001-14039) +4.13 Form of Warrant entitling certain holders of the Company's 10.125% +Senior Subordinated Notes due 2002 to purchase common stock from +the Company (incorporated by reference to Exhibit 4.13 of the +Company's Form 10-Q for the period ended June 30, 2002, File No. +001- 14039) +4.14 Second Supplemental Indenture, dated September 16, 2002, to +Indenture between Callon Petroleum Company and American Stock +Transfer & Trust Company dated July 31, 1997. (incorporated by +reference to Exhibit 4.1 of the Company's Current Report on Form +8-K dated September 16, 2002, File No. 001-14039) +9. Voting trust agreement +None. +10. Material contracts +10.1 Registration Rights Agreement dated September 16, 1994 between the +Company and NOCO Enterprises, L. P. (incorporated by reference +from Exhibit 10.2 of the Company's Registration Statement on Form +8-B filed October 3, 1994) +10.2 Counterpart to Registration Rights Agreement by and between the +Company, Ganger Rolf ASA and Bonheur ASA. (incorporated by +reference from Exhibit 10.2 of the Company's Report on Form 10-K +for the fiscal year ended December 31, 2000, File No. 001-14039) +10.3 Registration Rights Agreement dated September 16, 1994 between the +Company and Callon Stockholders (incorporated by reference from +Exhibit 10.3 of the Company's Registration Statement on Form 8-B +filed October 3, 1994) +10.4 Callon Petroleum Company 1994 Stock Incentive Plan (incorporated +by reference from Exhibit 10.5 of the Company's Registration +Statement on Form 8-B filed October 3, 1994) +10.5 Consulting Agreement between the Company and John S. Callon dated +June 19, 1996 (incorporated by reference from Exhibit 10.10 of the +Company's Registration Statement on Form S-1, filed November 5, +1996, Reg. No. 333-15501) +10.6 Callon Petroleum Company Amended 1996 Stock Incentive Plan +(incorporated by reference from Exhibit 4.4 of the Post-Effective +Amendment No. 1 to the Company's Registration Statement on Form +S-8, filed February 5, 1999, Reg No. 333-29537) +10.7 Purchase and Sale Agreement between Callon Petroleum Operating +Company and Murphy Exploration Company, dated May 26, 1999 +(incorporated by reference from Exhibit 10.11 on Form S-2, filed +June 14, 1999, Reg. No. 333-80579) +10.8 Callon Petroleum Company 1996 Stock Incentive Plan as amended on +May 9, 2000 (incorporated by reference from Appendix I of the +Company's Definitive Proxy Statement of Schedule 14A filed March +28, 2000) +10.9 Credit Agreement dated as of October 30, 2000 between the Company +and First Union National Bank, as administrative agent for the +lenders (incorporated by reference from Exhibit 10.2 of the +Company's Quarterly Report on Form 10-Q for the period ended +September 30, 2000, File No. 001-14039) +10.10 Credit Agreement dated as of June 29, 2001 between the Company and +Duke Capital Partners, LLC, as Administrative Agent (incorporated +by reference to Exhibit 10.01 of the Company's Quarterly Report on +Form 10-Q for the period ended June 30, 2001, File No. 001-14039) +10.11 Second Amendment to Credit Agreement by and among the Company and +First Union National Bank, as Administrative Agent, effective as +of June 29, 2001 (incorporated by reference to Exhibit 10.01 of +the Company's Quarterly Report on Form 10-Q for the period ended +June 30, 2001, File No. 001-14039) +10.12 Conveyance of Overriding Royalty Interest from the Company to Duke +Capital Partners, LLC, dated June 29, 2001 (incorporated by +reference to Exhibit 10.03 of the Company's Quarterly Report on +Form 10-Q for the period ended June 30, 2001, File No. 001-14039) +10.13 Callon Petroleum Company 2002 Stock Incentive Plan (incorporated +by reference to Exhibit 10.13 of the Company's Annual Report on +Form 10-K for the year ended December 31, 2001, File No. +001-14039). +10.14 Change of Control Severance Compensation Agreement by and between +Callon Petroleum and John S. Weatherly dated January 1, 2002 +(incorporated by reference to Exhibit 10.14 of the Company's +Annual Report on Form 10-K for the year ended December 31, 2001, +File No. 001-14039) +10.15 Change of Control Severance Compensation Agreement by and between +Callon Petroleum Company and Fred L. Callon, dated January 1, 2002 +(incorporated by reference to Exhibit 10.15 of the Company's +Annual Report on Form 10-K for the year ended December 31, 2001, +File No. 001-14039) +10.16 Change of Control Severance Compensation Agreement by and between +Callon Petroleum Company and Dennis W. Christian, dated January 1, +2002 (incorporated by reference to Exhibit 10.16 of the Company's +Annual Report on Form 10-K for the year ended December 31, 2001, +File No. 001-14039) +10.17 First Amended and Restated Credit Agreement dated as of June 30, +2002, among Callon Petroleum Company, each of the lenders that is +a signatory thereto, Wachovia Bank National Association, as +administrative agent, and Union Bank of California, N.A., as +documentation agent (incorporated by reference to Exhibit 10.1 of +the Company's Form 10-Q for the period ended June 30, 2002, File +No. 001-14039) +11. Statement re computation of per share earnings* +12. Statements re computation of ratios* +13. Annual Report to security holders, Form 10-Q or quarterly reports* +16. Letter re change in certifying accountant* +18. Letter re change in accounting principles* +21. Subsidiaries of the Company +21.1 Subsidiaries of the Company (incorporated by reference from +Exhibit 21.1 of the Company's Registration Statement on Form 8-B +filed October 3, 1994) +22. Published report regarding matters submitted to vote of security +holders* +23. Consents of experts and counsel +23.1 Consent of Ernst & Young LLP +24. Power of attorney* +99. Additional Exhibits +99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. +Section 1350, as adopted pursuant to Section 906 of the +Sarbanes-Oxley Act of 2002 +99.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. +Section 1350, as adopted pursuant to Section 906 of the +Sarbanes-Oxley Act of 2002 +---------------------------- +*Inapplicable to this filing. \ No newline at end of file diff --git a/raw/filings/0000928022/2002/0000950134-03-004701/filing_metadata.csv b/raw/filings/0000928022/2002/0000950134-03-004701/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..0926837d65556f7bca59ecd6aa3edbfdf30759b5 --- /dev/null +++ b/raw/filings/0000928022/2002/0000950134-03-004701/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000928022,CPE,Callon Petroleum Co,10-K,2003-03-27,2002-12-31,2003-03-27T20:45:14.000Z,0000950134-03-004701,d04345e10vk.txt,FORM 10-K,277552,0,0,https://www.sec.gov/Archives/edgar/data/928022/000095013403004701/d04345e10vk.txt,https://www.sec.gov/Archives/edgar/data/928022/000095013403004701/,2002,2002,1 diff --git a/raw/filings/0000928022/2002/0000950134-03-004701/item1.txt b/raw/filings/0000928022/2002/0000950134-03-004701/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..7ce3870ea3b292552d1ec191d73aa8710c9cf113 --- /dev/null +++ b/raw/filings/0000928022/2002/0000950134-03-004701/item1.txt @@ -0,0 +1,3078 @@ +ITEM 1 AND 2. BUSINESS AND PROPERTIES +OVERVIEW +Callon Petroleum Company has been engaged in the exploration, development, +acquisition and production of oil and gas properties since 1950. Our properties +are geographically concentrated primarily offshore in the Gulf of Mexico and +onshore in Louisiana and Alabama. The public Company was incorporated under the +laws of the state of Delaware in 1994 through the consolidation of a publicly +traded limited partnership, a joint venture with a consortium of European +institutional investors and an independent energy company owned by certain +members of current management (the "Consolidation"). As used herein, the +"Company," "Callon," "we," "us," and "our" refer to Callon Petroleum Company and +its predecessors and subsidiaries unless the context requires otherwise. +In 1989, we began increasing our reserves through the acquisition of producing +properties that were geologically complex, had (or were analogous to fields +with) an established production history from stacked pay zones and were +candidates for exploitation. We focused on reducing operating costs and +implementing production enhancements through the application of technologically +advanced production and recompletion techniques. +Over the past seven years, we have also placed emphasis on the acquisition of +acreage with exploration and development drilling opportunities in the Gulf of +Mexico Shelf area. We acquired an infrastructure of production platforms, +gathering systems and pipelines to minimize development expenditures of these +drilling opportunities. We also joined with other industry partners, primarily +Murphy Exploration and Production, Inc., ("Murphy"), to explore federal offshore +blocks acquired in the Gulf of Mexico. Our areas of exploration include the Gulf +of Mexico Deepwater area (generally 900 to 5,500 feet of water). +We ended the year 2002 with estimated net proved reserves of 236 billion cubic +feet of natural gas equivalent ("Bcfe"). This represents a decrease of 22% from +2001 year-end estimated net proved reserves of 303 Bcfe. +The major focus of our future operations is expected to continue to be the +exploration for and development of oil and gas properties, primarily in the Gulf +of Mexico. +AVAILABILITY OF REPORTS +All of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current +reports on Form 8-K, and amendments to such reports as well as other filings we +make pursuant to Section 13(a) and 15(d) of the Securities Exchange Act of 1934 +are available free of charge on our Internet website. The address of our +Internet website is www.callon.com. Our SEC filings are available on our website +as soon as they are posted to the EDGAR database on the SEC's website. +BUSINESS STRATEGY +Our goal is to increase shareholder value by increasing our reserves, +production, cash flow and earnings. We seek to achieve these goals through the +following strategies: +o Focus on Gulf of Mexico exploration with a balance between shelf and +deepwater areas using the latest available technology. +o Aggressively explore our existing prospect inventory. +o Replenish our prospect inventory with increasing emphasis on prospect +generation. +2 +o Achieve moderate increases in current production levels through +continued shelf exploration. +o Achieve significant increases in longer-term production levels through +development of deepwater discoveries and ongoing deepwater exploration. +EXPLORATION AND DEVELOPMENT ACTIVITIES +Capital expenditures for exploration and development costs related to oil and +gas properties totaled approximately $61.9 million in 2002. We incurred +approximately $24.4 million in the Gulf of Mexico Shelf area, with approximately +$9.7 million related to the Mobile 952/953/955 acceleration project. The Gulf of +Mexico Deepwater area expenditures ($24.6 million) accounted for the remainder +of the total capital expended, along with $660,000 incurred in leasehold and +seismic acquisition costs and $15.2 million of interest and general and +administrative costs allocable directly to exploration and development projects. +The Gulf of Mexico Deepwater area expenditures were incurred primarily in the +production facility fabrication for our Medusa discovery. +As a result of drilling successes in the Gulf of Mexico Deepwater area, we are +faced with increased costs to develop these significant proved undeveloped +reserves. A large portion of these future development costs will be incurred in +2003 and beyond. While management believes that current availability under our +existing credit facilities along with current cash flows are expected to meet +the needs of these development costs, no assurances can be made that we will be +able to fund these development costs. +SEC REVIEW OF PROVED RESERVES +In October 2002, we received a letter from the SEC requesting supplemental +information concerning our operations in the Gulf of Mexico. We believe that a +similar letter was sent to other oil and gas companies with off-shore +operations. We responded to the SEC's letter on October 18, 2002. +On February 21, 2003, we received another letter from the SEC requesting +additional information about the procedures we used to classify our offshore +reserves as "proved" in our Form 10-K for our fiscal year ended December 31, +2001. The letter also questions the procedures used to classify reserves at our +Boomslang property as proved undeveloped reserves at year end 1998. In 2002, we +drilled a development well which caused us to reduce our estimated reservoir +volumes at our Boomslang property (and record a downward revision of our +estimates of the reserves attributable to such property at December 31, 2002) to +such an extent that the partners determined that the risk of further development +was not economic. The staff of the SEC has asked Callon to restate its financial +statements for fiscal years 2000 and 2001 to remove the reserves attributable to +Boomslang as proved. We responded to the SEC's second letter on March 13, 2003. +We have reviewed the SEC comments with our independent petroleum reserve +engineers, Huddleston & Co., Inc., Houston, Texas. Both Huddleston & Co. and +Callon believe that our proved reserves were properly classified in accordance +with SEC definitions and industry practices. The Company believes the reserve +revision has no effect on prior year financial statements as it represents a +change in estimate. If the SEC requires us to retroactively classify Boomslang +as an unproved property through December, 2002, we would be required to restate +our financial position, results of operations, and supplemental oil and gas +reserve data from 1998 through 2002. +Based on our discussions with others in the oil and gas business, we believe +that the SEC is reviewing generally the procedures used by reserve engineers to +classify oil and gas reserves as proved in the +3 +deepwater areas of the Gulf of Mexico. In particular, the SEC appears to +indicate that it is not appropriate to classify reserves as proved without +conducting a "flow test." It has not been our practice to conduct a flow test on +our deepwater properties prior to classifying the reserves as proved. We +believe, and have been advised by Huddleston & Co., that our procedures for +classifying our deepwater reserves as proved are in accordance with SEC rules +and industry practices. +The SEC has asked us, and we have provided substantial detail, about our proved +reserves, including the detailed reserve report. At this point, we cannot +predict the ultimate outcome of the SEC's review of our proved reserves. With +respect to our deepwater projects other than Boomslang, we believe that the +outcome of the SEC's review of practices in the oil and gas industry for +classifying deepwater reserves as proved should not affect us materially +differently than other similarly situated oil and gas companies with deepwater +projects. With respect to Boomslang, we believe that reserves attributable to +the project were properly classified as proved at year end 1998, 1999, 2000 and +2001, and that no restatement of our financial statements is required as this +revision to our Boomslang reserves in 2002 represented a change in estimates of +our proved reserves. We cannot make any assurances, however, that the SEC will +ultimately agree with this position. +RISK FACTORS +DECREASE IN OIL AND GAS PRICES MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS +AND FINANCIAL CONDITION. Our success is highly dependent on prices for oil and +gas, which are extremely volatile. Any substantial or extended decline in the +price of oil or gas would have a material adverse effect on us. Oil and gas +markets are both seasonal and cyclical. The prices of oil and gas depend on +factors we cannot control such as weather, economic conditions, and levels of +production, actions by OPEC and other countries and government actions. Prices +of oil and gas will affect the following aspects of our business: +o our revenues, cash flows and earnings; +o the amount of oil and gas that we are economically able to produce; +o our ability to attract capital to finance our operations and the cost of +the capital; +o the amount we are allowed to borrow under our senior credit facility; +o the value of our oil and gas properties; and +o the profit or loss we incur in exploring for and developing our +reserves. +UNLESS WE ARE ABLE TO REPLACE RESERVES WHICH WE HAVE PRODUCED, OUR CASH FLOWS +AND PRODUCTION WILL DECREASE OVER TIME. Our future success depends upon our +ability to find, develop and acquire oil and gas reserves that are economically +recoverable. As is generally the case for Gulf properties, our producing +properties usually have high initial production rates, followed by a steep +decline in production. As a result, we must continually locate and develop or +acquire new oil and gas reserves to replace those being depleted by production. +We must do this even during periods of low oil and gas prices when it is +difficult to raise the capital necessary to finance these activities and during +periods of high operating costs when it is expensive to contract for drilling +rigs and other equipment and personnel necessary to explore for oil and gas. +Without successful exploration or acquisition activities, our reserves, +production and revenues will decline rapidly. We cannot assure you that we will +be able to find and develop or acquire additional reserves at an acceptable +cost. +A SIGNIFICANT PART OF THE VALUE OF OUR PRODUCTION AND RESERVES IS CONCENTRATED +IN A SMALL NUMBER OF OFFSHORE PROPERTIES, AND ANY PRODUCTION PROBLEMS OR +INACCURACIES IN RESERVE ESTIMATES RELATED TO THOSE PROPERTIES WOULD ADVERSELY +IMPACT OUR BUSINESS. During 2002, 49% of our daily production came from two of +our properties in the Gulf of Mexico. Moreover, one property accounted for 33% +of our production during this period. If mechanical problems, storms or other +events curtailed a substantial +4 +portion of this production, our results of operations would be adversely +affected. In addition, at December 31, 2002, most of our proved reserves were +located in five fields in the Gulf of Mexico, with approximately 93% of our +total net proved reserves attributable to these properties. If the actual +reserves associated with any one of these producing properties are less than our +estimated reserves, our results of operations and financial condition could be +adversely affected. +OUR FOCUS ON EXPLORATION PROJECTS INCREASES THE RISKS INHERENT IN OUR OIL AND +GAS ACTIVITIES. Our business strategy focuses on replacing reserves through +exploration, where the risks are greater than in acquisitions and development +drilling. Although we have been successful in exploration in the past, we cannot +assure you that we will continue to increase reserves through exploration or at +an acceptable cost. Additionally, we are often uncertain as to the future costs +and timing of drilling, completing and producing wells. Our drilling operations +may be curtailed, delayed or canceled as a result of a variety of factors, +including: +o unexpected drilling conditions; +o pressure or inequalities in formations; +o equipment failures or accidents; +o adverse weather conditions; +o compliance with governmental requirements; and +o shortages or delays in the availability of drilling rigs and the +delivery of equipment. +BECAUSE WE DO NOT CONTROL, AND DO NOT OPERATE, ALL OF OUR PROPERTIES, ESPECIALLY +OUR DEEPWATER PROPERTIES, WE HAVE LIMITED INFLUENCE OVER THEIR DEVELOPMENT. Our +lack of control could result in the following: +o the operator may initiate exploration or development on a faster or +slower pace than we prefer; +o the operator may propose to drill more wells or build more facilities on +a project than we have funds for or that we deem appropriate, which may +mean that we are unable to participate in the project or share in the +revenues generated by the project even though we paid our share of +exploration costs; and +o if an operator refuses to initiate a project, we may be unable to pursue +the project. +Any of these events could materially reduce the value of our properties. +OUR DEEPWATER OPERATIONS HAVE SPECIAL OPERATIONAL RISKS THAT MAY NEGATIVELY +AFFECT THE VALUE OF THOSE ASSETS. Drilling operations in the deepwater area are +by their nature more difficult and costly than drilling operations in shallow +water. Deepwater drilling operations require the application of more advanced +drilling technologies, involving a higher risk of technological failure and +usually have significantly higher drilling costs than shallow water drilling +operations. Deepwater wells are completed using sub sea completion techniques +that require substantial time and the use of advanced remote installation +equipment. These operations involve a high risk of mechanical difficulties and +equipment failures that could result in significant cost overruns. +In deepwater, the time required to commence production following a discovery is +much longer than in shallow water and on-shore. Our deepwater discoveries and +prospects will require the construction of expensive production facilities and +pipelines prior to the beginning of production. We cannot estimate the costs and +timing of the construction of these facilities with certainty, and the accuracy +of our estimates will be affected by a number of factors beyond our control, +including the following: +5 +o decisions made by the operators of our deepwater wells; +o the availability of materials necessary to construct the facilities; +o the proximity of our discoveries to pipelines; and +o the price of oil and natural gas. +Delays and cost overruns in the commencement of production will affect the value +of our deepwater prospects and the discounted present value of reserves +attributable to those prospects. +Competitive industry conditions may negatively affect our ability to conduct +operations. We operate in the highly competitive areas of oil and gas +exploration, development and production. We compete for the purchase of leases +in the Gulf of Mexico from the U. S. government and from other oil and gas +companies. These leases include exploration prospects as well as properties with +proved reserves. Factors that affect our ability to compete in the marketplace +include: +o our access to the capital necessary to drill wells and acquire +properties; +o our ability to acquire and analyze seismic, geological and other +information relating to a property; +o our ability to retain the personnel necessary to properly evaluate +seismic and other information relating to a property; +o the location of, and our ability to access, platforms, pipelines and +other facilities used to produce and transport oil and gas production; +o the standards we establish for the minimum projected return on an +investment of our capital; and +o the availability of alternate fuel sources. +Our competitors include major integrated oil companies, substantial independent +energy companies, and affiliates of major interstate and intrastate pipelines +and national and local gas gatherers, many of which possess greater financial, +technological and other resources than we do. +OUR COMPETITORS MAY USE SUPERIOR TECHNOLOGY, WHICH WE MAY BE UNABLE TO AFFORD OR +WHICH WOULD REQUIRE COSTLY INVESTMENT BY US IN ORDER TO COMPETE. Our industry is +subject to rapid and significant advancements in technology, including the +introduction of new products and services using new technologies. As our +competitors use or develop new technologies, we may be placed at a competitive +disadvantage, and competitive pressures may force us to implement new +technologies at a substantial cost. In addition, our competitors may have +greater financial, technical and personnel resources that allow them to enjoy +technological advantages and may in the future allow them to implement new +technologies before we can. We cannot be certain that we will be able to +implement technologies on a timely basis or at a cost that is acceptable to us. +One or more of the technologies that we currently use or that we may implement +in the future may become obsolete, and we may be adversely affected. For +example, marine seismic acquisition technology has been characterized by rapid +technological advancements in recent years, and further significant +technological developments could substantially impair our 3-D seismic data's +value. +WE MAY NOT BE ABLE TO REPLACE OUR RESERVES OR GENERATE CASH FLOWS IF WE ARE +UNABLE TO RAISE CAPITAL. WE WILL BE REQUIRED TO MAKE SUBSTANTIAL CAPITAL +EXPENDITURES TO DEVELOP OUR EXISTING RESERVES, AND TO DISCOVER NEW OIL AND GAS +RESERVES. Historically, we have financed these expenditures primarily with cash +from operations, proceeds from bank borrowings and proceeds from the sale of +debt and equity securities. See "Management's Discussion and Analysis of +Financial Condition and Results of Operations -- Liquidity and Capital +Resources" for a discussion of our capital budget. We cannot assure you that we +will be able to raise capital in the future. We also make offers to acquire oil +and gas properties in the ordinary course of our business. If these offers are +accepted, our capital needs may increase substantially. +6 +We expect to continue using our senior credit facility to borrow funds to +supplement our available cash. The amount we may borrow under our senior credit +facility may not exceed a borrowing base determined by the lenders based on +their projections of our future production, future production costs, taxes, +commodity prices and any other factors deemed relevant by our lenders. We cannot +control the assumptions the lenders use to calculate our borrowing base. The +lenders may, without our consent, adjust the borrowing base semiannually or in +situations where we purchase or sell assets or issue debt securities. If our +borrowings under the senior credit facility exceed the borrowing base, the +lenders may require that we repay the excess. If this were to occur, we might +have to sell assets or seek financing from other sources. Sales of assets could +further reduce the amount of our borrowing base. We cannot assure you that we +would be successful in selling assets or arranging substitute financing. If we +were not able to repay borrowings under our senior credit facility to reduce the +outstanding amount to less than the borrowing base, we would be in default under +our senior credit facility. For a description of our senior credit facility and +its principal terms and conditions, see "Management's Discussion and Analysis of +Financial Condition and Results of Operations -- Liquidity and Capital +Resources." +7 +OUR RESERVE INFORMATION REPRESENTS ESTIMATES THAT MAY TURN OUT TO BE INCORRECT +IF THE ASSUMPTIONS UPON WHICH THESE ESTIMATES ARE BASED ARE INACCURATE. ANY +MATERIAL INACCURACIES IN THESE RESERVE ESTIMATES OR UNDERLYING ASSUMPTIONS WILL +MATERIALLY AFFECT THE QUANTITIES AND PRESENT VALUE OF OUR RESERVES. The process +of estimating oil and gas reserves is complex. It requires interpretations of +available technical data and various assumptions, including assumptions relating +to economic factors. Any significant inaccuracies in these interpretations or +assumptions could materially affect the estimated quantities and present value +of reserves shown in this annual report. +In order to prepare these estimates, we must project production rates and the +timing of development expenditures. The assumptions regarding the timing and +costs to commence production from our deepwater wells used in preparing our +reserves are often subject to revisions over time as described under "our +deepwater operations have special operational risks that may negatively affect +the value of those assets." We must also analyze available geological, +geophysical, production and engineering data, the extent, quality and +reliability of which can vary. The process also requires economic assumptions, +such as oil and gas prices, drilling and operating expenses, capital +expenditures, taxes and availability of funds. Therefore, estimates of oil and +gas reserves are inherently imprecise. +Actual future production, oil and gas prices, revenues, taxes, development +expenditures, operating expenses and quantities of recoverable oil and gas +reserves most likely will vary from our estimates. Any significant variance +could materially affect the estimated quantities and present value of reserves +shown in this report. In addition, we may adjust estimates of proved reserves to +reflect production history, results of exploration and development, prevailing +oil and gas prices and other factors, many of which are beyond our control. +You should not assume that the present value of future net cash flows from our +proved reserves referred to in this report is the current market value of our +estimated oil and gas reserves. In accordance with SEC requirements, we +generally base the estimated discounted future net cash flows from our proved +reserves on prices and costs on the date of the estimate. Actual future prices +and costs may differ materially from those used in the present value estimate. +Information about reserves constitutes forward-looking information. See +"Forward-Looking Statements" for information regarding forward-looking +information. The discounted present value of our oil and gas reserves is +prepared in accordance with guidelines established by the SEC. A purchaser of +reserves would use numerous other factors to value our reserves. The discounted +present value of reserves, therefore, does not represent the fair market value +of those reserves. +On December 31, 2002, approximately 81.4% of the discounted present value of our +estimated net proved reserves were proved undeveloped. Proved undeveloped oil +volumes represented 96% of total proved oil reserves. Substantially all of these +proved undeveloped reserves were attributable to our deepwater properties. +Development of these properties is subject to additional risks as described +above. +THE SEC MAY REQUIRE US TO BOOK RESERVES AS PROVED IN A MANNER THAT DIFFERS FROM +OUR HISTORICAL PRACTICES AND CURRENT INDUSTRY STANDARDS, AND WHICH MAY RESULT IN +A SIGNIFICANT DOWNWARD REVISION OF OUR PROVED RESERVES. As discussed above, in +October 2002 and February 2003, we received letters from the SEC regarding our +Annual Report on Form 10-K for the year ended December 31, 2001 requesting +supplemental information concerning our operations in the Gulf of Mexico. The +comment letters requested information about the procedures we used to classify +our deepwater reserves as proved and requested that our financials be restated +to reflect the removal of the Boomslang reserves as proved for all prior periods +during which such reserves were reported as proved. We have reviewed the SEC +8 +comments with our independent petroleum reserve engineers, Huddleston & Co., +Inc. of Houston, Texas. Both Huddleston & Co and Callon believe that such +reserves were properly classified as proved. However, if the SEC decides to +question our other deepwater properties and these reserves are ultimately +required to be reclassified as not proved; our proved reserves will be +materially reduced. If the SEC requires us to retroactively classify Boomslang +as an unproved property through December, 2002, we would be required to restate +our financial position, results of operations, and supplemental oil and gas +reserve data from 1998 through 2002. A material reduction in our proved reserves +could have a material adverse effect on our financial condition and results of +operations. +WEATHER, UNEXPECTED SUBSURFACE CONDITIONS, AND OTHER UNFORESEEN OPERATING +HAZARDS MAY ADVERSELY IMPACT OUR ABILITY TO CONDUCT BUSINESS. There are many +operating hazards in exploring for and producing oil and gas, including: +o our drilling operations may encounter unexpected formations or +pressures, which could cause damage to equipment or personal injury; +o we may experience equipment failures which curtail or stop production; +and +o we could experience blowouts or other damages to the productive +formations that may require a well to be re-drilled or other corrective +action to be taken. +In addition, any of the foregoing may result in environmental damages for which +we will be liable. Moreover, a substantial portion of our operations are +offshore and are subject to a variety of risks peculiar to the marine +environment such as capsizing, collisions, hurricanes and other adverse weather +conditions. These conditions can cause substantial damage to facilities and +interrupt production. Offshore operations are also subject to more extensive +governmental regulation. +We cannot assure you that we will be able to maintain adequate insurance at +rates we consider reasonable to cover our possible losses from operating +hazards. The occurrence of a significant event not fully insured or indemnified +against could materially and adversely affect our financial condition and +results of operations. +WE MAY NOT HAVE PRODUCTION TO OFFSET HEDGES; BY HEDGING, WE MAY NOT BENEFIT FROM +PRICE INCREASES. Part of our business strategy is to reduce our exposure to the +volatility of oil and gas prices by hedging a portion of our production. In a +typical hedge transaction, we will have the right to receive from the other +parties to the hedge the excess of the fixed price specified in the hedge over a +floating price based on a market index, multiplied by the quantity hedged. If +the floating price exceeds the fixed price, we are required to pay the other +parties this difference multiplied by the quantity hedged. We are required to +pay the difference between the floating price and the fixed price when the +floating price exceeds the fixed price regardless of whether we have sufficient +production to cover the quantities specified in the hedge. Significant +reductions in production at times when the floating price exceeds the fixed +price could require us to make payments under the hedge agreements even though +such payments are not offset by sales of production. Hedging will also prevent +us from receiving the full advantage of increases in oil or gas prices above the +fixed amount specified in the hedge. See "Quantitative and Qualitative +Disclosures About Market Risks" for a discussion of our hedging practices. +9 +COMPLIANCE WITH ENVIRONMENTAL AND OTHER GOVERNMENT REGULATIONS COULD BE COSTLY +AND COULD NEGATIVELY IMPACT PRODUCTION. Our operations are subject to numerous +laws and regulations governing the operation and maintenance of our facilities +and discharge of materials into the environment or otherwise relating to +environmental protection. For a discussion of the material regulations +applicable to us, see "Federal Regulations," "State Regulations," and +"Environmental Regulations." These laws and regulations may: +o require that we acquire permits before commencing drilling; +o restrict the substances that can be released into the environment in +connection with drilling and production activities; +o limit or prohibit drilling activities on protected areas such as +wetlands or wilderness areas; and +o require remedial measures to mitigate pollution from former operations, +such as dismantling abandoned production facilities. +Under these laws and regulations, we could be liable for personal injury and +clean-up costs and other environmental and property damages, as well as +administrative, civil and criminal penalties. We maintain limited insurance +coverage for sudden and accidental environmental damages. We do not believe that +insurance coverage for environmental damages that occur over time is available +at a reasonable cost. Also, we do not believe that insurance coverage for the +full potential liability that could be caused by sudden and accidental +environmental damages is available at a reasonable cost. Accordingly, we may be +subject to liability or we may be required to cease production from properties +in the event of environmental damages. +FACTORS BEYOND OUR CONTROL AFFECT OUR ABILITY TO MARKET PRODUCTION AND OUR +FINANCIAL RESULTS. The ability to market oil and gas from our wells depends upon +numerous factors beyond our control. These factors include: +o the extent of domestic production and imports of oil and gas; +o the proximity of the gas production to gas pipelines; +o the availability of pipeline capacity; +o the demand for oil and gas by utilities and other end users; +o the availability of alternative fuel sources; +o the effects of inclement weather; +o state and federal regulation of oil and gas marketing; and +o federal regulation of gas sold or transported in interstate commerce. +Because of these factors, we may be unable to market all of the oil or gas we +produce. In addition, we may be unable to obtain favorable prices for the oil +and gas we produce. +IF OIL AND GAS PRICES DECREASE, WE MAY BE REQUIRED TO TAKE WRITEDOWNS. We may be +required to writedown the carrying value of our oil and gas properties when oil +and gas prices are low or if we have substantial downward adjustments to our +estimated net proved reserves, increases in our estimates of development costs +or deterioration in our exploration results. Under the full cost method which we +use to account for our oil and gas properties, the net capitalized costs of our +oil and gas properties may not exceed the present value, discounted at 10%, of +future net cash flows from estimated net proved reserves, using period end oil +and gas prices or prices as of the date of our auditor's report, plus the lower +of cost or fair market value of our unproved properties. If net capitalized +costs of our oil and gas properties exceed this limit, we must charge the amount +of the excess to earnings. This type of charge will not affect our cash flows, +but will reduce the book value of our stockholders' equity. We review the +carrying value of our properties quarterly, based on prices in effect as of the +end of each quarter or at the time of reporting our +10 +results. Once incurred, a writedown of oil and gas properties is not reversible +at a later date, even if prices increase. +FORWARD-LOOKING STATEMENTS +In this report, we have made many forward-looking statements. We cannot assure +you that the plans, intentions or expectations upon which our forward-looking +statements are based will occur. Our forward-looking statements are subject to +risks, uncertainties and assumptions, including those discussed elsewhere in +this report. Forward-looking statements include statements regarding: +o our oil and gas reserve quantities, and the discounted present value of +these reserves; +o the amount and nature of our capital expenditures; +o drilling of wells; +o the timing and amount of future production and operating costs; +o business strategies and plans of management; and +o prospect development and property acquisitions. +Some of the risks, which could affect our future results and could cause results +to differ materially from those expressed in our forward-looking statements +include: +o general economic conditions; +o the volatility of oil and natural gas prices; +o the uncertainty of estimates of oil and natural gas reserves; +o the impact of competition; +o the availability and cost of seismic, drilling and other equipment; +o operating hazards inherent in the exploration for and production of +oil and natural gas; +o difficulties encountered during the exploration for and production +of oil and natural gas; +o difficulties encountered in delivering oil and natural gas to +commercial markets; +o changes in customer demand and producers' supply; +o the uncertainty of our ability to attract capital; +o compliance with, or the effect of changes in, the extensive +governmental regulations regarding the oil and natural gas business; +o actions of operators of our oil and gas properties; and +o weather conditions. +The information contained in this report, including the information set forth +under the heading "Risk Factors," identifies additional factors that could +affect our operating results and performance. We urge you to carefully consider +these factors and the other cautionary statements in this report. Our +forward-looking statements speak only as of the date made, and we have no +obligation to update these forward-looking statements. +CORPORATE OFFICES +Our headquarters are located in Natchez, Mississippi, in approximately 51,500 +square feet of owned space, with a field office in Houston, Texas. We also +maintain owned or leased field offices in the area of the major fields in which +we operate properties or have a significant interest. Replacement of any of our +leased offices would not result in material expenditures by us as alternative +locations to our leased space are anticipated to be readily available. +11 +EMPLOYEES +We had 100 employees as of December 31, 2002, none of whom are currently +represented by a union. We believe that we have good relations with our +employees. We employ nine petroleum engineers and seven petroleum geoscientists. +FEDERAL REGULATIONS +SALES OF NATURAL GAS. Effective January 1, 1993, the Natural Gas Wellhead +Decontrol Act deregulated prices for all "first sales" of natural gas. Thus, all +sales of gas by the Company may be made at market prices, subject to applicable +contract provisions. +TRANSPORTATION OF NATURAL GAS. The rates, terms and conditions applicable to the +interstate transportation of natural gas by pipelines are regulated by the +Federal Energy Regulatory Commission ("FERC") under the Natural Gas Act ("NGA"), +as well as under section 311 of the Natural Gas Policy Act ("NGPA"). Since 1985, +the FERC has implemented regulations intended to make natural gas transportation +more accessible to gas buyers and sellers on an open-access, non-discriminatory +basis. +The FERC has announced several important transportation-related policy +statements and rule changes, including a statement of policy and final rule +issued February 25, 2000 concerning alternatives to its traditional +cost-of-service rate-making methodology to establish the rates interstate +pipelines may charge for their services. The final rule revises FERC's pricing +policy and current regulatory framework to improve the efficiency of the market +and further enhance competition in natural gas markets. +With respect to the transportation of natural gas on or across the Outer +Continental Shelf ("OCS"), the FERC requires, as part of its regulation under +the Outer Continental Shelf Lands Act, that all pipelines provide open and +non-discriminatory access to both owner and non-owner shippers. Although to date +the FERC has imposed light-handed regulation on off-shore facilities that meet +its traditional test of gathering status, it has the authority to exercise +jurisdiction under the Outer Continental Shelf Lands Act ("OCSLA") over +gathering facilities, if necessary, to permit non-discriminatory access to +service. For those facilities transporting natural gas across the OCS that are +not considered to be gathering facilities, the rates, terms, and conditions +applicable to this transportation are regulated by FERC under the NGA and NGPA, +as well as the OCSLA. +SALES AND TRANSPORTATION OF CRUDE OIL. Sales of crude oil and condensate can be +made by the Company at market prices not subject at this time to price controls. +The price that the Company receives from the sale of these products will be +affected by the cost of transporting the products to market. The rates, terms, +and conditions applicable to the interstate transportation of oil and related +products by pipelines are regulated by the FERC under the Interstate Commerce +Act. As required by the Energy Policy Act of 1992, the FERC has revised its +regulations governing the rates that may be charged by oil pipelines. The new +rules, which were effective January 1, 1995, provide a simplified, generally +applicable method of regulating such rates by use of an index for setting rate +ceilings. The FERC will also, under defined circumstances, permit alternative +ratemaking methodologies for interstate oil pipelines such as the use of cost of +service rates, settlement rates, and market-based rates. Market-based rates will +be permitted to the extent the pipeline can demonstrate that it lacks +significant market power in the market in which it proposes to charge +market-based rates. The cumulative effect that these rules may have on moving +the Company's production to market cannot yet be determined. +With respect to the transportation of oil and condensate on or across the OCS, +the FERC requires, as part of its regulation under the OCSLA, that all pipelines +provide open and non-discriminatory access to both owner and non-owner shippers. +Accordingly, the FERC has the authority to exercise jurisdiction under the +OCSLA, if necessary, to permit non-discriminatory access to service. +12 +LEGISLATIVE PROPOSALS. In the past, Congress has been very active in the area of +natural gas regulation. There are legislative proposals pending in Congress and +in various state legislatures which, if enacted, could significantly affect the +petroleum industry. At the present time it is impossible to predict what +proposals, if any, might actually be enacted by Congress or the various state +legislatures and what effect, if any, such proposals might have on the Company's +operations. +FEDERAL, STATE OR INDIAN LEASES. In the event the Company conducts operations on +federal, state or Indian oil and gas leases, such operations must comply with +numerous regulatory restrictions, including various nondiscrimination statutes, +royalty and related valuation requirements, and certain of such operations must +be conducted pursuant to certain on-site security regulations and other +appropriate permits issued by the Bureau of Land Management ("BLM") or Minerals +Management Service ("MMS") or other appropriate federal or state agencies. +The Company's OCS leases in federal waters are administered by the MMS and +require compliance with detailed MMS regulations and orders. The MMS has +promulgated regulations implementing restrictions on various production-related +activities, including restricting the flaring or venting of natural gas. Under +certain circumstances, the MMS may require Company operations on federal leases +to be suspended or terminated. Any such suspension or termination could +materially and adversely affect the Company's financial condition and +operations. On March 15, 2000, the MMS issued a final rule effective June 1, +2000 which amends its regulations governing the calculation of royalties and the +valuation of crude oil produced from federal leases. Among other matters, this +rule amends the valuation procedure for the sale of federal royalty oil by +eliminating posted prices as a measure of value and relying instead on arm's +length sales prices and spot market prices as market value indicators. Because +the Company sells its production in the spot market and therefore pays royalties +on production from federal leases, it is not anticipated that this final rule +will have any substantial impact on the Company. +The Mineral Leasing Act of 1920 ("Mineral Act") prohibits direct or indirect +ownership of any interest in federal onshore oil and gas leases by a foreign +citizen of a country that denies "similar or like privileges" to citizens of the +United States. Such restrictions on citizens of a "non-reciprocal" country +include ownership or holding or controlling stock in a corporation that holds a +federal onshore oil and gas lease. If this restriction is violated, the +corporation's lease can be canceled in a proceeding instituted by the United +States Attorney General. Although the regulations of the BLM (which administers +the Mineral Act) provide for agency designations of non-reciprocal countries, +there are presently no such designations in effect. The Company owns interests +in numerous federal onshore oil and gas leases. It is possible that holders of +equity interests in the Company may be citizens of foreign countries, which at +some time in the future might be determined to be non-reciprocal under the +Mineral Act. +STATE REGULATIONS +Most states regulate the production and sale of oil and natural gas, including +requirements for obtaining drilling permits, the method of developing new +fields, the spacing and operation of wells and the prevention of waste of oil +and gas resources. The rate of production may be regulated and the maximum daily +production allowable from both oil and gas wells may be established on a market +demand or conservation basis or both. +The Company may enter into agreements relating to the construction or operation +of a pipeline system for the transportation of natural gas. To the extent that +such gas is produced, transported and consumed wholly within one state, such +operations may, in certain instances, be subject to the jurisdiction of such +state's administrative authority charged with the responsibility of regulating +intrastate pipelines. In such event, the rates which the Company could charge +for gas, the transportation of gas, and the costs of construction and operation +of such +13 +pipeline would be impacted by the rules and regulations governing such matters, +if any, of such administrative authority. Further, such a pipeline system would +be subject to various state and/or federal pipeline safety regulations and +requirements, including those of, among others, the Department of +Transportation. Such regulations can increase the cost of planning, designing, +installing and operating such facilities. The impact of such pipeline safety +regulations would not be any more adverse to the Company than it would be to +other similar owners or operators of such pipeline facilities. +ENVIRONMENTAL REGULATIONS +GENERAL. The Company's activities are subject to federal, state and local laws +and regulations governing environmental quality and pollution control. Although +no assurances can be made, the Company believes that, absent the occurrence of +an extraordinary event, compliance with existing federal, state and local laws, +rules and regulations regulating the release of materials into the environment +or otherwise relating to the protection of the environment will not have a +material effect upon the capital expenditures, earnings or the competitive +position of the Company with respect to its existing assets and operations. The +Company cannot predict what effect future regulation or legislation, enforcement +policies, and claims for damages to property, employees, other persons and the +environment resulting from the Company's operations could have on its +activities. +Activities of the Company with respect to natural gas facilities, including the +operation and construction of pipelines, plants and other facilities for +transporting, processing, treating or storing natural gas and other products, +are subject to stringent environmental regulation by state and federal +authorities including the United States Environmental Protection Agency ("EPA"). +Such regulation can increase the cost of planning, designing, installing and +operating such facilities. In most instances, the regulatory requirements relate +to water and air pollution control measures. Although the Company believes that +compliance with environmental regulations will not have a material adverse +effect on it, risks of substantial costs and liabilities are inherent in oil and +gas production operations, and there can be no assurance that significant costs +and liabilities will not be incurred. Moreover, it is possible that other +developments, such as stricter environmental laws and regulations, and claims +for damages to property or persons resulting from oil and gas production, would +result in substantial costs and liabilities to the Company. +SOLID AND HAZARDOUS WASTE. The Company currently owns or leases, and in the past +owned or leased, properties that have been used for the exploration and +production of oil and gas for many years. Although the Company has utilized +operating and disposal practices that were standard in the industry at the time, +hydrocarbons or other solid wastes may have been disposed or released on or +under the properties owned or leased by the Company or on or under locations +where such wastes have been taken for disposal. In addition, many of these +properties have been operated by third parties. The Company has no control over +such entities' treatment of hydrocarbons or other solid wastes and the manner in +which such substances may have been disposed or released. State and federal laws +applicable to oil and gas wastes and properties have gradually become stricter +over time. Under new laws, the Company could be required to remediate property, +including groundwater, containing or impacted by previously disposed wastes +(including wastes disposed or released by prior owners or operators, or property +contamination, including groundwater contamination by prior owners or operators) +or to perform remedial plugging operations to prevent future or mitigate +existing contamination. +The Company generates wastes, including hazardous wastes that are subject to the +federal Resource Conservation and Recovery Act ("RCRA") and comparable state +statutes. The Environmental Protection Agency ("EPA") and various state agencies +have limited the disposal options for certain wastes, including wastes +designated as hazardous under the RCRA and similar state statutes ("Hazardous +Wastes"). Furthermore, it is possible that certain wastes generated by the +Company's oil and gas operations that are (currently exempt from +14 +treatment as) Hazardous Wastes may in the future be designated as Hazardous +Wastes under RCRA or other applicable statutes and, therefore, may be subject to +more rigorous and costly disposal requirements. +SUPERFUND. The federal Comprehensive Environmental Response, Compensation and +Liability Act ("CERCLA"), also known as the "Superfund" law, generally imposes +joint and several liability for costs of investigation and remediation and for +natural resource damages, without regard to fault or the legality of the +original conduct, on certain classes of persons with respect to the release into +the environment of substances designated under CERCLA as hazardous substances +("Hazardous Substances"). These classes of persons, or so-called potentially +responsible parties ("PRPs"), include the current and certain past owners and +operators of a facility where there has been a release or threat of release of a +Hazardous Substance and persons who disposed of or arranged for the disposal of +Hazardous Substances found at a site. CERCLA also authorizes the EPA and, in +some cases, third parties to take actions in response to threats to the public +health or the environment and to seek to recover from the PRPs the costs of such +action. Although CERCLA generally exempts "petroleum" from the definition of +Hazardous Substance, in the course of its operations, the Company has generated +and will generate wastes that may fall within CERCLA's definition of Hazardous +Substance. The Company may also be the owner or operator of sites on which +Hazardous Substances have been released. To its knowledge, neither the Company +nor its predecessors have been designated as a PRP by the EPA under CERCLA; the +Company also does not know of any prior owners or operators of its properties +that are named as PRPs related to their ownership or operation of such +properties. +CLEAN WATER ACT. The Clean Water Act ("CWA") imposes restrictions and strict +controls regarding the discharge of wastes including produced waters and other +oil and natural gas wastes, into waters of the United States, a term broadly +defined. These controls have become more stringent over the years, and it is +probable that additional restrictions will be imposed in the future. Permits +must be obtained to discharge pollutants into federal waters. The CWA provides +for civil, criminal and administrative penalties for unauthorized discharges of +oil and hazardous substances and of other pollutants. It imposes substantial +potential liability for the costs of removal or remediation associated with +discharges of oil or hazardous substances and other pollutants. State laws +governing discharges to water also provide varying civil, criminal and +administrative penalties and impose liabilities in the case of a discharge of +petroleum or its derivatives, or other hazardous substances, into state waters. +In addition, the EPA has promulgated regulations that may require us to obtain +permits to discharge storm water runoff, including discharges associated with +construction activities. In the event of an unauthorized discharge of wastes, +the Company may be liable for penalties and costs. +OIL POLLUTION ACT. The Oil Pollution Act of 1990 ("OPA"), which amends and +augments oil spill provisions of CWA, imposes certain duties and liabilities on +certain "responsible parties" related to the prevention of oil spills and +damages resulting from such spills in or threatening United States waters or +adjoining shorelines. A liable "responsible party" includes the owner or +operator of a facility, vessel or pipeline that is a source of an oil discharge +or that poses the substantial threat of discharge, or the lessee or permittee of +the area in which a discharging facility is located. OPA assigns joint and +several liability, without regard to fault, to each liable party for oil removal +costs and a variety of public and private damages. Although defenses and +limitations exist to the liability imposed by OPA, they are limited. In the +event of an oil discharge or substantial threat of discharge, the Company may be +liable for costs and damages. +The OPA also imposes ongoing requirements on a responsible party, including +proof of financial responsibility to cover at least some costs in a potential +spill. Certain amendments to the OPA that were enacted in 1996 require owners +and operators of offshore facilities that have a worst case oil spill potential +of more than 1,000 barrels to demonstrate financial responsibility in amounts +ranging from $10 million in specified state waters and $35 million in federal +outer continental shelf ("OCS") waters, with higher amounts, up to $150 million +based upon worst +15 +case oil-spill discharge volume calculations. The Company believes that it has +established adequate proof of financial responsibility for its offshore +facilities. +AIR EMISSIONS. The Company's operations are subject to local, state and federal +regulations for the control of emissions from sources of air pollution. Federal +and state laws require new and modified sources of air pollutants to obtain +permits prior to commencing construction. Major sources of air pollutants are +subject to more stringent, federally imposed requirements including additional +permits. Federal and state laws designed to control hazardous (toxic) air +pollutants, might require installation of additional controls. Administrative +enforcement actions for failure to comply strictly with air pollution +regulations or permits are generally resolved by payment of monetary fines and +correction of any identified deficiencies. Alternatively, regulatory agencies +could bring lawsuits for civil penalties or require the Company to forego +construction, modification or operation of certain air emission sources. +COASTAL COORDINATION. There are various federal and state programs that regulate +the conservation and development of coastal resources. The federal Coastal Zone +Management Act ("CZMA") was passed in 1972 to preserve and, where possible, +restore the natural resources of the Nation's coastal zone. The CZMA provides +for federal grants for state management PROGRAMS that regulate land use, water +use and coastal development. +Various states, such as Alabama, Louisiana and Texas, also have coastal +management programs, which provide for, among other things, the coordination +among local and state authorities to protect coastal resources through +regulating land use, water, and coastal development. Coastal management programs +also may provide for the review of state and federal agency rules and agency +actions for consistency with the goals and policies of the state coastal +management plan. This review may impact agency permitting and review activities +and add an additional layer of review to certain activities undertaken by the +Company. +OSHA AND OTHER REGULATIONS. The Company is subject to the requirements of the +federal Occupational Safety and Health Act ("OSHA") and comparable state +statutes. The OSHA hazard communication standard, the EPA community +right-to-know regulations under Title III of CERCLA and similar state statutes +require the Company to organize and/or disclose information about hazardous +materials used or produced in its operations. +Management believes that the Company is in substantial compliance with current +applicable environmental laws and regulations and that continued compliance with +existing requirements would not have a material adverse impact on the Company. +PROPERTY SUMMARY +We are engaged in the exploration, development, acquisition and production of +oil and gas properties and natural gas transmission and provide oil and gas +property management services for other investors. Our properties are +concentrated offshore in the Gulf of Mexico and onshore, primarily, in Louisiana +and Alabama. We have historically grown our reserves and production by focusing +primarily on low to moderate risk exploration and acquisition opportunities in +the Gulf of Mexico Shelf area. Over the last several years, we have expanded our +area of exploration to include the Gulf of Mexico Deepwater area. As of December +31, 2002, our estimated net proved reserves totaled 24.0 million barrels of oil +("MBbl") and 91.5 billion cubic feet of natural gas ("Bcf"), with a pre-tax +present value, discounted at 10%, of the estimated future net revenues based on +constant prices in effect at year-end ("Discounted Cash Flow") of $623.9 +million. Gas constitutes approximately 39% of our total estimated proved +reserves and approximately 17% of our total estimated proved reserves are proved +producing reserves. +16 +Our Medusa (Mississippi Canyon Blocks 538/582) discovery and Habanero (Garden +Banks Block 341) discovery are projected to begin production late in the third +quarter of 2003. Construction of a production facility, subsea completions and +flowlines are projected to be completed by the fall of 2003. These two deepwater +discoveries are expected to increase our projected production from our existing +producing properties by 58% in the second half of 2003. A detail discussion of +each of these properties is provided in the Significant Properties section of +this report. +SIGNIFICANT PROPERTIES +The following table shows discounted cash flows and estimated net proved oil and +gas reserves by major field, within the focus area, for our seven largest fields +and for all other properties combined at December 31, 2002. +ESTIMATED NET PROVED RESERVES PRE-TAX +------------------------------------------ DISCOUNTED +OIL GAS TOTAL RESENT VALUE +OPERATOR (MBbls) (MMcf) (MMcfe) ($000) +------------ ------------ ------------ ------------ ------------- +(a) +GULF OF MEXICO DEEPWATER: +Mississippi Canyon Blocks 538/582 +"Medusa" Murphy 10,479 8,460 71,336 $ 226,810 +Garden Banks Block 341 +"Habanero" Shell 4,736 11,280 39,696 103,589 +Garden Banks Blocks 738/782/826/827 +"Entrada" BP Amoco 7,772 29,126 75,761 164,272 +17 +GULF OF MEXICO SHELF: +Mobile Blocks 863/864/907/908 Callon -- 9,991 9,991 27,866 +Mobile Blocks 952/953/955 Callon -- 23,117 23,117 76,382 +Ship Shoal Blocks 28/35 Callon 12 1,141 1,210 3,722 +ONSHORE AND OTHER: +Big Escambia Creek Exxon 353 1,298 3,414 8,199 +Other Various 691 7,126 11,274 13,106 +------------ ------------ ------------ ------------ +TOTAL NET PROVED RESERVES 24,043 91,539 235,799 $ 623,946 +============ ============ ============ ============ +(a) Represents the present value of future net cash flows before deduction +of federal income taxes, discounted at 10%, attributable to estimated +net proved reserves as of December 31, 2002, as set forth in the +Company's reserve reports prepared by its independent petroleum reserve +engineers, Huddleston & Co., Inc. of Houston, Texas. +GULF OF MEXICO DEEPWATER +Medusa, Mississippi Canyon Blocks 538/582 +Medusa was our third deepwater discovery and was announced in September 1999. We +drilled the initial test well in 2,235 feet of water to a total depth of 16,241 +feet and encountered over 120 feet of pay in two intervals. We performed +subsequent sidetrack drilling from the well bore to determine the extent of the +discovery. We drilled a second successful well in the first quarter of 2000 to +further delineate the extent of the pay intervals. We own a 15% working +interest, Murphy, the operator, owns a 60% interest and Agip Ventures, formerly +British-Borneo Petroleum, Inc., owns the remaining 25% interest. +In 2001 a drilling program began which included four development wells and one +sidetrack. The program included production casing being set on six wells which +will provide initial production take-points. The program was completed in the +first half of 2002. Also in 2001, the operator submitted an Authorization +18 +for Expenditure for a floating production system at Medusa and awarded the +contract to J. Ray McDermott, Inc. The spar was barged to the Mississippi Canyon +Block 582 in January 2003 and installed. The topside deck and production +facilities should be delivered and lifted into place atop the spar during the +second quarter of 2003. Initial production is scheduled to commence in the third +quarter of 2003 as the six wells are individually completed and tied into the +spar and production facilities. Once all six wells are tied in, it is estimated +that the production facility will have the capacity to handle up to 40,000 +barrels of crude oil and 110 million cubic feet of natural gas per day. +Habanero, Garden Banks Block 341 +During February 1999 the initial test well on our Habanero prospect encountered +over 200 feet of net pay in two zones. Located in 2,000 feet of water, the well +was drilled to a measured depth of 21,158 feet. This discovery was our second +deepwater success. We own an 11.25% working interest in the well. It is operated +by Shell Deepwater Development Inc., which owns a 55% working interest, with the +remaining working interest being owned by Murphy. +Current development plans include sub-sea completion and tie back to an existing +production facility in the area that is operated by Shell. A field delineation +program began in mid-year 2001, which included sidetracking the discovery well +with three sidetracks. Production casing was set on this well through one of the +sidetracks to the Hab 52 oil sand and the Hab 55 gas sand. Initial production +will be from the Hab55 gas sand and future recompletions are scheduled up-hole +to the Hab 52 oil sand for this well. Also, a development well is scheduled to +be drilled in the summer of 2003 and will provide a take-point for production +from the Hab 52 oil sand. The operator has submitted to the co-owners a +development schedule which estimates initial production to commence in late +summer 2003. +Entrada, Garden Banks Blocks 738/782/826/827 +The Entrada discovery is located in approximately 4,500 feet of water in the +Gulf of Mexico. Two wells and seven sidetracks have been drilled to date on +Garden Banks 782 on a northwest plunging salt ridge along the southern edge of +the Entrada Basin. Multiple stacked amplitudes trapped against a salt or fault +interface characterize the Entrada Area. We own a 20% working interest in this +discovery with BP Amoco, the operator, holding the remaining working interest. +The owners of an adjacent discovery have announced their plans to construct +production facilities to enable them to be a regional off-take point in +Southeastern Garden Banks. These plans include handling third party tie-ins, +which we expect to include Entrada. First production from their discovery is +expected in late 2004. Information obtained in a data swap with the adjacent +owners, is being incorporated into the Entrada development plans. An integrated +project team was formed by the working interest owners during 2002 to begin +planning the development of the field. +Boomslang, Ewing Bank Block 994 +A major revision to reserves in 2002 was at our Boomslang discovery. The initial +exploratory well drilled at this location in 1998 encountered 185 feet of pay. +The first well was drilled with significant mechanical problems and was +subsequently determined not to be a viable well for completion and production of +the estimated proved reserves encountered in this initial well. A second well, +to serve as a production take point, was drilled in the fourth quarter of 2002 +in a down dip direction from the first well targeting what was anticipated to be +a better sand development in the three separate reservoirs found in the first +well, but still up dip of the lowest known hydrocarbons in the first well. +Reservoir sand quality changed dramatically, reducing the estimated reservoir +volumes found and booked as estimated proved reserves by the first well +19 +to an extent that the partners determined that the risk of development was not +economic. Callon had a 40% working interest. The Company's proved reserves in +the prior year included 7.2 million barrels of oil and 13 billion cubic feet of +natural gas attributable to Boomslang. +GULF OF MEXICO SHELF +Mobile Blocks 863/864/ 907/908 +We own an average 67.9% working interest in these blocks and we are the +operator. The Mobile 864 unit, in which we have a 66.4% working interest, has +three producing wells, unit production facilities and covers portions of these +four blocks. In addition, there are two other wells located on the blocks in +which we own a 100% and 66.4% working interest. These wells produce through the +unit facilities. During 2002 the unit and the other two wells produced an +average of 7.1 MMcf per day net to us. +Mobile Blocks 952/953/955 +We own a 100% working interest in these three blocks and we are the operator. In +the fourth quarter of 2001, we initiated a production acceleration program for +Mobile Blocks 952, 953 and 955, which were being produced through the Mobile +Block 864 unit facilities. Plans included an acceleration well, which was +successfully drilled in the fourth quarter of 2001. Stand-alone production +facilities were installed and production flow lines were rerouted to the new +facilities. Production commenced through the new facilities in April 2002. This +program offset normal production declines curves from existing field wells and +added an annual increase of 3.8 MMcf per day net to us over 2001 production +levels of 10.1 MMcf per day. From May 1, 2002 to December 31, 2002 the wells +produced 18.6 MMcf per day net to us. +Ship Shoal Blocks 28/35 +We successfully drilled an exploratory well on our prospect at Ship Shoal Blocks +28 and 35 during the third quarter of 2002. The well was drilled to a measured +depth of 15,237 feet (12,295 feet of true vertical depth) and encountered 140 +feet of net natural gas pay. The well is being completed as a single producer in +the deepest of three productive intervals and is scheduled for first production +during the second quarter of 2003. We operate and own a 22% working interest. +ONSHORE AND OTHER +Big Escambia Creek +This gas field in south Alabama produces from the Smackover formation at depths +ranging from 15,100 to 15,600 and is operated by Exxon/Mobil. We own an average +working interest of 4.9% (5.5% net revenue interest), in six wells and a 2.2% +average royalty interest in another five wells. This field produced 1.0 MMcfe +per day to our interest in 2002. The field has an estimated reserve life in +excess of ten years given current production rates. +Other +20 +We own various royalty and working interest in numerous onshore areas and the +Gulf of Mexico other than the fields discussed above. +OIL AND GAS RESERVES +The following table sets forth certain information about our estimated proved +reserves as of the dates set forth below. +YEARS ENDED DECEMBER 31, +------------------------------------------ +2002 2001(a) 2000(a) +------------ ------------ ------------ +(IN THOUSANDS) +Proved developed: +Oil (Bbls) 1,056 885 2,192 +Gas (Mcf) 37,631 52,375 67,463 +Proved undeveloped: +Oil (Bbls) 22,988 29,324 31,190 +Gas (Mcf) 53,908 69,078 65,940 +Total proved: +Oil (Bbls) 24,043 30,209 33,382 +Gas (Mcf) 91,539 121,453 133,403 +Estimated pre-tax future net cash flows $ 970,198 $ 473,896 $ 1,610,320 +============ ============ ============ +Pre-tax discounted present value $ 623,946 $ 272,053 $ 939,325 +============ ============ ============ +Standardized measure of discounted future +net cash flows $ 556,046 $ 254,857 $ 671,197 +============ ============ ============ +(a) The estimates include reserve volumes of approximately 3.5 Bcf, $31.8 +million of pre-tax future net cash flows and $29.5 million of pre-tax discounted +present value in 2000, 1.2 Bcf, $2.9 million of pre-tax discounted present value +in 2001, attributable to a volumetric production payment. Standardized measure +of discounted future net cash flows does not include any volumes or cash flows +associated with the volumetric production payment. +Our independent reserve engineers, Huddleston & Co., Inc. prepared the estimates +of the proved reserves and the future net cash flows and present value thereof +attributable to such proved reserves. Reserves were estimated using oil and gas +prices and production and development costs in effect on December 31 of each +such year, without escalation, and were otherwise prepared in accordance with +Securities and Exchange Commission regulations regarding disclosure of oil and +gas reserve information. +There are numerous uncertainties inherent in estimating quantities of proved +reserves, including many factors beyond our control or the control of the +reserve engineers. Reserve engineering is a subjective process of estimating +underground accumulations of oil and gas that cannot be measured in an exact +manner. The accuracy of any reserve or cash flow estimate is a function of the +quality of available data and of engineering and geological interpretation and +judgment. Estimates by different engineers often vary, sometimes significantly. +In addition, physical factors, such as the results of drilling, testing and +production subsequent to the date of an +21 +estimate, as well as economic factors, such as an increase or decrease in +product prices that renders production of such reserves more or less economic, +may justify revision of such estimates. Accordingly, reserve estimates could be +different from the quantities of oil and gas that are ultimately recovered. +We have not filed any reports with other federal agencies which contain an +estimate of total proved net oil and gas reserves during our last fiscal year. +PRESENT ACTIVITIES AND PRODUCTIVE WELLS +The following table sets forth the wells we have drilled and completed during +the periods indicated. All such wells were drilled in the continental United +States primarily in federal and state waters in the Gulf of Mexico. +YEARS ENDED DECEMBER 31, +------------------------ +2002 2001 2000 +---- ---- ---- +GROSS NET GROSS NET GROSS NET +------ ------ ------ ------ ------ ------ +Development: +Oil 2 .30 6 .45 2 .35 +Gas -- -- 4 3.17 -- -- +Non-productive 1 .40 -- -- -- -- +------ ------ ------ ------ ------ ------ +Total 3 .70 10 3.62 2 .35 +====== ====== ====== ====== ====== ====== +Exploration: +Oil -- -- -- -- 1 .20 +Gas 1 .22 3 2.00 2 2.00 +Non-productive 1 .50 12 5.77 6 2.29 +------ ------ ------ ------ ------ ------ +Total 2 .72 15 7.77 9 4.49 +====== ====== ====== ====== ====== ====== +The following table sets forth our productive wells as of December 31, 2002: +WELLS +----- +GROSS NET +-------- -------- +Oil: +Working interest 39.00 3.07 +Royalty interest 220.00 3.40 +-------- -------- +Total 259.00 6.47 +Gas: +Working interest 45.00 21.25 +Royalty interest 243.00 1.51 +-------- -------- +Total 288.00 22.76 +A well is categorized as an oil well or a natural gas well based upon the ratio +of oil to gas reserves on a Mcfe basis. However, some of our wells produce both +oil and gas. At December 31, 2002, we had no wells with multiple completions. At +December 31, 2002, we had 1 gross (1.0 net) exploratory gas well in progress. +22 +LEASEHOLD ACREAGE +The following table shows our approximate developed and undeveloped (gross and +net) leasehold acreage as of December 31, 2002. +LEASEHOLD ACREAGE +----------------- +DEVELOPED UNDEVELOPED +--------- ----------- +LOCATION GROSS NET GROSS NET +------------------ ---------- ---------- ---------- ---------- +Louisiana 7,862 4,835 3,801 1,237 +Other States 1,500 740 879 689 +Federal Waters 116,566 82,442 300,475 98,231 +---------- ---------- ---------- ---------- +Total 125,928 88,017 305,155 100,157 +========== ========== ========== ========== +As of December 31, 2002, we owned various royalty and overriding royalty +interests in 1,336 net developed and 6,862 net undeveloped acres. In addition, +we owned 5,181 developed and 120,819 undeveloped mineral acres. +MAJOR CUSTOMERS +Our production is sold generally on month-to-month contracts at prevailing +prices. The following table identifies customers to whom we sold a significant +percentage of our total oil and gas production during each of the twelve-month +periods ended: +DECEMBER 31, +------------ +2002 2001 2000 +------ ------ ------ +Adams Resources Marketing, Ltd. -- -- 14% +Petrocom Energy Group, Ltd. 4% -- -- +Dynegy 7% 8% -- +Prior Energy Corporation -- 20% -- +Reliant Energy Services 70% 49% 37% +Unocal Exploration Corporation -- -- 8% +Because alternative purchasers of oil and gas are readily available, we believe +that the loss of any of these purchasers would not result in a material adverse +effect on our ability to market future oil and gas production. +23 +TITLE TO PROPERTIES +We believe that the title to our oil and gas properties is good and defensible +in accordance with standards generally accepted in the oil and gas industry, +subject to such exceptions which, in our opinion are not so material as to +detract substantially from the use or value of such properties. Our properties +are typically subject, in one degree or another, to one or more of the +following: royalties and other burdens and obligations, express or implied, +under oil and gas leases; overriding royalties and other burdens created by us +or our predecessors in title; a variety of contractual obligations (including, +in some cases, development obligations) arising under operating agreements, +farmout agreements, production sales contracts and other agreements that may +affect the properties or their titles; back-ins and reversionary interests +existing under purchase agreements and leasehold assignments; liens that arise +in the normal course of operations, such as those for unpaid taxes, statutory +liens securing obligations to unpaid suppliers and contractors and contractual +liens under operating agreements; pooling, unitization and communitization +agreements, declarations and orders; and easements, restrictions, rights-of-way +and other matters that commonly affect property. To the extent that such burdens +and obligations affect our rights to production revenues, they have been taken +into account in calculating our net revenue interests and in estimating the size +and value of our reserves. We believe that the burdens and obligations affecting +our properties are conventional in the industry for properties of the kind owned +by us. +ITEM 3. LEGAL PROCEEDINGS +We are a defendant in various legal proceedings and claims, which arise in the +ordinary course of our business. We do not believe the ultimate resolution of +any such actions will have a material affect on our financial position or +results of operations. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +There were no matters submitted to a vote of security holders during the fourth +quarter of 2002. +PART II. +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS +Our common stock trades on the New York Stock Exchange under the symbol "CPE". +The following table sets forth the high and low sale prices per share as +reported for the periods indicated. +QUARTER ENDED HIGH LOW +-------------------- -------- -------- +2001: +First quarter $ 16.69 $ 10.00 +Second quarter 13.22 10.65 +Third quarter 11.82 5.90 +Fourth quarter 7.20 5.35 +2002: +First quarter $ 9.40 $ 3.97 +Second quarter 8.39 4.50 +Third quarter 5.15 3.20 +Fourth quarter 6.25 3.35 +As of March 7, 2003, there were approximately 4,896 common stockholders of +record. +We have never paid dividends on our common stock and intend to retain our cash +flow from operations, net of preferred stock dividends, for the future operation +and development of our business. In addition, our primary credit facility and +the terms of our outstanding subordinated debt restrict payments of dividends on +our common stock. +24 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth, as of the dates and for the periods indicated, +selected financial information about us. The financial information for each of +the five years in the period ended December 31, 2002 has been derived from our +audited Consolidated Financial Statements for such periods. The information +should be read in conjunction with "Management's Discussion and Analysis of +Financial Condition and Results of Operations" and the Consolidated Financial +Statements and Notes thereto. The following information is not necessarily +indicative of our future results. +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) +YEARS ENDED DECEMBER 31, +------------------------------------------------------------------------- +2002 2001 2000 1999 1998 +------------ ------------ ------------ ------------ ------------ +STATEMENT OF OPERATIONS DATA: +Revenues: +Oil and gas sales $ 61,171 $ 60,010 $ 56,310 $ 37,140 $ 35,624 +Interest and other 1,004 1,742 1,767 1,853 2,094 +Gain on sale of pipeline 2,454 -- -- -- -- +Gain on sale of Enron derivatives 2,479 -- -- -- -- +------------ ------------ ------------ ------------ ------------ +Total revenues 67,108 61,752 58,077 38,993 37,718 +------------ ------------ ------------ ------------ ------------ +Costs and expenses: +Lease operating expenses 11,030 11,252 9,339 7,536 7,817 +Depreciation, depletion and amortization 27,096 21,081 17,153 16,727 19,284 +General and administrative 4,705 4,635 4,155 4,575 5,285 +Writedown of Enron derivatives -- 9,186 -- -- -- +Loss on mark-to-market commodity derivative contracts 708 -- -- -- -- +Interest 26,140 12,805 8,420 6,175 1,925 +Accelerated vesting and retirement benefits -- -- -- -- 5,761 +Impairment of oil and gas properties -- -- -- -- 43,500 +------------ ------------ ------------ ------------ ------------ +Total costs and expenses 69,679 58,959 39,067 35,013 83,572 +------------ ------------ ------------ ------------ ------------ +Income (loss) from operations (2,571) 2,793 19,010 3,980 (45,854) +Income tax expense (benefit) (900) 977 6,463 1,353 (15,100) +------------ ------------ ------------ ------------ ------------ +Net income (loss) (1,671) 1,816 12,547 2,627 (30,754) +Preferred stock dividends 1,277 1,277 2,403 2,497 2,779 +------------ ------------ ------------ ------------ ------------ +Net income (loss) available to common shares $ (2,948) $ 539 $ 10,144 $ 130 $ (33,533) +============ ============ ============ ============ ============ +Net income (loss) per common share: +Basic $ (.22) $ .04 $ .82 $ .01 $ (4.17) +Diluted $ (.22) $ .04 $ .80 $ .01 $ (4.17) +Shares used in computing net income (loss) per +common share: +Basic 13,387 13,273 12,420 8,976 8,034 +Diluted 13,387 13,366 12,745 9,075 8,034 +BALANCE SHEET DATA (END OF PERIOD): +Oil and gas properties, net $ 377,661 $ 343,158 $ 258,613 $ 194,365 $ 141,905 +Total assets $ 410,613 $ 372,095 $ 301,569 $ 259,877 $ 181,652 +Long-term debt, less current portion $ 248,269 $ 161,733 $ 134,000 $ 100,250 $ 78,250 +Stockholders' equity $ 140,960 $ 147,224 $ 136,328 $ 124,380 $ 84,484 +------------- +We use the full-cost method of accounting. Under this method of accounting, our +net capitalized costs to acquire, explore and develop oil and gas properties may +not exceed the standardized measure of our proved reserves. If these capitalized +costs exceed a ceiling amount, the excess is charged to expense. As a result of +the significant decline in oil and gas prices, we recorded a non-cash impairment +expense related to our oil and gas properties in the amount of $43.5 million +during the fourth quarter of 1998. +ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS +OF OPERATIONS +The following discussion is intended to assist in an understanding of our +financial condition and results of operations. Our Financial Statements and +Notes thereto contain detailed information that should be referred to in +conjunction with the following discussion. See Item 8. "Financial Statements and +Supplementary Data." +GENERAL +Callon Petroleum Company has been engaged in the exploration, development, +acquisition and production of oil and gas properties since 1950. Our revenues, +profitability and future growth and the carrying value of our oil and gas +properties are substantially dependent on prevailing prices of oil and gas and +our ability to find, develop and acquire additional oil and gas reserves that +are economically recoverable. Our ability to maintain or increase our borrowing +capacity and to obtain additional capital on attractive terms is also influenced +by oil and gas prices. +25 +Our estimated net proved oil and gas reserves decreased at December 31, 2002 to +236 billion cubic feet of natural gas equivalent (Bcfe). This represents a +decrease of 22% over previous year-end 2001 estimated proved reserves of 303 +Bcfe. +A major revision to reserves in 2002 was at our Boomslang discovery. The initial +exploratory well drilled at this location in 1998 encountered 185 feet of pay. +The well was drilled with mechanical problems and was subsequently determined +not to be a viable well for completion and production of the estimated proved +reserves encountered in this initial well. A second well, drilled in the fourth +quarter of 2002, to serve as a production take point, was drilled in a down dip +direction from the first well targeting what was anticipated to be a better sand +development in the three separate reservoirs found in the first well, but still +up dip of the lowest known hydrocarbons in the first well. Reservoir sand +quality changed dramatically, reducing the estimated reservoir volumes found and +booked as estimated proved reserves by the first well to an extent that the +partners determined that the risk of development was not economic. Callon had a +40% working interest. The Company's proved reserves in the prior year included +7.2 million barrels of oil and 13 billion cubic feet of natural gas attributable +to Boomslang. +Prices for oil and gas are subject to large fluctuations in response to +relatively minor changes in the supply of and demand for oil and gas, market +uncertainty and a variety of additional factors beyond our control. These +factors include weather conditions in the United States, the condition of the +United States economy, the actions of the Organization of Petroleum Exporting +Countries, governmental regulation, political stability in the Middle East and +elsewhere, the foreign supply of crude oil and natural gas, the price of foreign +imports and the availability of alternate fuel sources. Any substantial and +extended decline in the price of crude oil or natural gas would have an adverse +effect on our carrying value of our proved reserves, borrowing capacity, +revenues, profitability and cash flows from operations. We use derivative +financial instruments (see Note 6 and Item 7A. "Quantitative and Qualitative +Disclosures About Market Risks") for price protection purposes on a limited +amount of our future production and do not use them for trading purposes. On a +Mcfe basis, natural gas represents 65% of the budgeted 2003 production and 39% +of proved reserves at year-end 2002. +Inflation has not had a material impact on us and is not expected to have a +material impact on us in the future. +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +RECENT ACCOUNTING PRONOUNCEMENTS. In June 1998, the Financial Accounting +Standards Board issued Statement of Financial Accounting Standards No. 133 +("SFAS 133"), Accounting for Derivative Instruments and Hedging Activities. The +Statement establishes accounting and reporting standards requiring that every +derivative instrument, including certain derivative instruments embedded in +other contracts, be recorded in the balance sheet as either an asset or +liability measured at its fair value. SFAS 133 requires the Company to report +changes in the fair value of our derivative financial instruments that qualify +as cash flow hedges in other comprehensive income, a component of stockholders' +equity, until realized. We adopted SFAS 133 effective January 1, 2001. +In June 2001, the Financial Accounting Standards Board approved Statement of +Accounting Standards No. 143, Asset Retirement Obligations ("SFAS 143"). SFAS +143 addresses financial accounting and reporting for obligations associated with +the retirement of tangible long-lived assets and the associated asset retirement +costs. We will record the fair value of these obligations on January 1, 2003, as +well as the related additional assets. The net difference between our previously +recorded abandonment liability and the amounts estimated under SFAS 143, after +taxes, is expected to total a gain of approximately $180,000, which will +26 +be recognized as a cumulative effect of a change in accounting principle and an +expected abandonment liability for retirement obligations of approximately $26 +million. +In December 2002, the Financial Accounting Standards Board issued Statement of +Financial Accounting Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based +Compensation-Transition and Disclosure -an amendment of SFAS No. 123." SFAS 148 +amends SFAS 123 to provide alternative methods of transition for a voluntary +change to the fair value based method of accounting for stock-based employee +compensation. In addition, this statement amends the disclosure requirements of +SFAS 123 to require disclosures in both annual and interim financial statements +about the method of accounting for stock-based employee compensation and the +effect of the method used on the reported results. SFAS 148 is effective for the +year ended December 31, 2002 and for interim financial statements commencing in +2003. The adoption of this pronouncement by the Company did not have an impact +on our financial condition or results of operations. +PROPERTY AND EQUIPMENT. We follow the full-cost method of accounting for oil and +gas properties whereby all costs incurred in connection with the acquisition, +exploration and development of oil and gas reserves, including certain overhead +costs, are capitalized into the "full cost pool." The amounts we capitalize into +the full cost pool are depleted (charged against earnings) using the +unit-of-production method. The full cost method of accounting for our proved oil +and gas properties requires that we make estimates based on assumptions as to +future events which could change. These estimates are described below. +Depreciation, Depletion and Amortization (DD&A) of Oil and Gas Properties. We +calculate depletion by using the capitalized costs in our full cost pool plus +future development and abandonment costs (combined, the depletable base) and our +estimated net proved reserve quantities. Capitalized costs added to the full +cost pool and other costs added to the depletable base include the following: +o The cost of drilling and equipping productive wells, dry hole costs, +acquisition costs of properties with proved reserves, delay rentals and +other costs related to exploration and development of our oil and gas +properties; +o Our payroll and general and administrative costs and costs related +fringe benefits paid to employees directly engaged in the acquisition, +exploration and/or development of oil and gas properties as well as +other directly identifiable general and administrative costs associated +with such activities. Such capitalized costs do not include any costs +related to our production of oil and gas or our general corporate +overhead; +o Costs associated with properties that do not have proved reserves +attributed to them are excluded from the full cost pool. These +unevaluated property costs are added to the full cost pool at such time +as wells are completed on the properties, the properties are sold or we +determine these costs have been impaired. Our determination that a +property has or has not been impaired (which is discussed below) +requires that we make assumptions about future events. +o Our estimates of future costs to develop proved properties are added to +the full cost pool for purposes of the DD&A computation. We use +assumptions based on the latest geologic, engineering, regulatory and +cost data available to us to estimate these amounts. However, the +estimates we make are subjective and may change over time. Our +estimates of future development costs are periodically updated as +additional information becomes available. +o Estimated costs to dismantle, abandon and restore a proved property are +added to the full cost pool for the purposes of DD&A. Such cost +estimates are periodically updated as additional information becomes +available. As discussed above under Accounting Pronouncements, +specifically FAS 143, beginning January 1, 2003, we will change the +method for which we account for such costs +27 +Capitalized costs included in the full cost pool are depleted and charged +against earnings using the unit of production method. Under this method, we +estimate our quantity of proved reserves at the beginning of each accounting +period. For each barrel of oil equivalent produced during the period, we record +a depletion charge equal to the amount included in the depletable base (net of +accumulated depreciation, depletion and amortization) divided by our estimated +net proved reserve quantities. +Because we use estimates and assumptions to calculate proved reserves (as +discussed below) and the amounts included in the full cost pool, our depletion +calculations will change as the estimates and assumptions are not realized. Such +changes may be material. +Ceiling Test. Under the full cost accounting rules, capitalized costs included +in the full cost pool, net of accumulated depreciation, depletion and +amortization (DD&A) and deferred income taxes, may not exceed the present value +of our estimated future net cash flows from proved oil and gas reserves, +discounted at 10 percent, plus the lower of cost or fair value of unproved +properties included in the costs being amortized, net of related tax effects. +These rules generally require that, in estimating future net cash flow, we +assume that future oil and gas production will be sold at the unescalated market +price for oil and gas received at the end of each fiscal quarter and that future +costs to produce oil and gas will remain constant at the prices in effect at the +end of the fiscal quarter. We are required to write-down and charge to earnings +the amount, if any, by which these costs exceed the discounted future net cash +flows, unless prices recover sufficiently before the date of our financial +statements. Given the volatility of oil and gas prices, it is likely that our +estimates of discounted future net cash flows from proved oil and gas reserves +will change in the near term. If oil and gas prices decline significantly, even +if only for a short period of time, it is possible that writedowns of oil and +gas properties could occur in the future. +Estimating Reserves and Present Values. Our estimates of quantities of proved +oil and gas reserves and the discounted present value of such reserves at the +end of each quarter are based on numerous assumptions which are likely to change +over time. These assumptions include: +o The prices at which we can sell our oil and gas production in the +future. Oil and gas process are volatile, but we are generally required +to assume that they will not change from the prices in effect at the +end of the quarter. In general, higher oil and gas prices will increase +quantities of proved reserves and the present value of such reserves, +while lower prices will decrease these amounts. Because our properties +have relatively short productive lives, changes in prices will affect +the present value more than quantities of oil and gas reserves. +o The costs to develop and produce our reserves and the costs to +dismantle our production facilities when reserves are depleted. These +costs are likely to change over time, but we are required to assume +that costs in effect at the end of the quarter will not change. +Increases in costs will reduce oil and gas quantities and present +values, while decreases in costs will increase such amounts. Because +our properties have relatively short productive lives, changes in costs +will affect the present value more than quantities of oil and gas +reserves. +In addition, the process of estimating proved oil and gas reserves requires that +our independent and internal reserve engineers exercise judgment based on +available geological, geophysical and technical information. We have described +the risks associated with reserve estimation and the volatility of oil and gas +prices, under "Risk Factors." +Unproved Properties. Costs associated with properties that do not have proved +reserves, including capitalized interest, are excluded from the full cost pool. +These unproved properties are included in the line item "Unevaluated properties +excluded from amortization." Unproved property costs are transferred to the full +cost pool when wells are completed on the properties or the properties are sold. +In addition, we are required to +28 +determine whether our unproved properties are impaired and, if so, add the costs +of such properties to the full cost pool. We determine whether an unproved +property should be impaired by periodically reviewing our exploration program on +a property by property basis. This determination may require the exercise of +substantial judgment by our management. +DERIVATIVES. We use derivative financial instruments for price protection +purposes on a limited amount of our future production and do not use them for +trading purposes. Such derivatives were accounted for in years prior to 2001 as +hedges and have been recognized as an adjustment to oil and gas sales in the +period in which they are related. Current accounting treatment is under SFAS +133. +LIQUIDITY AND CAPITAL RESOURCES +Our primary sources of capital are cash flows from operations, borrowings from +financial institutions and the sale of debt and equity securities. Net cash and +cash equivalents decreased during 2002 by $1.1 million. Cash provided from +operating activities during 2002 totaled $12.2 million. Dividends paid on +preferred stock were $1.3 million. Average debt outstanding was $246.0 million +during 2002 compared to $164.9 million in 2001. At December 31, 2002, we had +working capital of $.6 million. +In early July of 2001, we closed a $95 million multiple advance term loan +("Senior Notes") with a private lender. We drew $45 million on July 3, 2001 and +paid down our revolving Credit Facility. We drew the remaining $50 million in +December 2001. Under the terms of the agreement, we also issued warrants for the +purchase, at a nominal exercise price, of 265,210 shares of our common stock to +the lender and conveyed an overriding royalty interest equal to 2% of our net +interest in four of our deepwater discoveries. The warrants and the overriding +royalty interest were earned by the lender based on the ratio of the amount of +the loan proceeds advanced to the total loan facility amount. This senior debt +will mature March 31, 2005 and contains restrictions on certain types of future +indebtedness and dividends on common stock. +Effective October 31, 2000, we entered into a $75 million Credit Facility with +First Union National Bank. Borrowings under the Credit Facility are secured by +mortgages covering substantially all of our producing oil and gas properties and +guaranteed by our subsidiaries. On June 30, 2002, the lenders under the +Company's Credit Facility agreed to increase availability under the revolving +borrowing base from $50 million to $75 million. +The Credit Facility, the Senior Notes and our subordinated debt contain various +covenants including restrictions on additional indebtedness and payment of cash +dividends as well as maintenance of certain financial ratios. We are in +compliance with these covenants at December 31, 2002. +The holders of $22.9 million of the $36.0 million of the Company's 10.125% +Senior Subordinated Notes (the "Notes") consented to an extension of such Notes +until July 31, 2004. The Company granted 274,980 warrants with a fair market +value of approximately $1.3 million to purchase Common Stock of the Company and +paid consent fees in the amount of $2.3 million to the holders of the Notes that +granted the extensions. The holders of the Notes that did not consent to the +extension were paid on the maturity date of the Notes in September 2002. +Subsequent to September 2002, the holders of the Notes exercised approximately +116,000 warrants that were granted as a result of the extension of the Notes. +Our plans for 2003 include non-discretionary capital expenditures of $51.2 +million. Approximately $8.6 million of this amount is allocated to the +completion of the Medusa deepwater discovery, currently scheduled to begin +production in the third quarter of 2003. +29 +Following Medusa, the Habanero deepwater discovery is scheduled for development +with projected capital expenditures in 2003 of approximately $17.2 million and +is projected to begin initial production in the second half of 2003. Once +producing, this deepwater discovery is projected to have the same positive +impact on borrowing capacity as Medusa. Habanero will be produced through a +sidetrack of the initial discovery well and the additional development well to +be drilled in the summer of 2003. A sub sea completion will be routed into one +of the operator's existing facilities and initial production is expected in late +third quarter of 2003. +The Company anticipates that cash flow generated during 2003 and current +availability under the Credit Facility will provide necessary capital to enable +the Company to continue its operational activities until such time as production +from Medusa and Habanero begins. At that time, the Company anticipates that the +Medusa and Habanero reserves and production will be integrated into the +borrowing base of the Company's Credit Facility and will provide additional +available borrowing capacity. This increase in borrowing capacity as well as +significant additional cash flow from the new production will provide funds for +future discretionary capital expenditures. +The completion of the Company's deepwater discoveries will require the +construction of expensive production facilities and pipelines, including the +transportation and installation of production facilities and the use of sub sea +completion techniques. The Company cannot estimate the timing of the +construction of these facilities with certainty. The operators completing these +discoveries will possibly face inclement weather and other unfavorable +environmental conditions, delays in fabrication and delivery of necessary +equipment, and other unforeseen circumstances that may delay completion of these +properties. Long-term delays in the completion of these deepwater projects that +prevent the commencement of production from such discoveries could have a +material adverse effect on the Company's financial position and result of +operations. Such a delay would require the Company to reduce future anticipated +capital expenditures or seek additional sources of liquidity to finance capital +expenditures, which may not be available. +The following table describes our outstanding contractual obligations (in +thousands) as of December 31, 2002: +CONTRACTUAL LESS THAN ONE-THREE FOUR-FIVE AFTER-FIVE +OBLIGATIONS TOTAL ONE YEAR YEARS YEARS YEARS +------------------------------------------ -------- -------- -------- ---------- ---------- +Credit Facility $ 65,000 $ -- $ 65,000 $ -- $ -- +Senior Notes 95,000 -- 95,000 -- -- +10.125% Senior +Subordinated Debt 22,915 -- 22,915 -- -- +10.25% Senior Subordinated Debt 40,000 -- 40,000 -- -- +11% Senior Subordinated Debt 33,000 -- 33,000 -- -- +Capital lease (future minimum payments) 6,419 1,998 2,712 787 923 +RESULTS OF OPERATIONS +The following table sets forth certain operating information with respect to our +oil and gas operations for each of the three years in the period ended December +31, 2002. +30 +DECEMBER 31, +------------------------------------------ +2002(a)(b) 2001(a)(b) 2000(a)(b) +------------ ------------ ------------ +Production: +Oil (MBbls) 226 273 232 +Gas (MMcf) 14,215 13,566 13,943 +Total production (MMcfe) 15,571 15,206 15,334 +Average daily production (MMcfe) 42.7 41.7 41.9 +Average sales price: +Oil (per Bbl) $ 23.11 $ 22.95 $ 27.88 +Gas (per Mcf) $ 3.94 $ 3.96 $ 3.57 +Total production (per Mcfe) $ 3.93 $ 3.95 $ 3.67 +Average costs (per Mcfe): +Lease operating expenses $ .71 $ .73 $ .61 +Depletion $ 1.73 $ 1.37 $ 1.10 +General and administrative (net of management fees) $ .30 $ .30 $ .27 +(a) Includes hedging gains and losses. +(b) Includes volumes of 1,200 MMcf for the year 2002 and 2,300 MMcf for each of +the years 2001 and 2000, at an average price of $2.08 per Mcf associated with a +volumetric production payment. +PENDING SEC REVIEW OF RESERVE INFORMATION +In October 2002 and February 2003, we received letters from the SEC regarding +our Annual Report on Form 10-K for the year ended December 31, 2001 requesting +supplemental information concerning our operations in the Gulf of Mexico. The +comment letters requested information about the procedures we used to classify +our deepwater reserves as proved and requested that our financials be restated +to reflect the removal of the Boomslang reserves as proved for all prior periods +during which such reserves were reported as proved. We have reviewed the SEC +comments with our independent petroleum reserve engineers, Huddleston & Co., +Inc. of Houston, Texas. Both Huddleston & Co and Callon believe that such +deepwater reserves are properly classified as proved. +COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2002 AND +2001 +OIL AND GAS REVENUES +Oil and gas revenues for 2002 were $61.2 million, a 2% increase from the 2001 +amount of $60.0 million. 2002 oil and gas production of 15,571 MMcfe increased +as well from the 2001 amount of 15,206 MMcfe. +Oil production decreased from 273,000 barrels in 2001 to 226,000 barrels in 2002 +but the average sales price increased from $22.95 in 2001 to $23.11 in 2002. As +a result, oil revenues dropped from $6.3 million in 2001 to $5.2 million in +2002. The production decrease was primarily due to older properties' normal and +expected decline in production. +Gas revenues for 2002 were $55.9 million based on sales of 14.2 Bcf at an +average sales price of $3.94 per Mcf. For 2001, gas revenues were $53.7 million +based on production of 13.6 Bcf sold at an average sales price of $3.96 per Mcf. +Our gas production in 2002 increased when compared to last year due primarily to +the acceleration program at Mobile Blocks 952/953/955 area initiated in the +fourth quarter of 2001. +31 +LEASE OPERATING EXPENSES +Lease operating expenses remained relatively stable at $11.3 million ($.73 per +Mcfe) in 2001 compared to $11.0 million ($.71 per Mcfe) in 2002. +DEPRECIATION, DEPLETION AND AMORTIZATION +Depreciation, depletion and amortization increased by 28% due in large part to +the downward reserve revisions at Boomslang. This decrease in estimated proved +reserves, over which depletable costs are amortized, increased the per unit +depletion rate, while production remained relatively constant between years. +Total charges increased from $21.1 million or $1.39 per Mcfe in 2001, to $27.1 +million, or $1.74 per Mcfe in 2002. +GENERAL AND ADMINISTRATIVE +General and administrative expenses for 2002 were $4.7 million, or $.30 per +Mcfe, compared to $4.6 million, or $.30 per Mcfe, in 2001. +INTEREST EXPENSE +Interest expense for 2002 was $26.1 million increasing from $12.8 million in +2001. This is a result of an increase in our long-term debt as well as higher +interest rates associated with additional debt incurred in 2002. +INCOME TAXES +Our 2002 results include a deferred income tax benefit of $900,000. We evaluated +the deferred income tax asset in light of our reserve quantity estimates, our +long-term outlook for oil and gas prices and our expected level of future +revenues and expenses. We believe it is more likely than not, based upon this +evaluation, that we will realize the recorded deferred income tax asset. +However, there is no assurance that such asset will ultimately be realized. +COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2001 AND +2000 +OIL AND GAS REVENUES +Oil and gas revenues for 2001 were $60.0 million, a 7% increase from the 2000 +amount of $56.3 million. However, 2001 oil and gas production of 15,206 MMcfe +decreased slightly from the 2000 amount of 15,334 MMcfe. +Oil production increased from 232,000 barrels in 2000 to 273,000 barrels in 2001 +but the average sales price decreased from $27.88 in 2000 to $22.95 in 2001. As +a result, oil revenues dropped from $6.5 million in 2000 to $6.3 million in +2001. The production increase was primarily from increased oil production at +South Marsh Island 261 offset by older properties' normal and expected decline +in production. The slight decrease in oil revenue was due to the decline in +average oil prices received in 2001. +Gas revenues for 2001 were $53.7 million based on sales of 13.6 Bcf at an +average sales price of $3.96 per Mcf. For 2000, gas revenues were $49.8 million +based on production of 13.9 Bcf sold at an average sales price of $3.57 per Mcf. +Our gas production in 2001 decreased when compared to last year as a result of +32 +production declines at East Cameron 275 and South Marsh Island 261, offset by +increases in production at Mobile Block 864 and Chandeleur Block 40. The +production declines at East Cameron 275 and South Marsh Island 261 were normal +and expected as the 2000 rates were indicative of higher initial production. The +Mobile Block 864 Area increased production due to a well stimulation program as +well additions to production through exploratory and developmental drilling on +the property. Gas revenue increased due to higher prices received for production +in 2001. +LEASE OPERATING EXPENSES +Lease operating expenses increased from $9.3 million ($.61 per Mcfe) in 2000 to +$11.3 million ($.73 per Mcfe) in 2001. The increase was attributable to higher +operating costs at South Marsh Island 261 and at Mobile Block 864. Also, +production declines related to older properties that have relatively fixed +operating costs contributed to the higher per Mcf costs with lower production +levels for those properties in 2001. +WRITEDOWN OF ENRON DERIVATIVES +In April of 2001, we entered into derivative contracts for 2002 production with +Enron North America Corp. Enron North America Corp. filed for protection under +the bankruptcy laws in late 2001. As a result of the credit risk associated with +the derivatives with Enron North America Corp., hedge accounting was not +available due to ineffectiveness as of September 30, 2001 and the contracts at +December 31, 2001 were marked to the market. In the fourth quarter of 2001, we +charged to expense (non-cash) $9.2 million related to these Enron North America +Corp. derivatives. We have no other contracts with Enron or their related +subsidiaries. +DEPRECIATION, DEPLETION AND AMORTIZATION +Depreciation, depletion and amortization increased by 23% due to a combination +of an increase in the amortization base due to higher drilling costs with +reserve additions being less than expected from exploration efforts in 2001 and +downward reserve revisions in 2000 as a result of a field delineation program at +Habanero. +Total charges increased from $17.2 million, or $1.12 per Mcfe in 2000 to $21.1 +million, or $1.39 per Mcfe in 2001. +GENERAL AND ADMINISTRATIVE +General and administrative expenses for 2001 were $4.6 million, or $.30 per +Mcfe, compared to $4.2 million, or $.27 per Mcfe, in 2000. This increase was due +primarily to expenses incurred in the second quarter of 2001 related to our +withdrawn debt offering. +INTEREST EXPENSE +Interest expense for 2001 was $12.8 million increasing from $8.4 million in +2000. This is a result of an increase in our long-term debt as well as higher +interest rates associated with additional debt incurred in 2001. +INCOME TAXES +Our 2001 results include a deferred income tax expense of $977,000. We evaluated +the deferred income tax asset in light of our reserve quantity estimates, our +long-term outlook for oil and gas prices and our expected level of future +revenues and expenses. We believe it is more likely than not, based upon this +evaluation, that we will realize the recorded deferred income tax asset. +However, there is no assurance that such asset will ultimately be realized. +33 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS +The Company's revenues are derived from the sale of its crude oil and natural +gas production. In recent months, the prices for oil and gas have increased; +however, they remain extremely volatile and sometimes experience large +fluctuations as a result of relatively small changes in supplies, weather +conditions, economic conditions and government actions. The Company enters into +derivative financial instruments to hedge oil and gas price risks for the +production volumes to which the hedge relates. The derivatives reduce the +Company's exposure on the hedged volumes to decreases in commodity prices and +limit the benefit the Company might otherwise have received from any increases +in commodity prices on the hedged volumes. +The Company also enters into price "collars" to reduce the risk of changes in +oil and gas prices. Under these arrangements, no payments are due by either +party so long as the market price is above the floor price set in the collar and +below the ceiling. If the price falls below the floor, the counter-party to the +collar pays the difference to the Company and if the price is above the ceiling, +the counter-party receives the difference from the Company. The Company enters +into these various agreements to reduce the effects of volatile oil and gas +prices and does not enter into hedge transactions for speculative purposes. See +Note 6 to the Consolidated Financial Statements for a description of the +Company's hedged position at December 31, 2002. There have been no significant +changes in market risks faced by the Company since the end of 2002. +Based on projected annual sales volumes for 2003 (excluding forecast production +increases over 2002), a 10% decline in the prices we receive for our crude oil +and natural gas production would have an approximate $6.5 million impact on our +revenues. +34 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +---------- +Report of Independent Auditors 36 and 37 +Consolidated Balance Sheets as of December 31, 2002 and 2001 38 +Consolidated Statements of Operations for Each of the Three Years +in the Period Ended December 31, 2002 39 +Consolidated Statements of Stockholders' Equity for Each of the Three Years in +the Period Ended December 31, 2002 40 +Consolidated Statements of Cash Flows for Each of the Three Years in the Period +Ended December 31, 2002 41 +Notes to Consolidated Financial Statements 42 +35 +REPORT OF INDEPENDENT AUDITORS +The Stockholders and Board of Directors +Callon Petroleum Company: +We have audited the accompanying consolidated balance sheet of Callon +Petroleum Company as of December 31, 2002, and the related consolidated +statements of operations, stockholders' equity and cash flows for the year then +ended. These financial statements are the responsibility of the Company's +management. Our responsibility is to express an opinion on these financial +statements based on our audit. The financial statements of Callon Petroleum +Company as of December 31, 2001 and for each of the two years in the period then +ended, were audited by other auditors who have ceased operations and whose +report dated March 29, 2002, expressed an unqualified opinion on those +statements and included an explanatory paragraph that disclosed the change in +the Company's method of accounting for derivative instruments and hedging +activities discussed in Note 2 to those financial statements. +We conducted our audit in accordance with auditing standards generally +accepted in the United States. Those standards require that we plan and perform +the audit to obtain reasonable assurance about whether the financial statements +are free of material misstatement. An audit includes examining, on a test basis, +evidence supporting the amounts and disclosures in the financial statements. An +audit also includes assessing the accounting principles used and significant +estimates made by management, as well as evaluating the overall financial +statement presentation. We believe that our audit provides a reasonable basis +for our opinion. +In our opinion, the financial statements referred to above present fairly, +in all material respects, the consolidated financial position of Callon +Petroleum Company as of December 31, 2002, and the results of its operations and +its cash flows for the year then ended in conformity with accounting principles +generally accepted in the United States. +ERNST & YOUNG LLP +New Orleans, Louisiana +February 28, 2003 +36 +The following report is a copy of the audit report previously issued by Arthur +Andersen LLP in connection with Callon Petroleum Company's annual report on Form +10-K for the year ended December 31, 2001. This audit report has not been +reissued by Arthur Andersen LLP in connection with this filing on form 10-K for +the year ended December 31, 2002. The consolidated balance sheet as of December +31, 2000 and the consolidated statements of operations, stockholders' equity and +cash flows for the year ended December 31, 1999, mentioned in the report, are +not required in the Company's annual report for 2002 and are therefore not +presented among the financial statements in this annual report. +REPORT OF INDEPENDENT AUDITORS +To the Stockholders and Board of Directors of Callon Petroleum Company: +We have audited the accompanying consolidated balance sheets of Callon +Petroleum Company (a Delaware corporation) and subsidiaries as of December 31, +2001 and 2000, and the related consolidated statements of operations, +stockholders' equity and cash flows for each of the three years in the period +ended December 31, 2001. These financial statements are the responsibility of +the Company's management. Our responsibility is to express an opinion on these +financial statements based on our audits. +We conducted our audits in accordance with auditing standards generally +accepted in the United States. Those standards require that we plan and perform +the audit to obtain reasonable assurance about whether the financial statements +are free of material misstatement. An audit includes examining, on a test basis, +evidence supporting the amounts and disclosures in the financial statements. An +audit also includes assessing the accounting principles used and significant +estimates made by management, as well as evaluating the overall financial +statement presentation. We believe that our audits provide a reasonable basis +for our opinion. +In our opinion, the financial statements referred to above present +fairly, in all material respects, the financial position of Callon Petroleum +Company and subsidiaries, as of December 31, 2001 and 2000, and the results of +their operations and their cash flows for each of the three years in the period +ended December 31, 2001, in conformity with accounting principles generally +accepted in the United States. +As discussed in Note 2 to the consolidated financial statements +effective January 1, 2001, the Company adopted SFAS 133, "Accounting for +Derivative Instruments and Hedging Activities." +ARTHUR ANDERSEN LLP +New Orleans, Louisiana +March 29, 2002 +37 +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(IN THOUSANDS, EXCEPT SHARE DATA) +DECEMBER 31, +---------------------------- +2002 2001 +------------ ------------ +ASSETS +Current assets: +Cash and cash equivalents $ 5,807 $ 6,887 +Accounts receivable 10,875 5,908 +Other current assets 570 209 +------------ ------------ +Total current assets 17,252 13,004 +------------ ------------ +Oil and gas properties, full-cost accounting method: +Evaluated properties 762,918 704,937 +Less accumulated depreciation, depletion and amortization (426,254) (399,339) +------------ ------------ +336,664 305,598 +Unevaluated properties excluded from amortization 40,997 37,560 +------------ ------------ +Total oil and gas properties 377,661 343,158 +------------ ------------ +Pipeline and other facilities, net 853 5,364 +Other property and equipment, net 1,890 2,455 +Deferred tax asset 8,767 4,399 +Long-term gas balancing receivable 761 473 +Other assets, net 3,429 3,242 +------------ ------------ +Total assets $ 410,613 $ 372,095 +============ ============ +LIABILITIES AND STOCKHOLDERS' EQUITY +Current liabilities: +Accounts payable and accrued liabilities $ 12,498 $ 9,985 +Undistributed oil and gas revenues 1,109 1,131 +Accrued net profits interest payable 1,707 1,501 +Accounts payable and accrued liabilities to be refinanced -- 9,558 +Current maturities of long-term debt 1,320 37,345 +------------ ------------ +Total current liabilities 16,634 59,520 +------------ ------------ +Long-term debt-excluding current maturities 248,269 161,733 +Accounts payable and accrued liabilities to be refinanced 3,861 -- +Deferred revenue on sale of production payment -- 2,406 +Accrued retirement benefits 204 137 +Long-term gas balancing payable 685 1,075 +------------ ------------ +Total liabilities 269,653 224,871 +------------ ------------ +Stockholders' equity: +Preferred Stock, $.01 par value; 2,500,000 shares +authorized; 600,861 shares of Convertible +Exchangeable Preferred Stock, Series A issued +and outstanding at December 31, 2002 +with a liquidation preference of $15,021,525 6 6 +Common Stock, $.01 par value; 20,000,000 shares +authorized; 13,900,466 shares and 13,397,706 shares +outstanding at December 31, 2002 and 2001, respectively 139 134 +Capital in excess of par value 158,370 154,425 +Unearned restricted stock compensation (826) -- +Accumulated other comprehensive income (loss) (469) 5,971 +Retained earnings (deficit) (16,260) (13,312) +------------ ------------ +Total stockholders' equity 140,960 147,224 +------------ ------------ +Total liabilities and stockholders' equity $ 410,613 $ 372,095 +============ ============ +The accompanying notes are an integral part of these financial statements. +38 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF OPERATIONS +FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 +(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) +2002 2001 2000 +------------ ------------ ------------ +Revenues: +Oil and gas sales $ 61,171 $ 60,010 $ 56,310 +Interest and other 1,004 1,742 1,767 +Gain on sale of pipeline 2,454 -- -- +Gain on sale of Enron derivatives 2,479 -- -- +------------ ------------ ------------ +Total revenues 67,108 61,752 58,077 +------------ ------------ ------------ +Costs and expenses: +Lease operating expenses 11,030 11,252 9,339 +Depreciation, depletion and amortization 27,096 21,081 17,153 +General and administrative 4,705 4,635 4,155 +Writedown of Enron derivatives -- 9,186 -- +Loss on mark-to-market commodity derivative contracts 708 -- -- +Interest 26,140 12,805 8,420 +------------ ------------ ------------ +Total costs and expenses 69,679 58,959 39,067 +------------ ------------ ------------ +Income (loss) from operations (2,571) +2,793 19,010 +Income tax expense (benefit) (900) 977 6,463 +------------ ------------ ------------ +Net income (loss) (1,671) 1,816 12,547 +Preferred stock dividends 1,277 1,277 2,403 +------------ ------------ ------------ +Net income (loss) available to common shares $ (2,948) $ 539 $ 10,144 +============ ============ ============ +Net income (loss) per common share: +Basic $ (.22) $ .04 $ .82 +============ ============ ============ +Diluted $ (.22) $ .04 $ .80 +============ ============ ============ +Shares used in computing net income (loss) per common share: +Basic 13,387 13,273 12,420 +============ ============ ============ +Diluted 13,387 13,366 12,745 +============ ============ ============ +The accompanying notes are an integral part of these financial statements. +39 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY +(IN THOUSANDS) +Unearned Accumulated Total +Restricted Capital in Other Retained Stock- +Preferred Common Stock Excess of Comprehensive Earnings holders' +Stock Stock Compensation Par Value Income (Loss) (Deficit) Equity +---------- ---------- ------------ ---------- ------------- --------- ---------- +Balances, December 31, 1999 $ 11 $ 122 $ -- $ 148,242 $ -- $ (23,995) $ 124,380 +---------- ---------- ---------- ---------- ---------- --------- ---------- +Net income -- -- -- -- -- 12,547 12,547 +Preferred stock dividends -- -- -- -- -- (1,978) (1,978) +Shares issued pursuant to employee +benefit and option plan -- -- -- 1,069 -- -- 1,069 +Employee stock purchase plan -- -- -- 269 -- -- 269 +Tax benefits related to stock +compensation plans -- -- -- 41 -- -- 41 +Conversion of preferred shares +to common stock (5) 11 -- 419 -- (425) -- +---------- ---------- ---------- ---------- ---------- --------- ---------- +Balances, December 31, 2000 6 133 -- 150,040 -- (13,851) 136,328 +---------- ---------- ---------- ---------- ---------- --------- ---------- +Comprehensive income: +Net income -- -- -- -- -- 1,816 +Other comprehensive income -- -- -- -- 5,971 -- +---------- +Total comprehensive income 7,787 +Preferred stock dividend -- -- -- -- -- (1,277) (1,277) +Shares issued pursuant to employee +benefit and option plan -- 1 -- 942 -- -- 943 +Employee stock purchase plan -- -- -- 357 -- -- 357 +Tax benefits related to stock +compensation plans -- -- -- 18 -- -- 18 +Warrants -- -- -- 3,068 -- -- 3,068 +---------- ---------- ---------- ---------- ---------- --------- ---------- +Balances, December 31, 2001 6 134 -- 154,425 5,971 (13,312) 147,224 +---------- ---------- ---------- ---------- ---------- --------- ---------- +Comprehensive income: +Net loss -- -- -- -- -- (1,671) +Other comprehensive loss -- -- -- -- (6,440) -- +---------- +Total comprehensive loss (8,111) +Preferred stock dividends -- -- -- -- -- (1,277) (1,277) +Shares issued pursuant to employee +benefit and option plan -- 1 -- 770 -- -- 771 +Employee stock purchase plan -- -- -- 79 -- -- 79 +Tax benefits related to stock +compensation plans -- -- -- (29) -- -- (29) +Restricted stock -- 3 (826) 1,849 -- -- 1,026 +Warrants -- 1 -- 1,276 -- -- 1,277 +---------- ---------- ---------- ---------- ---------- --------- ---------- +Balances, December 31, 2002 $ 6 $ 139 $ (826) $ 158,370 $ (469) $ (16,260) $ 140,960 +========== ========== ========== ========== ========== ========= ========== +The accompanying notes are an integral part of these financial statements. +40 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 +(IN THOUSANDS) +2002 2001 2000 +------------ ------------ ------------ +Cash flows from operating activities: +Net income (loss) $ (1,671) $ 1,816 $ 12,547 +Adjustments to reconcile net income (loss) to +cash provided by operating activities: +Depreciation, depletion and amortization 27,774 21,709 17,598 +Gain on sale of pipeline (2,454) -- -- +Amortization of deferred costs 5,521 2,485 1,034 +Non-cash derivative income (9,186) -- -- +Mark-to-market commodity derivative contracts 708 -- -- +Amortization of deferred production payment revenue (2,406) (4,830) (4,844) +Writedown of Enron derivatives -- 9,186 -- +Deferred income tax expense (benefit) (900) 977 6,463 +Non-cash charge related to compensation plans 1,267 942 1,069 +Changes in current assets and liabilities: +Accounts receivable (4,967) 3,336 (3,882) +Advance to operators (98) 1,131 (1,131) +Other current assets (6) (2) (18) +Investment in derivative contracts (1,687) -- -- +Current liabilities 3,198 (8,782) 1,077 +Increase in accounts payable and accrued liabilities to be +refinanced -- 9,558 -- +Change in gas balancing receivable (288) 170 (400) +Change in gas balancing payable (390) 355 204 +Change in other long-term liabilities 67 (1,749) (221) +Change in other assets, net (2,315) (1,071) (751) +------------ ------------ ------------ +Cash provided (used) by operating activities 12,167 35,231 28,745 +------------ ------------ ------------ +Cash flows from investing activities: +Capital expenditures (66,023) (113,833) (81,849) +Proceeds from sale of pipeline 6,784 -- -- +Cash proceeds from sale of mineral interests 4,492 1,195 -- +------------ ------------ ------------ +Cash provided (used) by investing activities (54,747) (112,638) (81,849) +------------ ------------ ------------ +Cash flows from financing activities: +Decrease in accounts payable and accrued liability to be refinanced (5,697) -- -- +Equity issued related to employee stock plans 79 357 269 +Payment on debt (58,085) (84,900) (29,250) +Increase in debt 109,900 155,000 63,000 +Debt issuance costs (2,291) (2,374) (1,496) +Capital lease (1,129) 5,612 -- +Cash dividends on preferred stock (1,277) (1,277) (2,214) +------------ ------------ ------------ +Cash provided (used) by financing activities 41,500 72,418 30,309 +------------ ------------ ------------ +Net increase (decrease) in cash and cash equivalents (1,080) (4,989) (22,795) +Cash and cash equivalents: +Balance, beginning of period 6,887 11,876 34,671 +------------ ------------ ------------ +Balance, end of period $ 5,807 $ 6,887 $ 11,876 +============ ============ ============ +The accompanying notes are an integral part of these financial statements. +41 +CALLON PETROLEUM COMPANY +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +GENERAL +Callon Petroleum Company ("Company") was organized under the laws of the state +of Delaware in March 1994 to serve as the surviving entity in the consolidation +and combination of several related entities (referred to herein collectively as +the "Constituent Entities"). The combination of the businesses and properties of +the Constituent Entities with the Company was completed on September 16, 1994 +("Consolidation"). +As a result of the Consolidation, all of the businesses and properties of the +Constituent Entities are owned (directly or indirectly) by the Company. Certain +registration rights were granted to the stockholders of certain of the +Constituent Entities. See Note 7. +The Company and its predecessors have been engaged in the acquisition, +development and exploration of crude oil and natural gas since 1950. The +Company's properties are geographically concentrated in Louisiana, Alabama, +Texas and offshore Gulf of Mexico. +LIQUIDITY AND CAPITAL RESOURCES +In 2002, the lenders under the Company's Credit Facility agreed to increase +availability under the revolving borrowing base from $50 million to $75 million. +In addition, the holders of $22.9 million of the $36.0 million of the Company's +10.125% Senior Subordinated Notes ("Notes") consented to an extension of such +Notes until July 31, 2004. The Company granted 274,980 warrants with a fair +market value of approximately $1.3 million to purchase Common Stock of the +Company for $.01 per share and paid consent fees in the amount of $2.3 million +to the holders of the Notes that granted the extensions. The holders of the +Notes that did not consent to the extension were paid on the maturity date of +the Notes in September 2002. Subsequent to September 2002, the holders of the +Notes exercised approximately 116,000 warrants that were granted as a result of +the extension of the Notes. +Non-discretionary capital expenditures include completion of the Medusa +deepwater discovery, currently scheduled to begin production in the late summer +of 2003. The Company anticipates that cash flow generated during 2003 and +current availability under the Credit Facility will provide necessary capital to +enable the Company to continue its operational activities until such time as +production from the Medusa discovery begins. At that time, the Company +anticipates that the Medusa reserves and production will be integrated into the +borrowing base of the Company's Credit Facility and will provide additional +available borrowing capacity. This increase in borrowing capacity as well as +significant additional cash flow expected from the new production will provide +funds for future discretionary capital expenditures. +Following Medusa, the Habanero deepwater discovery is scheduled for development +and is projected to begin initial production in the second half of 2003. Once +producing, this deepwater discovery is projected to have the same positive +impact on borrowing capacity as Medusa. Habanero will be produced by the +42 +existing delineation well and an additional well to be drilled in the summer of +2003. A sub sea completion will be routed into one of the operator's existing +facilities and initial production is expected in late third quarter of 2003. +The completion of the Company's deepwater discoveries will require the +construction of expensive production facilities and pipelines, including the +transportation and installation of production facilities and the use of sub sea +completion techniques. The Company cannot estimate the timing of the +construction of these facilities with certainty. The operators completing these +discoveries will possibly face inclement weather and other unfavorable +environmental conditions, delays in fabrication and delivery of necessary +equipment, and other unforeseen circumstances that may delay completion of these +properties. Long-term delays in the completion of these deepwater projects that +prevent the commencement of production from such discoveries could have a +material adverse effect on the Company's financial position and result of +operations. Such a delay would require the Company to reduce future anticipated +capital expenditures or seek additional sources of liquidity to finance capital +expenditures, which may not be available. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +PRINCIPLES OF CONSOLIDATION AND REPORTING +The Consolidated Financial Statements include the accounts of the Company, and +its subsidiary, Callon Petroleum Operating Company ("CPOC"). CPOC also has +subsidiaries, namely Callon Offshore Production, Inc. and Mississippi Marketing, +Inc. All intercompany accounts and transactions have been eliminated. Certain +prior year amounts have been reclassified to conform to presentation in the +current year. +USE OF ESTIMATES +The preparation of financial statements in conformity with generally accepted +accounting principles requires management to make estimates and assumptions that +affect the reported amounts of assets and liabilities and disclosure of +contingent assets and liabilities at the date of the financial statements and +the reported amounts of revenues and expenses during the reporting period. +Actual results could differ from those estimates. +ACCOUNTING PRONOUNCEMENTS +In June 1998, the Financial Accounting Standards Board issued Statement of +Financial Accounting Standards No. 133 ("SFAS 133"), Accounting for Derivative +Instruments and Hedging Activities. The Statement establishes accounting and +reporting standards requiring that every derivative instrument, including +certain derivative instruments embedded in other contracts, be recorded in the +balance sheet as either an asset or liability measured at its fair value. The +Company adopted SFAS 133 effective January 1, 2001. The cumulative effect of the +accounting change, net of tax, recorded as other comprehensive loss was $3.8 +million. +SFAS 133 requires the Company to report changes in the fair value of our +derivative financial instruments that qualify as cash flow hedges in other +comprehensive income, a component of stockholders' equity, until realized. See +Note 6 for a discussion of our derivative financial instruments. +In June 2001, the Financial Accounting Standards Board approved Statement of +Accounting Standards No. 143, Asset Retirement Obligations ("SFAS 143"). SFAS +143 addresses financial accounting and reporting for obligations associated with +the retirement of tangible long-lived assets and the associated asset retirement +costs. We will record the fair value of these obligations on January 1, 2003, as +well as the related additional +43 +assets. The net difference between our previously recorded abandonment liability +and the amounts estimated under SFAS 143, after taxes, is expected to total a +gain of approximately $180,000, which will be recognized as a cumulative effect +of a change in accounting principle and an expected abandonment liability for +retirement obligations of approximately $26 million. +In December 2002, the Financial Accounting Standards Board issued Statement of +Financial Accounting Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based +Compensation-Transition and Disclosure--an amendment of SFAS No. 123." SFAS 148 +amends SFAS 123 to provide alternative methods of transition for a voluntary +change to the fair value based method of accounting for stock-based employee +compensation. In addition, this statement amends the disclosure requirements of +SFAS 123 to require disclosures in both annual and interim financial statements +about the method of accounting for stock-based employee compensation and the +effect of the method used on the reported results. SFAS 148 is effective for the +year ended December 31, 2002 and for interim financial statements commencing in +2003. The adoption of this pronouncement by the Company did not have an impact +on our financial condition or results of operations. +PROPERTY AND EQUIPMENT +The Company follows the full cost method of accounting for oil and gas +properties whereby all costs incurred in connection with the acquisition, +exploration and development of oil and gas reserves, including certain overhead +costs, are capitalized. Such amounts include the cost of drilling and equipping +productive wells, dry hole costs, lease acquisition costs, delay rentals, +interest capitalized on unevaluated leases and other costs related to +exploration and development activities. Payroll and general and administrative +costs capitalized include salaries and related fringe benefits paid to employees +directly engaged in the acquisition, exploration and/or development of oil and +gas properties as well as other directly identifiable general and administrative +costs associated with such activities. Such capitalized costs ($9.6 million in +2002, $10.0 million in 2001 and $7.4 million in 2000) do not include any costs +related to production or general corporate overhead. Costs associated with +unevaluated properties, including capitalized interest on such costs, are +excluded from amortization. Unevaluated property costs are transferred to +evaluated property costs at such time as wells are completed on the properties, +the properties are sold or management determines these costs have been impaired. +Costs of properties, including future development and net future site +restoration, dismantlement and abandonment costs, which have proved reserves and +those which have been determined to be worthless, are depleted using the +unit-of-production method based on proved reserves. If the total capitalized +costs of oil and gas properties, net of amortization, exceed the sum of (1) the +estimated future net revenues from proved reserves at current prices and +discounted at 10% and (2) the lower of cost or market of unevaluated properties +(the full cost ceiling amount), net of tax effects, then such excess is charged +to expense during the period in which the excess occurs. See Note 8. +Upon the acquisition or discovery of oil and gas properties, management +estimates the future net costs to be incurred to dismantle, abandon and restore +the property using geological, engineering and regulatory data available. Such +cost estimates are periodically updated for changes in conditions and +requirements. Such estimated amounts are considered as part of the full cost +pool subject to amortization upon acquisition or discovery. Such costs are +capitalized as oil and gas properties as the actual restoration, dismantlement +and abandonment activities take place. As discussed above under Accounting +Pronouncements, beginning January 1, 2003, the Company will change the method +for which we account for such cost as described by FAS 143. +44 +Depreciation of other property and equipment is provided using the straight-line +method over estimated lives of three to 20 years. Depreciation of pipeline and +other facilities is provided using the straight-line method over estimated lives +of 15 to 27 years. +SALE OF PRODUCTION PAYMENT INTEREST +In June 1999, the Company acquired a working interest in the Mobile Block 864 +Area where the Company already owned an interest. Concurrent with this +acquisition, the seller received a volumetric production payment, valued at +approximately $14.8 million, from production attributable to a portion of the +Company's interest in the area over a 39-month period. The Company recorded a +liability associated with the sale of this production payment interest because a +substantial obligation for future performance existed. Under the terms of the +sale, the Company was obligated to deliver the production volumes free and clear +of royalties, lease operating expenses, production taxes and all capital costs. +The production payment was amortized, beginning in June 1999, to oil and gas +sales on the units-of-production method as associated hydrocarbons were +delivered, and expired in July 2002. +NATURAL GAS IMBALANCES +The Company follows an entitlement method of accounting for its proportionate +share of gas production on a well-by-well basis, recording a receivable to the +extent that a well is in an "undertake" position and conversely recording a +liability to the extent that a well is in an "overtake" position. Imbalance +positions are not significant at December 31, 2002. +DERIVATIVES +The Company uses derivative financial instruments for price protection purposes +on a limited amount of its future production and does not use them for trading +purposes. Such derivatives were accounted for, prior to adoption of SFAS 133, as +hedges and have been recognized as an adjustment to oil and gas sales in the +period in which they are related. Current accounting treatment is under SFAS 133 +(see Note 6). +ACCOUNTS RECEIVABLE +Accounts receivable consists primarily of accrued oil and gas production +receivables. The balance in the reserve for doubtful accounts included in +accounts receivable was $143,000 and $68,000 at December 31, 2002 and 2001, +respectively. Net recoveries were $75,000 in 2002 and net charge offs were +$10,000 in 2001. There were no provisions to expense in the three-year period +ended December 31, 2002. +ACCOUNTS PAYABLE AND ACCRUED LIABILITIES TO BE REFINANCED +These amounts included in the Balance Sheet represent capital expenditures in +accounts payable and accrued liabilities that were refinanced with the +availability under the Credit Facility subsequent to December 31, 2002. Amounts +in 2001 were classified as short term because of the maturity of the Credit +Facility at December 31, 2001. See Footnote 5 for a discussion of the amendment +to the Credit Facility in June of 2001. +45 +STOCK BASED COMPENSATION +The Company accounts for its stock based compensation plans under the +recognition and measurement principles of APB Opinion No. 25, Accounting for +Stock Issued to Employees, and related Interpretations. See Footnote 10 for +descriptions and additional disclosures related to the plans. +MAJOR CUSTOMERS +Our production is sold generally on month-to-month contracts at prevailing +prices. The following table identifies customers to whom we sold a significant +percentage of our total oil and gas production during each of the twelve-month +periods ended: +DECEMBER 31, +------------ +2002 2001 2000 +---- ---- ---- +Adams Resources Marketing, Ltd. -- -- 14% +Petrocom Energy Group, Ltd. 4% -- -- +Dynegy 7% 8% -- +Prior Energy Corporation -- 20% -- +Reliant Energy Services 70% 49% 37% +Unocal Exploration Corporation -- -- 8% +Because alternative purchasers of oil and gas are readily available, we believe +that the loss of any of these purchasers would not result in a material adverse +effect on our ability to market future oil and gas production. +STATEMENTS OF CASH FLOWS +For purposes of the Consolidated Financial Statements, the Company considers all +highly liquid investments purchased with an original maturity of three months or +less to be cash equivalents. +The Company paid no federal income taxes for the three years ended December 31, +2002. During the years ended December 31, 2002, 2001 and 2000, the Company made +cash payments for interest of $25,507,000, $16,441,000 and $11,449,000 +respectively. +PER SHARE AMOUNTS +Basic income or loss per common share was computed by dividing net income or +loss by the weighted average number of shares of common stock outstanding during +the year. Diluted income or loss per common share was determined on a weighted +average basis using common shares issued and outstanding adjusted for the effect +of stock options considered common stock equivalents computed using the treasury +stock method. The conversion of the preferred stock was not included in any +annual calculation due to its antidilutive effect on diluted income or loss per +common share. +46 +A reconciliation of the basic and diluted per share computation is as follows +(in thousands, except per share amounts): +2002 2001 2000 +---------- ---------- ---------- +(a) Net income (loss) available for common stock $ (2,948) $ 539 $ 10,144 +Preferred dividends assuming conversion of +preferred stock (if dilutive) -- -- -- +(b) Income (loss) available for common stock assuming +conversion of preferred stock (if dilutive) $ (2,948) $ 539 $ 10,144 +(c) Weighted average shares outstanding 13,387 13,273 12,420 +Dilutive impact of stock options -- 27 325 +Dilutive impact of warrants -- 66 -- +Convertible preferred stock (if dilutive) -- -- -- +(d) Total diluted shares 13,387 13,366 12,745 +Stock options and warrants excluded due to +antidilutive impact 2,945 1,438 150 +Basic income (loss) per share (a/c) $ (.22) $ .04 $ .82 +Diluted income (loss) per share (b/d) $ (.22) $ .04 $ .80 +FAIR VALUE OF FINANCIAL INSTRUMENTS +Fair value of cash, cash equivalents, accounts receivable, accounts payable, the +capital lease and the Credit Facility approximates book value at December 31, +2002 and 2001. Fair value of long-term debt (specifically, the 10.125%, the +10.25%, the 11% Senior Subordinated Notes and the 12% Senior Notes) have an +estimated fair value of between 84% and 86% of face value at December 31, 2002. +3. INCOME TAXES +The Company follows the asset and liability method of accounting for deferred +income taxes prescribed by Statement of Financial Accounting Standards No. 109 +("SFAS 109") "Accounting for Income Taxes". The statement provides for the +recognition of a deferred tax asset for deductible temporary timing differences, +capital and operating loss carryforwards, statutory depletion carryforward and +tax credit carryforwards, net of a "valuation allowance". The valuation +allowance is provided for that portion of the asset, for which it is deemed more +likely than not, that it will not be realized. The Company's management +determined that no valuation allowance was required in 2002 or 2001. +Accordingly, the Company has recorded a deferred tax asset at December 31, 2002 +and 2001 as follows: +47 +DECEMBER 31, +------------ +2002 2001 +---------- ---------- +(IN THOUSANDS) +Federal net operating loss carryforwards $ 42,464 $ 29,723 +Statutory depletion carryforward 4,251 4,184 +Temporary differences: +Oil and gas properties (39,159) (28,685) +Pipeline and other facilities (299) (1,822) +Non-oil and gas property (30) (62) +Other 1,540 1,061 +---------- ---------- +Total tax asset 8,767 4,399 +Valuation allowance -- -- +---------- ---------- +Net tax asset $ 8,767 $ 4,399 +========== ========== +At December 31, 2002, the Company had, for federal tax reporting purposes, net +operating loss carryforwards of $121.3 million, which expire in 2003 through +2017. Net operating loss carryforwards includes approximately $1.4 million of +the total that will expire within the next five years including approximately $1 +million in 2003. Additionally, the Company had available for tax reporting +purposes $12.0 million in statutory depletion deductions, which can be carried +forward for an indefinite period. No valuation allowance has been provided +against these carryforwards because management believes that it is more likely +than not they will be realized. However, realization is not assured. +The Company has significant state net operating loss carryforwards that are not +included in the deferred tax asset above, as the Company does not anticipate +generating taxable state income in the states in which these loss carryforwards +apply. The Company has very limited state taxable income as primarily all of its +revenue is generated in federal waters not subject to state income taxes. +The provision for income taxes at the Company's effective tax rate approximated +the provision for income taxes at the statutory rate. +4. OTHER COMPREHENSIVE INCOME +The Company did not have any items of other comprehensive income prior to 2001. +A recap of the Company's 2002 and 2001 comprehensive income (net of tax) is +shown below (in thousands): +YEARS ENDED DECEMBER, +------------------------ +2002 2001 +---------- ---------- +Other comprehensive income (loss): +Cumulative effect of change in +accounting principle $ -- $ (3,764) +Change in unrealized derivatives' +fair value (469) 9,735 +Amortization of Enron derivatives (5,971) -- +---------- ---------- +Total other comprehensive income (loss) $ (6,440) $ 5,971 +========== ========== +48 +5. LONG-TERM DEBT +Long-term debt consisted of the following at: +DECEMBER 31, +------------ +2002 2001 +------------ ------------ +(IN THOUSANDS) +Credit Facility $ 65,000 $ 100 +Senior Notes, net of discount 87,020 84,366 +10.125% Senior Subordinated Notes (due 2004), +net of discount 20,086 36,000 +10.25% Senior Subordinated Notes (due 2004) 40,000 40,000 +11% Senior Subordinated Notes (due 2005) 33,000 33,000 +Capital lease 4,483 5,612 +------------ ------------ +249,589 199,078 +Less: current portion 1,320 37,345 +------------ ------------ +$ 248,269 $ 161,733 +============ ============ +The Company negotiated its Credit Facility effective October 31, 2000 with First +Union National Bank. Borrowings under the Credit Facility are secured by +mortgages covering substantially all of the Company's producing oil and gas +properties. On June 30, 2002, the Company amended the Credit Facility to +increase availability under the revolving borrowing base from $50 million to $75 +million under a dual tranche loan. The Tranche A revolver bears interest at +0.25% to 0.75% above a defined base rate depending on utilization of the +borrowing base or, at the option of the Company, LIBOR plus 2% to 2.5% based on +utilization of the borrowing base and has a maximum aggregate credit amount of +$45 million. The range of interest rates on the Tranche A revolver was 3.36% to +5.25% for the twelve months ended December 31, 2002. The Tranche B part of the +facility will bear interest at 15% and has an aggregate maximum credit amount of +$30 million. The amended Credit Facility contains substantially the same +covenants as the original Credit Facility. The weighted average interest rate +for the Credit Facility debt outstanding at December 31, 2002 and 2001 was 9.00% +and 4.75%, respectively. Under the Credit Facility, a commitment fee of 0.25% or +0.375% per annum, depending on the amount of the unused portion of the borrowing +base, is payable quarterly. The maturity date of the Credit Facility is June 30, +2004 and the $75 million borrowing base is subject to semi-annual +re-determinations in April and October of each year. +On September 15, 2002, $36 million of the Company's 10.125% Senior Subordinated +Notes ("Notes")that were issued on July 31, 1997, were due. The holders of $22.9 +million of the Notes consented to an extension of such Notes until July 31, +2004. The Company granted 274,980 warrants (with a fair market value of +approximately $1.3 million) to purchase Common Stock of the Company and paid +consent fees in the amount of $2.3 million to the holders of the Notes that +granted the extensions. The warrants have a term of five years and an exercise +price of $0.01. The holders of the Notes had exercised approximately 116,000 +warrants as of December 31, 2002. The holders of the Notes that did not consent +to the extension were paid on the maturity date in September 2002. Interest on +the Notes is payable quarterly, on March 15, June 15, September 15, and December +15 of each year. +The Company accounted for the extension of the $22.9 million in Notes described +above as an extinguishment of the Notes and the issuance of new securities +recorded at a fair value of $19.3 million. +49 +The net loss on extinguishment, including the warrants and fees paid described +above was not significant. Costs deferred with the extensions will be amortized +through July 2004. +On July 15, 1999, the Company completed the sale of $40 million of Senior +Subordinated Notes due 2004 at 10.25%. The net proceeds of approximately $38.2 +million were used to pay down the Credit Facility at that time. These notes are +not entitled to any mandatory sinking fund payments and are subject to +redemption at the Company's option at par plus unpaid interest at any time after +March 15, 2001. The notes are listed on the New York Stock Exchange under the +symbol "CPE 04" and are subject to a change of control clause that obligates the +Company to repurchase the notes for 101% of par should a change of control +occur. Interest is paid quarterly. +The Company completed the sale of $33 million of 11% Senior Subordinated Notes +due 2005, on October 26, 2000. The Company netted $31.5 million from the +offering after deducting the underwriters' discount and offering expenses. +Approximately $20.8 million of the net proceeds from the offering were used to +purchase a portion of the Company's outstanding 10% Senior Subordinated Notes +due 2001 in conjunction with a tender offer. The Company redeemed the remaining +$3.4 million of its 10% Senior Subordinated Notes due 2001 not tendered in the +offer. +In July 2001, the Company entered into a $95 million multiple advance term loan +("Senior Notes") with a private lender. The Company issued $45 million of 12% +Senior Notes upon closing of the loan and issued the remaining $50 million of +Senior Notes in December 2001. Under the terms of the agreement Callon also +issued warrants to purchase, at a nominal exercise price, 265,210 shares of its +common stock (fair value of $3.1 million) and conveyed an overriding royalty +interest equal to 2% of the Company's net interest in four existing deepwater +discoveries (fair value of $5.9 million). The warrants and the overriding +royalty interest were earned by the lender based on the ratio of the amount of +the loan proceeds advanced to the total loan facility amount. The Senior Notes +will mature March 31, 2005, have an effective interest rate of approximately 16% +and contain restrictions on certain types of future indebtedness. +In December 2001, the Company entered into a ten-year gas processing agreement +associated with a production facility on Callon's Mobile 952 field with Hanover +Compression Limited Partnership, which is being accounted for as a capital +lease. Total minimum obligations are $8.4 million with interest representing +approximately $2.8 million and the present value minimum obligations were $5.6 +million ($1.2 million current). +Future minimum lease payments and debt maturities (in thousands) are as follows: +CAPITAL LEASE +YEAR PAYMENTS DEBT +---------------- ------------- ------------ +2003 $ 1,998 $ -- +2004 1,890 128,000 +2005 822 128,000 +2006 439 -- +2007 348 -- +Thereafter 923 -- +The Credit Facility, the subordinated debt and the Senior Notes contain various +covenants including restrictions on additional indebtedness and payment of cash +dividends as well as maintenance of certain financial ratios. The Company is in +compliance with these covenants at December 31, 2002. +50 +6. DERIVATIVES +The Company periodically uses derivative financial instruments to manage oil and +gas price risk. Settlements of gains and losses on commodity price contracts are +generally based upon the difference between the contract price or prices +specified in the derivative instrument and a NYMEX price or other cash or +futures index price. As a result of these contracts, there was no effect on oil +and gas revenue during 2002 and in 2001, $1,371,000 was recognized as additional +oil and gas revenue. +In 2002, the Company purchased and sold various put options and call options and +elected not to designate these derivative financial instruments as accounting +hedges and accordingly, accounted for these contracts under mark-to-market +accounting. Year-to-date charges to income were $708,000. +During 2002, the Company entered into no-cost natural gas collar contracts in +effect for February 2003 through October 2003. These agreements are for volumes +of 275,000 Mcf per month with an average ceiling price of $4.79 and a floor +price of $3.52. These contracts are accounted for as cash flow hedges under SFAS +133. The fair value of these collar contracts at December 31, 2002, recorded on +the balance sheet is $721,350 and $468,878 (net of tax) as other comprehensive +income. +In April 2001, the Company entered into derivative contracts for 2002 production +with Enron North America Corp. These agreements are for average gas volumes of +approximately 600,000 Mcf per month in 2002 with a weighted average ceiling +price of $6.09 and floor price of $4.11. Enron North America Corp. filed for +protection under the bankruptcy laws in late 2001. As a result of the credit +risk associated with the derivatives with Enron North America Corp., hedge +accounting was not available due to ineffectiveness as of September 30, 2001 and +the contracts at December 31, 2001 were marked to the market. In the fourth +quarter of 2001, the Company charged to expense (non-cash) $9.2 million related +to these Enron North America Corp. derivatives. The Company has no other +contracts with Enron or its subsidiaries. +The $5,971,000 (net of tax) recorded in other comprehensive income at December +31, 2001 is related to the fair value as of September 30, 2001 of the natural +gas collar contracts with Enron North America Corp., which matured in 2002. As +the contracts matured, the Company recorded non-cash revenue each month, +offsetting the amounts in other comprehensive income related to the derivatives. +The Company recorded approximately $1.7 million related to these Enron +derivatives in the fourth quarter of 2002 and $9.2 million for the year ended +December 31, 2002 as oil and gas revenue. +In the second quarter of 2002, the Company completed the sale of its claim +against Enron for hedging transactions for $2.5 million in cash. As a result of +the sale, the Company reported a pre-tax gain of $2.5 million in the second +quarter of 2002. +The Company has no other derivative contracts. +51 +7. COMMITMENTS AND CONTINGENCIES +As described in Note 9, abandonment trusts (the "Trusts") have been established +for future abandonment obligations of those oil and gas properties of the +Company burdened by a net profits interest. The management of the Company +believes the Trusts will be sufficient to offset those future abandonment +liabilities; however, the Company is responsible for any abandonment expenses in +excess of the Trusts' balances. As of December 31, 2002, total estimated site +restoration, dismantlement and abandonment costs were approximately $6,896,000, +net of expected salvage value. Substantially all such costs are expected to be +funded through the Trusts' funds, all of which will be accessible to the Company +when abandonment work begins. In addition, as a working interest owner and/or +operator of oil and gas properties, the Company is responsible for the cost of +abandonment of such properties. See Note 2. +From time to time, the Company, as part of the Consolidation and other capital +transactions, entered into Registration Rights Agreements whereby certain +parties to the transactions are entitled to require the Company to register +Common Stock of the Company owned by them with the Securities and Exchange +Commission for sale to the public in firm commitment public offerings and +generally to include shares owned by them, at no cost, in registration +statements filed by the Company. Costs of the offering will not include broker's +discounts and commissions, which will be paid by the respective sellers of the +Common Stock. +The Company is involved in various claims and lawsuits incidental to its +business. In the opinion of management, the ultimate liability thereunder, if +any, will not have a material adverse effect on the financial position or +results of operations of the Company. +The Company's activities are subject to federal, state and local laws and +regulations governing environmental quality and pollution control. Although no +assurances can be made, the Company believes that, absent the occurrence of an +extraordinary event, compliance with existing federal, state and local laws, +rules and regulating the release of materials in the environment or otherwise +relating to the protection of the environment will not have a material effect +upon the capital expenditures, earnings or the competitive position of the +Company with respect to its existing assets and operations. The Company cannot +predict what effect additional regulation or legislation, enforcement polices +thereunder, and claims for damages to property, employees, other persons and the +environment resulting from the Company's operations could have on its +activities. +52 +8. OIL AND GAS PROPERTIES +The following table discloses certain financial data relating to the Company's +oil and gas activities, all of which are located in the United States. +YEARS ENDED DECEMBER 31, +------------------------ +2002 2001 2000 +---------- ---------- ---------- +(IN THOUSANDS) +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance $ 704,937 $ 589,549 $ 511,689 +Property acquisition costs 1,471 1,713 3,211 +Exploration costs 17,851 85,782 51,837 +Development costs 43,151 34,980 25,242 +Sale of mineral interests (4,492) (7,087) (2,430) +---------- ---------- ---------- +End of period balance $ 762,918 $ 704,937 $ 589,549 +========== ========== ========== +Unevaluated Properties (excluded from +amortization) - +Beginning of period balance $ 37,560 $ 47,653 $ 44,434 +Additions 5,802 8,760 9,417 +Capitalized interest 5,289 4,879 4,548 +Transfers to evaluated (7,654) (23,732) (10,746) +---------- ---------- ---------- +End of period balance $ 40,997 $ 37,560 $ 47,653 +========== ========== ========== +Accumulated depreciation, depletion +and amortization +Beginning of period balance $ 399,339 $ 378,589 $ 361,758 +Provision charged to expense 26,915 20,750 16,831 +---------- ---------- ---------- +End of period balance $ 426,254 $ 399,339 $ 378,589 +========== ========== ========== +Unevaluated property costs, primarily lease acquisition costs incurred at +federal lease sales, unevaluated drilling costs, capitalized interest and +general and administrative costs being excluded from the amortizable evaluated +property base consisted of $9.4 million incurred in 2002, $7.5 million incurred +in 2001 and $24.1 million incurred in 2000 and prior. These costs are directly +related to the acquisition and evaluation of unproved properties and major +development projects. The excluded costs and related reserves are included in +the amortization base as the properties are evaluated and proved reserves are +established or impairment is determined. The Company expects that the majority +of these costs will be evaluated over the next three to five year period. +Depletion per unit-of-production (thousand cubic feet of gas equivalent) +amounted to $1.73, $1.37 and $1.10 for the years ended December 31, 2002, 2001, +and 2000, respectively. +Under the full cost accounting rules of the SEC, the Company reviews the +carrying value of its proved oil and gas properties each quarter. Under these +rules, capitalized costs of proved oil and gas properties net of accumulated +depreciation, depletion and amortization (DD&A) and deferred income taxes, may +not exceed the present value of estimated future net cash flows from proved oil +and gas reserves, discounted at 10 percent, plus the lower of cost or fair value +of unproved properties included in the costs being amortized, net of related tax +effects. These rules generally require pricing future oil and gas production at +the unescalated market price for oil and gas at the end of each fiscal quarter +and require a write-down if the "ceiling" is exceeded, unless prices recover +sufficiently before the date of the auditor's report. Given the volatility of +oil and gas prices, it is reasonably possible that the Company's estimate of +discounted future net cash flows from proved oil and gas reserves could change +in the near term. If oil and gas priced decline significantly, even if only for +a short period of time, it is possible that writedowns of oil and gas properties +could occur in the future. +53 +9. NET PROFITS INTEREST +From 1989 through 1994, the Constituent Entities entered into separate +agreements to purchase certain oil and gas properties with gross contract +acquisition prices of $170,000,000 ($150,000,000 net as of closing dates) and in +simultaneous transactions, entered into agreements to sell overriding royalty +interests ("ORRI") in the acquired properties. These ORRI are in the form of net +profits interests ("NPI") equal to a significant percentage of the excess of +gross proceeds over production costs, as defined, from the acquired oil and gas +properties. A net deficit incurred in any month can be carried forward to +subsequent months until such deficit is fully recovered. The Company has the +right to abandon the purchased oil and gas properties if it deems the properties +to be uneconomical. +The Company has, pursuant to the purchase agreements, created abandonment trusts +whereby funds are provided out of gross production proceeds from the properties +for the estimated amount of future abandonment obligations related to the +working interests owned by the Company. The Trusts are administered by unrelated +third party trustees for the benefit of the Company's working interest in each +property. The Trust agreements limit their funds to be disbursed for the +satisfaction of abandonment obligations. Any funds remaining in the Trusts after +all restoration, dismantlement and abandonment obligations have been met will be +distributed to the owners of the properties in the same ratio as contributions +to the Trusts. The Trusts' assets are excluded from the Consolidated Balance +Sheets of the Company because the Company does not control the Trusts. Estimated +future revenues and costs associated with the NPI and the Trusts are also +excluded from the oil and gas reserve disclosures at Note 12. As of December 31, +2002 and 2001, the Trusts' assets (all cash and investments) totaled $6,896,000 +and $6,567,000 respectively, all of which will be available to the Company to +pay its portion, as working interest owner, of the restoration, dismantlement +and abandonment costs discussed at Note 7. FAS 143, discussed in Footnote 2, +will require the Abandonment Trusts' assets and the associated abandonment +liability to be recorded in the balance sheet effective January 1, 2003. The +Company does not expect to record any income or loss associated with the Trust +asset or abandonment liability as a result of adoption of FAS 143. +At the time of acquisition of properties by the Company, the property owners +estimated the future costs to be incurred for site restoration, dismantlement +and abandonment, net of salvage value. A portion of the amounts necessary to pay +such estimated costs was deposited in the Trusts upon acquisition of the +properties, and the remainder is deposited from time to time out of the proceeds +from production. The determination of the amount deposited upon the acquisition +of the properties and the amount to be deposited as proceeds from production was +based on numerous factors, including the estimated reserves of the properties. +The amounts deposited in the Trusts upon acquisition of the properties were +capitalized by the Company as oil and gas properties. +As operator, the Company receives all of the revenues and incurs all of the +production costs for the purchased oil and gas properties but retains only that +portion applicable to its net ownership share. As a result, the payables and +receivables associated with operating the properties included in the Company's +Consolidated Balance Sheets include both the Company's and all other outside +owners' shares. However, revenues and production costs associated with the +acquired properties reflected in the accompanying Consolidated Statements of +Operations represent only the Company's share, after reduction for the NPI. +10. EMPLOYEE BENEFIT PLANS +The Company has adopted a series of incentive compensation plans designed to +align the interest of the executives and employees with those of its +stockholders. The following is a brief description of each plan: +The Savings and Protection Plan provides employees with the option to +defer receipt of a portion of their compensation and the Company may, +at its discretion, match a portion of the +54 +employee's deferral with cash and Company Common Stock. The Company may +also elect, at its discretion, to contribute a non-matching amount in +cash and Company Common Stock to employees. The amounts held under the +Savings and Protection Plan are invested in various funds maintained by +a third party in accordance with the directions of each employee. An +employee is fully vested, including Company discretionary +contributions, immediately upon participation in the Savings and +Protection Plan. The total amounts contributed by the Company, +including the value of the common stock contributed, were $611,000, +$595,000 and $500,000 in the years 2002, 2001 and 2000, respectively. +The 1994 Stock Incentive Plan (the "1994 Plan"), approved by the +shareholder's in 1994, provides for 600,000 shares of Common Stock to +be reserved for issuance pursuant to such plan. Under the 1994 Plan, +the Company may grant both stock options qualifying under Section 422 +of the Internal Revenue Code and options that are not qualified as +incentive stock options, as well as performance shares. These options +have an expiration date 10 years from date of grant. +On August 23, 1996, the Board of Directors of the Company approved and +adopted the Callon Petroleum Company 1996 Stock Incentive Plan (the +"1996 Plan"). The 1996 Plan was approved by the shareholders in 1997 +and provides for the same types of awards as the 1994 Plan and is +limited to a maximum of 1,200,000 shares (as amended from the original +900,000 shares) of common stock that may be subject to outstanding +awards. Unvested options are subject to forfeiture upon certain +termination of employment events and expire 10 years from date of +grant. +The Company granted 533,000 stock options to employees on March 23, +2000 and 120,000 stock options to directors on July 25, 2000 at $10.50 +per share. The March 23, 2000 grant was subject to shareholder approval +of an amendment to the 1996 Stock Incentive Plan. The amendment, which +was approved on May 9, 2000 at the Annual Meeting of Shareholders, +increased the number of shares reserved for issuance under the 1996 +plan to 2,200,000 shares. The excess of the market price over the +exercise price on the approval date of the amendment is amortized over +the three-year vesting period of the options. Compensation costs of +$416,000, $611,000 and $801,000 were recognized in 2002, 2001 and 2000 +respectively related to these options. +On February 14, 2002, the Board of Directors of the Company approved +and adopted the 2002 Stock Incentive Plan (the "2002 Plan"). Pursuant +to the 2002 Plan, 350,000 shares of common stock shall be reserved for +issuance upon the exercise of options or for grants of stock options, +stock appreciation rights or units, bonus stock, or performance shares +or units. This Plan qualifies as a "broadly based" plan under the +provisions of the New York Stock Exchanges rules and regulations and +therefore did not require shareholder approval. Because the 2002 Plan +is a broadly based plan, the aggregate number of shares underlying +awards granted to officer and directors cannot exceed 50% of the total +number of shares underlying the awards granted to all employees during +any three-year period. +In 2002, the Company awarded 300,000 shares of restricted stock from +the 1996 and the 2002 Plan and 70,500 from treasury shares to be issued +as vested. The issuance of the restricted stock using treasury shares +did not require shareholder approval pursuant to the New York Stock +Exchange's rules and regulations, and therefore shareholder approval +was not sought. These shares will generally vest to the recipients over +a three-year period (one-third in each year) +55 +beginning in November 2002. The deferred compensation portion of this +grant will be amortized to expense over the vesting period. The +non-cash amortization expense in 2002 was $496,000. +In 1997, the Board of Directors authorized the implementation of the +Callon Petroleum Company 1997 Employee Stock Purchase Plan (the "1997 +Purchase Plan"), which was approved by the Company's shareholders at +the 1997 Annual Meeting. The Plan provides eligible employees of the +Company with the opportunity to acquire a proprietary interest in the +Company through participation in a payroll deduction-based employee +stock purchase plan. An aggregate of 250,000 shares of Common Stock +have been reserved for issuance over the ten-year term of the 1997 +Purchase Plan. The purchase price per share at which Common Stock will +be purchased on the participant's behalf on each purchase date within +an offering period is equal to eighty-five percent of the fair market +value per share of Common Stock. +The Company accounts for the options issued pursuant to the stock incentive +plans under APB Opinion No. 25, under which no compensation cost has been +recognized unless the exercise price is less than the market price at the +measurement date. Had compensation cost for these plans been determined +consistent with Statement of Financial Accounting Standards No. 123 ("SFAS +123"), "Accounting for Stock-Based Compensation", the Company's net income and +earnings per common share would have been reduced to the following pro forma +amounts: +2002 2001 2000 +-------- ------- --------- +(IN THOUSANDS, EXCEPT PER SHARE DATA) +Net income (loss), as reported $ (2,948) $ 539 $ 10,144 +Deduct total stock-based employee +Compensation expense under fair +value based method, net of tax 637 1,378 1,726 +Pro forma net income (loss) (3,585) (839) 8,418 +Basic earnings (loss) per share: As Reported (.22) .04 .82 +Pro Forma (.27) (.06) .68 +Diluted earnings (loss) per share: As Reported (.22) .04 .80 +Pro Forma (.27) (.06) .66 +56 +A summary of the status of the Company's stock option plans for the three most +recent years and changes during the years then ended is presented in the table +and narrative below: +2002 2001 2000 +--------------------------- --------------------------- ---------------------------- +WTD AVG WTD AVG WTD AVG +SHARES EX PRICE SHARES EX PRICE SHARES EX PRICE +------------ ------------ ------------ ------------ ------------ ------------ +Outstanding, beginning of year 2,332,667 $ 10.84 2,304,167 $ 10.83 1,536,500 $ 10.60 +Granted (at market) 310,000 4.45 30,000 11.61 135,000 14.73 +Granted (below market) -- -- -- -- 653,000 10.50 +Exercised -- -- (1,500) 9.00 (20,333) 9.00 +Forfeited (122,250) 14.10 -- -- -- -- +Expired -- -- -- -- -- -- +------------ ------------ ------------ ------------ ------------ ------------ +Outstanding, end of year 2,520,417 $ 9.90 2,332,667 $ 10.84 2,304,167 $ 10.83 +============ ============ ============ ============ ============ ============ +Exercisable, end of year 2,224,334 $ 10.57 2,057,977 $ 10.80 1,647,657 $ 10.71 +============ ============ ============ ============ ============ ============ +Weighted average fair value of +options granted (at market) $ 2.44 $ 5.80 $ 7.68 +============ ============ ============ +Weighted average fair value of +options granted (below market) N/A N/A $ 7.90 +============ +The following table sets forth additional information regarding options +outstanding at December 31, 2002. Contractual life and exercise prices represent +weighted averages for options outstanding and options exercisable. +Options Outstanding Options Exercisable +------------------------------------------ -------------------------- +Range of Number Contractual Exercise Number Exercise +exercise prices Outstanding Life (years) Price Exercisable Price +-------------------- ----------- ------------- -------- ----------- --------- +$ 3.70 to $ 6.41 297,750 9.6 $ 4.38 31,667 $ 6.07 +$ 9.00 to $ 12.28 2,157,667 4.9 $ 10.53 2,127,667 $ 10.53 +$ 13.56 to $ 15.31 65,000 5.3 $ 14.16 65,000 $ 14.16 +The fair value of each option grant is estimated on the date of grant using the +Black-Scholes option pricing model with the following weighted average +assumptions used for options granted during the years presented are as follows: +2002 2001 2000 +------ ------ ------ +Risk free interest rate 3.7% 4.5% 6.3% +Expected life (years) 5.0 5.0 5.0 +Expected volatility 61.0% 43.9% 52.1% +Expected dividends -- -- -- +11. EQUITY TRANSACTIONS +In November 1995, the Company sold 1,315,500 shares of $2.125 Convertible +Exchangeable Preferred Stock, Series A (the "Preferred Stock") for net proceeds +of $30.9 million. Annual dividends are $2.125 per share and are cumulative. The +net proceeds of the $.01 par value stock after underwriters discount and expense +was $30,899,000. Each share has a liquidation preference of $25.00, plus accrued +and unpaid dividends. Dividends on the Preferred Stock are cumulative from the +date of issuance and are payable quarterly, commencing January 15, 1996. The +Preferred Stock is convertible at any time, at the option of +57 +the holders thereof, unless previously redeemed, into shares of Common Stock of +the Company at an initial conversion price of $11 per share of Common Stock, +subject to adjustments under certain conditions. +The Preferred Stock is redeemable at any time on or after December 31, 1998, in +whole or in part at the option of the Company at a redemption price of $26.488 +per share beginning at December 31, 1998 and at premiums declining to the $25.00 +liquidation preference by the year 2005 and thereafter, plus accrued and unpaid +dividends. The Preferred Stock is also exchangeable, in whole, but not in part, +at the option of the Company on or after January 15, 1998 for the Company's 8.5% +Convertible Subordinated Debentures due 2010 (the "Debentures") at a rate of +$25.00 principal amount of Debentures for each share of Preferred Stock. The +Debentures will be convertible into Common Stock of the Company on the same +terms as the Preferred Stock and will pay interest semi-annually. +In a December 1998 private transaction, a preferred stockholder elected to +convert 59,689 shares of Preferred Stock into 136,867 shares of the Company's +Common Stock. In 1999 certain other preferred stockholders, through private +transactions, agreed to convert 210,350 shares of Preferred Stock into 502,637 +shares of the Company's Common Stock under similar terms. Likewise in 2000, +444,600 shares of Preferred Stock were converted into 1,036,098 shares of the +Company's Common Stock. Any non-cash premium negotiated in excess of the +conversion rate was recorded as additional preferred stock dividends and +excluded from the Consolidated Statements of Cash Flows. +In November of 1999, the Company sold 3,680,000 shares of Common Stock in a +public offering at a price to the public of $11.875 per share. Cash proceeds +received by the Company were $41.1 million net of underwriting discount and +offering costs. +In 2001, under the terms of the $95 million multiple advance loans, the Company +issued warrants to purchase, at a nominal exercise price, 265,210 shares of its +common stock. See Note 5. +The Company adopted a stockholder rights plan on March 30, 2000, designed to +assure that the Company's stockholders receive fair and equal treatment in the +event of any proposed takeover of the Company and to guard against partial +tender offers, squeeze-outs, open market accumulations, and other abusive +tactics to gain control without paying all stockholders a fair price. The rights +plan was not adopted in response to any specific takeover proposal. Under the +rights plan, the Company declared a dividend of one right ("Right") on each +share of the Company's Common Stock. Each Right will entitle the holder to +purchase one one-thousandth of a share of a Series B Preferred Stock, par value +$0.01 per share, at an exercise price of $90 per one one-thousandth of a share. +The Rights are not currently exercisable and will become exercisable only in the +event a person or group acquires, or engages in a tender or exchange offer to +acquire, beneficial ownership of 15 percent or more (one existing stockholder +was granted an exception for up to 21 percent) of the Company's Common Stock. +After the Rights become exercisable, each Right will also entitle its holder to +purchase a number of common shares of the Company having a market value of twice +the exercise price. The dividend distribution was made to stockholders of record +at the close of business on April 10, 2000. The Rights will expire on March 30, +2010. +58 +12. SUPPLEMENTAL OIL AND GAS RESERVE DATA (UNAUDITED) +The Company's proved oil and gas reserves at December 31, 2002, 2001 and 2000 +have been estimated by independent petroleum consultants in accordance with +guidelines established by the Securities and Exchange Commission ("SEC"). +Accordingly, the following reserve estimates are based upon existing economic +and operating conditions. These estimates have been adjusted (per SEC +guidelines) to exclude the volumetric production payment described in Note 2. +There are numerous uncertainties inherent in establishing quantities of proved +reserves. The following reserve data represent estimates only and should not be +construed as being exact. In addition, the standard measure of discounted future +net cash flows should not be construed as the current market value of the +Company's oil and gas properties or the cost that would be incurred to obtain +equivalent reserves. +In October 2002, we received a letter from the SEC regarding our Annual Report +on Form 10-K for the year ended December 31, 2001 requesting supplemental +information concerning our operations in the Gulf of Mexico. The comment letters +requested information about the procedures we used to classify our deepwater +reserves as proved and requested that our financials be restated to reflect the +removal of the Boomslang reserves as proved for all prior periods during which +such reserves were reported as proved. We have reviewed the SEC comments with +our independent petroleum reserve engineers, Huddleston & Co., Inc. of Houston, +Texas. Both Huddleston & Co. and Callon believe that such deepwater reserves are +properly classified as proved. If the SEC requires us to retroactively classify +Boomslang as an unproved property through December, 2002, we would be required +to restate our financial position, results of operations, and supplemental oil +and gas reserve data from 1998 through 2002. +59 +ESTIMATED RESERVES +Changes in the estimated net quantities of crude oil and natural gas reserves, +all of which are located onshore and offshore in the continental United States, +are as follows: +RESERVE QUANTITIES +YEARS ENDED DECEMBER 31, +-------------------------------------------- +2002 2001 2000 +------------ ------------ ------------ +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period 30,209 33,382 23,834 +Revisions to previous estimates (5,951) (2,290) 85 +Purchase of reserves in place -- -- -- +Sales of reserves in place -- (624) -- +Extensions and discoveries 11 14 9,695 +Production (226) (273) (232) +------------ ------------ ------------ +End of period 24,043 30,209 33,382 +============ ============ ============ +Natural Gas (MMcf): +Beginning of period 120,299 129,922 110,621 +Revisions to previous estimates (17,279) (4,578) (4,817) +Purchase of reserves in place -- -- 347 +Sales of reserves in place -- (1,296) -- +Extensions and discoveries 1,579 7,483 35,387 +Production (13,060) (11,232) (11,616) +------------ ------------ ------------ +End of period 91,539 120,299 129,922 +============ ============ ============ +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period 885 2,192 1,376 +============ ============ ============ +End of period 1,056 885 2,192 +============ ============ ============ +Natural Gas (MMcf): +Beginning of period 51,221 63,982 76,295 +============ ============ ============ +End of period 37,631 51,221 63,982 +============ ============ ============ +STANDARDIZED MEASURE +The following tables present the Company's standardized measure of discounted +future net cash flows and changes therein relating to proved oil and gas +reserves and were computed using reserve valuations based on regulations +prescribed by the SEC. These regulations provide that the oil, condensate and +gas price structure utilized to project future net cash flows reflects current +prices (approximately $4.80 per Mcf for natural gas and $34.22 per Bbl for oil +for the 2002 disclosures, $2.58 per Mcf and $20.10 per Bbl for 2001 disclosures, +and $9.14 per Mcf and $26.71 per Bbl for 2000 disclosures) at each date +presented and have not been escalated. Future production, development and net +abandonment costs are based on current costs +60 +without escalation. The resulting net future cash flows have been discounted to +their present values based on a 10% annual discount factor. +STANDARDIZED MEASURE +YEARS ENDED DECEMBER 31, +------------------------ +2002 2001 2000 +-------------- -------------- -------------- +Future cash inflows $ 1,261,571 $ 883,145 $ 2,080,680 +Future costs - +Production (165,559) (220,857) (284,667) +Development and net abandonment (125,813) (191,369) (217,507) +-------------- -------------- -------------- +Future net inflows before income taxes 970,199 470,919 1,578,506 +Future income taxes (119,020) (30,315) (472,637) +-------------- -------------- -------------- +Future net cash flows 851,179 440,604 1,105,869 +10% discount factor (295,133) (185,747) (434,672) +-------------- -------------- -------------- +Standardized measure of discounted +future net cash flows $ 556,046 $ 254,857 $ 671,197 +============== ============== ============== +CHANGES IN STANDARDIZED MEASURE +YEARS ENDED DECEMBER 31, +------------------------ +2002 2001 2000 +------------ ------------ ------------ +(IN THOUSANDS) +Standardized measure - beginning of period $ 254,857 $ 671,197 $ 256,322 +Sales and transfers, net of production costs (38,375) (45,672) (42,132) +Net change in sales and transfer prices, +net of production costs 401,837 (604,391) 361,179 +Exchange and sale of in place reserves -- (5,850) -- +Purchases, extensions, discoveries, and improved +recovery, net of future production and +development costs incurred 8,456 9,358 276,770 +Revisions of quantity estimates (103,452) (23,314) (12,399) +Accretion of discount 26,915 90,978 28,581 +Net change in income taxes (53,608) 224,290 (209,090) +Changes in production rates, timing and other 59,416 (61,739) 11,966 +------------ ------------ ------------ +Standardized measure - end of period $ 556,046 $ 254,857 $ 671,197 +============ ============ ============ +61 +13. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) +FIRST SECOND THIRD FOURTH +QUARTER QUARTER QUARTER QUARTER +------------ ------------ ------------ ------------ +(IN THOUSANDS, EXCEPT PER SHARE DATA) +2002 +---- +Total revenues $ 11,624 $ 20,489 $ 15,786 $ 19,209 +Total costs and expenses 15,399 16,888 17,786 19,606 +Income tax expense (benefit) (1,321) 1,260 (700) (139) +Net income (loss) (2,454) 2,341 (1,300) (258) +Net income per share-basic (0.21) 0.15 (0.12) (0.04) +Net income per share-diluted (0.21) 0.15 (0.12) (0.04) +2001 +---- +Total revenues $ 20,812 $ 17,712 $ 12,715 $ 10,513 +Total costs and expenses 11,314 12,398 12,311 22,936 +Income tax expense (benefit) 3,324 1,860 142 (4,349) +Net income 6,174 3,454 262 (8,074) +Net income per share-basic 0.44 0.24 0.00 (0.63) +Net income per share-diluted 0.41 0.23 0.00 (0.63) +62 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND +FINANCIAL DISCLOSURE +As reported in our Current Report on Form 8-K dated June 28, 2002, in June 2002, +the Board of Directors of the company approved the engagement of Ernst & Young +LLP as its independent auditors for the fiscal year ending December 31, 2002 to +replace Arthur Andersen LLP, who were dismissed as auditors of the company +effective June 28, 2002. The audit committee of the Board of Directors approved +the change in auditors and recommended this change to the Board of Directors. +The letter of concurrence was filed as an exhibit to the Form 8-K. No +disagreements were cited. +There have been no disagreements with the independent auditors on any matters of +accounting principles or practices, financial statement disclosure, or auditing +scope or procedures. +63 +PART III. +ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. +For information concerning Item 10, see the definitive proxy statement of Callon +Petroleum Company relating to the Annual Meeting of Stockholders on May 2, 2003 +which will be filed with the Securities and Exchange Commission and is +incorporated herein by reference. +ITEM 11. EXECUTIVE COMPENSATION. +For information concerning Item 11, see the definitive proxy statement of Callon +Petroleum Company relating to the Annual Meeting of Stockholders on May 2, 2003 +which will be filed with the Securities and Exchange Commission and is +incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND +RELATED STOCKHOLDER MATTERS. +For information concerning the security ownership of certain beneficial owners +and management, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders on May 2, 2003 which will be +filed with the Securities and Exchange Commission and is incorporated herein by +reference. +64 +EQUITY COMPENSATION PLAN INFORMATION +The following table provides information as of December 31, 2002 regarding the +number of shares of Common Stock that may be issued under the Company's equity +compensation plans. +Plan Category Number of securities to be Weighted-average Number of securities +issued upon exercise of exercise price of remaining available for +outstanding options, outstanding options, future issuance under +warrants and rights warrants and rights equity compensation +plans (excluding +securities reflected +in column (a) +(a) (b) (c) +-------------------------- -------------------- ----------------------- +Equity compensation +plans approved by +security holders(1) 2,351,667 $ 10.31 186,493 +Equity compensation +plans not approved by +security holders (2) 168,750 $ 4.16 181,250 +-------------- -------------- -------------- +Total 2,520,417 $ 9.90 367,743 +============== ============== ============== +(1) Represents the Callon Petroleum Company 1994 and the 1996 Stock +Incentive Plans which were approved by the shareholders in prior +years. Remaining shares available for future issuance listed in +column (c) does not include 168,000 shares of restricted stock +awarded in 2002 which have not yet vested. +(2) Represents the Callon Petroleum Company 2002 Stock Incentive Plan +adopted by the Company on February 14, 2002. The plan qualifies as +a "broadly based" plan under the provisions of the New York Stock +Exchange rules and regulations and therefore did not require +shareholder approval. Remaining shares available for future +issuance listed in column (c) does not include 124,300 shares of +restricted stock awarded in 2002 which have not yet vested. +See Note 10 to the Consolidated Financial Statements for a description of the +material provisions of each equity compensation plan under which our equity +securities are authorized for issuance that was adopted without the approval of +shareholders. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +For information concerning Item 13, see the definitive proxy statement of Callon +Petroleum Company relating to the Annual Meeting of Stockholders on May 2, 2003 +which will be filed with the Securities and Exchange Commission and is +incorporated herein by reference. +65 +ITEM 14. CONTROLS AND PROCEDURES. +(a) Evaluation of Disclosure Controls and Procedures. Based on their +evaluation as of a date within 90 days of the filing date of this Annual Report +on Form 10-K, the Company's principal executive officer and principal financial +officer have concluded that the Company's disclosure controls and procedures (as +defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of +1934 (the "Exchange Act") are effective to ensure that information required to +be disclosed by the Company in reports that it files or submits under the +Exchange Act is recorded, processed, summarized and reported within the time +periods specified in the rules and forms of the Securities and Exchange +Commission. +(b) Changes in Internal Controls. There were no significant changes in +the Company's internal controls or in other factors that could significantly +affect these controls subsequent to the date of their evaluation, including any +corrective actions with regard to significant deficiencies and material +weaknesses. +66 \ No newline at end of file diff --git a/raw/filings/0000928022/2002/0000950134-03-004701/item13.txt b/raw/filings/0000928022/2002/0000950134-03-004701/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..b6a067c654f036ffb535aec511fb830e9d17dc97 --- /dev/null +++ b/raw/filings/0000928022/2002/0000950134-03-004701/item13.txt @@ -0,0 +1,6 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +For information concerning Item 13, see the definitive proxy statement of Callon +Petroleum Company relating to the Annual Meeting of Stockholders on May 2, 2003 +which will be filed with the Securities and Exchange Commission and is +incorporated herein by reference. +65 \ No newline at end of file diff --git a/raw/filings/0000928022/2002/0000950134-03-004701/item9a.txt b/raw/filings/0000928022/2002/0000950134-03-004701/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2002/0000950134-03-004701/rp_note.txt b/raw/filings/0000928022/2002/0000950134-03-004701/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2002/0000950134-03-004701/rpt_disclosure.txt b/raw/filings/0000928022/2002/0000950134-03-004701/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..278b81ffeaf272561b74300a8656fbfece88b968 --- /dev/null +++ b/raw/filings/0000928022/2002/0000950134-03-004701/rpt_disclosure.txt @@ -0,0 +1,59 @@ +Related Party Transactions Oversight . The Company shall not enter +into a related party transaction unless such transaction is approved by +the Committee after a review of the transaction by the Committee for +potential conflicts of interest. A transaction will be considered a +“related party transaction” if the transaction would be required to be +disclosed under Item 404 of Regulation S-K. +9. +Risk Management Oversight . +9.1. +Risk Exposure . The Committee shall periodically meet with +management and each Independent Auditor to review and discuss (a) +guidelines and policies with respect to risk assessment and risk +management to the extent necessary or appropriate to govern the process +by which the Company’s risk assessment and management is undertaken and +handled (although the Committee is not required to be the sole body +responsible for risk assessment and management) and (b) the Company’s +major financial risk exposures and the steps management has taken to +monitor and control such exposures. If the Company manages and +assesses its risk through mechanisms other than the Committee, the +mechanisms need not be replaced by the Committee, but the processes in +place should be reviewed in a general manner by the Committee. +9.2. +Insurance . The Committee shall periodically review and assess +insurance coverage, including Directors and Officers Liability, +property and casualty loss, errors and omissions and surety bonds, with +management and, at the Committee’s discretion, General Counsel. +9.3. +Special-Purpose Entities and Off-Balance Sheet Transactions . The +Committee shall periodically meet with management, the Internal +Auditor, the General Counsel and the External Auditor to review and +assess all “special-purpose” entities of the Company and all complex +financing transactions involving the Company, including all related +off-balance sheet accounting matters. +9.4. +Consultation with Legal Counsel . The Committee shall periodically, +at its discretion, review with the General Counsel and, if the +Committee deems it appropriate, outside legal counsel legal matters +(including material claims, pending legal proceedings, government +investigations and material reports, notices or inquires received from +governmental agencies) that may have a significant impact on the +Company’s financial statements or risk management. +10. +Reports and Assessments . +10.1. +Board Reports . The Chairperson of the Committee shall, +periodically, at his or her discretion, report to the Board on +Committee actions and on the fulfillment of the Committee’s +responsibilities under this Charter. Such reports shall include any +issues that arise with respect to the quality or integrity of the +Company’s financial statements, the Company’s compliance with legal or +regulatory requirements, the performance and independence of the +Company’s External Auditors and the performance of the Company’s +internal audit function. This report shall be presented and +incorporated with and into the next regularly scheduled Board meeting. +29 +Table of Contents +10.2. +Charter Assessment . The Committee shall annually assess the +adequacy of this Charter and advise the Board and the Nominating and \ No newline at end of file diff --git a/raw/filings/0000928022/2006/0000950134-07-005981/filing.txt b/raw/filings/0000928022/2006/0000950134-07-005981/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..86a5e3b2fce0fb3d2d4770ee53046dbfa70e4bf2 --- /dev/null +++ b/raw/filings/0000928022/2006/0000950134-07-005981/filing.txt @@ -0,0 +1,5165 @@ +10-K +1 +d44549e10vk.htm +FORM 10-K +e10vk +Table of Contents +UNITED STATES SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF +THE SECURITIES EXCHANGE ACT OF 1934 +FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006 +Commission File Number 001-14039 +CALLON PETROLEUM COMPANY +(Exact name of Registrant as specified in its charter) +Delaware +64-0844345 +(State or other jurisdiction of +(I.R.S. Employer +incorporation or organization) +Identification No.) +200 North Canal Street +Natchez, Mississippi 39120 +(601) 442-1601 +(Address of Principal Executive +(Registrant’s telephone number +Offices)(Zip Code) +including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of exchange on which registered +Common Stock, Par Value $.01 Per Share +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule +405 of the Securities Act. Yes o +No þ . +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or +Section 15(d) of the Act. Yes o No +þ . +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 +þ No o . +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is +not contained herein, and will not be contained, to the best of Registrant’s knowledge, in +definitive proxy or information statements incorporated by reference in Part III of this Form 10-K +or any amendment to this Form 10-K. o +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, +or a non-accelerated filer. See definitions of “accelerated filer and large accelerated filer” in +Rule 12b-2 of the Exchange Act. (Check one): +Large accelerated filer o Accelerated filer þ Non-accelerated filer o +Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule +12b-2). Yes o No +þ . +The aggregate market value of the voting and non-voting common equity held by nonaffiliates of the +registrant was approximately $384.5 million as of June 30, 2006 (based on the last reported sale +price of such stock on the New York Stock Exchange on such date of $19.34). +As of March 5, 2007, there were 20,750,449 shares of the Registrant’s Common Stock, par value $.01 +per share, outstanding. +Document incorporated by reference: Portions of the definitive Proxy Statement of Callon Petroleum +Company (to be filed no later than 120 days after December 31, 2007) relating to the Annual Meeting +of Stockholders to be held on May 3, 2007, which are incorporated into Part III of this Form 10-K. +TABLE OF CONTENTS +PART I +ITEM 1 and 2. BUSINESS and PROPERTIES +ITEM 3. LEGAL PROCEEDINGS +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS +ITEM 6. SELECTED FINANCIAL DATA +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +ITEM 9.A CONTROLS AND PROCEDURES +ITEM 9.B OTHER INFORMATION +PART III +ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT +ITEM 11. EXECUTIVE COMPENSATION +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K +SIGNATURES +Consent of Ernst & Young LLP +Consent of Huddleston & Co., Inc. +Certification of CEO Pursuant to Rule 13(a)-14(a) +Certification of CFO Pursuant to Rule 13(a)-14(a) +Certification of CEO Pursuant to Rule 13(a)-14(b) +Certification of CFO Pursuant to Rule 13(a)-14(b) +Table of Contents +PART I. +ITEM 1 and 2. BUSINESS and PROPERTIES +Overview +Callon Petroleum Company has been engaged in the exploration, development, acquisition and +production of oil and gas properties since 1950. Our properties are geographically +concentrated primarily offshore in the Gulf of Mexico and onshore in Louisiana and Alabama. We +were incorporated under the laws of the state of Delaware in 1994 and succeeded to the business of +a publicly traded limited partnership, a joint venture with a consortium of European investors and +an independent energy company owned by members of current management. As used herein, the +“Company,” “Callon,” “we,” “us,” and “our” refer to Callon Petroleum Company and its predecessors +and subsidiaries unless the context requires otherwise. +In 1989, we began increasing our reserves through the acquisition of producing properties that were +geologically complex, had (or were analogous to fields with) an established production history from +stacked pay zones and were candidates for exploitation. We focused on reducing operating costs and +implementing production enhancements through the application of technologically advanced production +and recompletion techniques. +Over the past 11 years, we have placed emphasis on the acquisition of acreage with exploration and +development drilling opportunities in the Gulf of Mexico shelf and deepwater areas. At December +31, 2006, we owned working interests in a total of 112 blocks/leases covering 223,000 net acres. +To minimize risk we join with industry partners to explore federal offshore blocks acquired in the +Gulf of Mexico. We perform extensive geological and geophysical studies using computer-aided +exploration techniques (CAEX), including, where appropriate, the acquisition of 3-D seismic or +high-resolution 2-D data to facilitate these efforts. We continue to develop prospects on the +shelf through our 3-D seismic partnership using Amplitude versus Offset (“AVO”) technology. We +have 8,000 square miles of 3-D seismic data and have invested in pre-stack time migration in order +to apply AVO de-risking to our prospects. In 1998, we began exploration in the Gulf of Mexico +deepwater area (generally 900 to 5,500 feet of water) and during the fourth quarter of 2003, our +first two deepwater projects, the Medusa and Habanero fields, began production. Please see +“Significant Properties” for a more detailed discussion. +We ended the year 2006 with estimated net proved reserves of 145.6 billion cubic feet of natural +gas equivalent (“Bcfe”). This represents a decrease of 23% from 2005 year-end estimated net proved +reserves of 188.6 Bcfe. +The major focus of our future operations is expected to continue to be the exploration for and +development of oil and gas properties, primarily in the Gulf of Mexico. +Availability of Reports +All of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form +8-K, and amendments to such reports as well as other filings we make pursuant to Section 13(a) and +15(d) of the Securities Exchange Act of 1934 are available free of charge on our Internet website. +The address of our +Internet website is www.callon.com. Our Securities and Exchange Commission (“SEC”) filings are +available on our website as soon as they are posted to the EDGAR database on the SEC’s website. +2 +Table of Contents +Business Strategy +Our goal is to increase shareholder value by increasing our reserves, production, cash flow and +earnings. We seek to achieve these goals through the following strategies: +• +focus on Gulf of Mexico exploration with a balance between shelf and deepwater areas, +and onshore Louisiana; +• +aggressively explore our existing prospect inventory; +• +replenish our prospect inventory with increasing emphasis on prospect generation using +AVO technology to reduce the risks associated with our exploratory drilling; and +• +acquire producing properties with infrastructure in areas of focus that contain upside +potential. +Exploration and Development Activities +In 2006, capital expenditures for exploration and development costs related to oil and gas +properties totaled approximately $167 million. These expenditures included: +• +$107 million in the Gulf of Mexico shelf, onshore south Louisiana and Texas State waters +areas which included the drilling of 10 exploratory wells, five of which were unsuccessful, +two development wells and completion costs for our successful wells; +• +$15 million in our deepwater area, which included four exploratory wells, three of which +were unsuccessful and one temporarily abandoned; +• +$16 million for leasehold and seismic costs; +• +$13 million for plugging and abandonment costs; and +• +$6 million for capitalized interest and $10 million for capitalized general and +administration costs allocable directly to exploration and development projects. +Risk Factors +A decrease in oil and gas prices may adversely affect our results of operations and financial +condition . Our success is highly dependent on prices for oil and gas, which are extremely volatile. +Any substantial or extended decline in the price of oil or gas would have a material adverse effect +on us. Oil and gas markets are both seasonal and cyclical. The prices of oil and gas depend on +factors we cannot control such as weather, economic conditions, and levels of production, actions +by OPEC and other countries and government actions. Prices of oil and gas will affect the following +aspects of our business: +• +our revenues, cash flows and earnings; +• +the amount of oil and gas that we are economically able to produce; +• +our ability to attract capital to finance our operations and the cost of the capital; +• +the amount we are allowed to borrow under our senior secured credit facility; +• +the value of our oil and gas properties; and +• +the profit or loss we incur in exploring for and developing our reserves. +3 +Table of Contents +Our reserve information represents estimates that may turn out to be incorrect if the assumptions +upon which these estimates are based are inaccurate. Any material inaccuracies in these reserve +estimates or underlying assumptions will materially affect the quantities and present value of our +reserves. The process of estimating oil and gas reserves is complex. It requires interpretations +of available technical data and various assumptions, including assumptions relating to economic +factors. Any significant inaccuracies in these interpretations or assumptions could materially +affect the estimated quantities and present value of reserves shown in this annual report. +In order to prepare these estimates, we must project production rates and the timing of development +expenditures. The assumptions regarding the timing and costs to commence production from our +deepwater wells used in preparing our reserves are often subject to revisions over time as +described under “Our deepwater operations have special operational risks that may negatively affect +the value of those assets.” We must also analyze available geological, geophysical, production and +engineering data, the extent, quality and reliability of which can vary. The process also requires +us to make economic assumptions, such as oil and gas prices, drilling and operating expenses, +capital expenditures, taxes and availability of funds. Therefore, estimates of oil and gas +reserves are inherently imprecise. +Actual future production, oil and gas prices, revenues, taxes, development expenditures, operating +expenses and quantities of recoverable oil and gas reserves most likely will vary from the +estimates. Any significant variance could materially affect the estimated quantities and present +value of reserves shown in this report. In addition, estimates of proved reserves may be adjusted +to reflect production history, results of exploration and development, prevailing oil and gas +prices and other factors, many of which are beyond our control. +Also, under Mineral Management Services (“MMS”) rules governing our deepwater Medusa property and +several of our shallow water, deep natural gas properties and prospects, we are eligible for +royalty suspensions depending on the difference between the average monthly New York Mercantile +Exchange (NYMEX) sales price for oil or gas and price thresholds set by the MMS. As a result, our +reserve estimates may increase or decrease depending upon the relation of price thresholds versus +the average NYMEX prices. +Our Entrada field is governed by leases from the MMS. These leases granted royalty suspension +without provisions for pricing thresholds for crude oil and natural gas which would require us to +pay royalties to the MMS if the thresholds were exceeded by the current year average of NYMEX +prices. The MMS has notified us the exclusion of the provisions occurred in error in the lease +issuance process and was not the MMS’s intention. Congress is considering various bills to address +this issue and if a bill were to pass to amend the leases to provide thresholds for crude oil and +natural gas prices the reserves for Entrada could be subject to royalties. However, the MMS stated +in their correspondence to us they will continue to honor the terms of the leases as issued unless +notified otherwise. This correspondence applies only to our 20% working interest in the Entrada field. +4 +Table of Contents +You should not assume that the present value of future net cash flows from our proved reserves +referred to in this report is the current market value of our estimated oil and gas reserves. In +accordance with SEC requirements, we generally base the estimated discounted future net cash flows +from our proved reserves on prices and costs on the date of the estimate. Actual future prices and +costs may differ materially from those used in the present value estimate. +The discounted present value of our oil and gas reserves is prepared in accordance with guidelines +established by the SEC. A purchaser of reserves would use numerous other factors to value the +reserves. The discounted present value of reserves, therefore, does not necessarily represent the +fair market value of those reserves. +On December 31, 2006, approximately 57% of the discounted present value of our estimated net proved +reserves were proved undeveloped. Proved undeveloped reserves represented 54% of total proved +reserves. Most of these proved undeveloped reserves were attributable to our deepwater properties. +Development of these properties is subject to additional risks as described above. +Information about reserves constitutes forward-looking information. See “Forward-Looking +Statements” for information regarding forward-looking information. +Unless we are able to replace reserves which we have produced, our cash flows and production will +decrease over time. Our future success depends upon our ability to find, develop and acquire oil +and gas reserves that are economically recoverable. As is generally the case for Gulf properties, +our producing properties usually have high initial production rates, followed by a steep decline in +production. As a result, we must continually locate and develop or acquire new oil and gas reserves +to replace those being depleted by production. We must do this even during periods of low oil and +gas prices when it is difficult to raise the capital necessary to finance these activities and +during periods of high operating costs when it is expensive to contract for drilling rigs and other +equipment and personnel necessary +to explore for oil and gas. Without successful +exploration or acquisition activities, our reserves, production and revenues will decline rapidly. +We cannot assure you that we will be able to find and develop or acquire additional reserves at an +acceptable cost. +Also, because of the aggregate short life of our reserves, our return on the investment we make in +our oil and gas wells and the value of our oil and gas wells will depend significantly on prices +prevailing during relatively short production periods. +A significant part of the value of our production and reserves is concentrated in a small number of +offshore properties, and any production problems or inaccuracies in reserve estimates related to +those properties would adversely impact our business. During 2006, approximately 80% of our daily +production came from eight of our properties in the Gulf of Mexico. Moreover, one property +accounted for 40% of our production during this period. In addition, at December 31, 2006, most of +our proved reserves were located in three fields in the Gulf of Mexico, with approximately 72% of +our total net proved reserves attributable to these properties. If mechanical problems, storms or +other events curtailed a substantial portion of this production or if the actual reserves +associated with any one of these producing properties are less than our estimated reserves, our +results of operations and financial condition could be adversely affected. +Our focus on exploration projects increases the risks inherent in our oil and gas activities. Our +business strategy focuses on replacing reserves through exploration, where the risks are greater +than in acquisitions and development drilling. Although we have been successful in exploration in +the past, we cannot assure you that we will continue to increase reserves through exploration or at +an acceptable cost. Additionally, we are often +uncertain as to the future costs and timing of drilling, completing and +5 +Table of Contents +producing wells. Our +drilling operations may be curtailed, delayed or canceled as a result of a variety of factors, +including: +• +unexpected drilling conditions; +• +pressure or inequalities in formations; +• +equipment failures or accidents; +• +adverse weather conditions; +• +compliance with governmental requirements; and +• +shortages or delays in the availability of drilling rigs and the delivery of equipment. +We do not operate all of our properties and have limited influence over the operations of some of +these properties, particularly our deepwater properties. Our lack of control could result in the +following: +• +the operator may initiate exploration or development at a faster or slower pace than we +prefer; +• +the operator may propose to drill more wells or build more facilities on a project than +we have funds for or that we deem appropriate, which may mean that we are unable to +participate in the project or share in the revenues generated by the project even though we +paid our share of exploration costs; and +• +if an operator refuses to initiate a project, we may be unable to pursue the project. +Any of these events could materially reduce the value of our non-operated properties. +Our deepwater operations have special operational risks that may negatively affect the value of +those assets. Drilling operations in the deepwater area are by their nature more difficult and +costly than drilling operations in shallow water. Deepwater drilling operations require the +application of more advanced drilling technologies involving a higher risk of technological failure +and usually have significantly higher drilling costs than shallow water drilling operations. +Deepwater wells are completed using sub-sea completion techniques that require substantial time and +the use of advanced remote installation equipment. These operations involve a high risk of +mechanical difficulties and equipment failures that could result in significant cost overruns. +In deepwater, the time required to commence production following a discovery is much longer than in +shallow water and on-shore. Deepwater discoveries require the construction of expensive production +facilities and pipelines prior to production. We cannot estimate the costs and timing of the +construction of these facilities with certainty, and the accuracy of our estimates will be affected +by a number of factors beyond our control, including the following: +• +decisions made by the operators of our deepwater wells; +• +the availability of materials necessary to construct the facilities; +• +the proximity of our discoveries to pipelines; and +• +the price of oil and natural gas. +Delays and cost overruns in the commencement of production will affect the value of our deepwater +prospects and the discounted present value of reserves attributable to those prospects. +Competitive industry conditions may negatively affect our ability to conduct operations. We +operate in the highly competitive areas of oil and gas exploration, development and production. We +compete for the purchase of leases in the Gulf of Mexico from the U. S. government and from other +oil and gas +6 +Table of Contents +companies. These leases include exploration prospects as well as properties with proved reserves. Factors that +affect our ability to compete in the marketplace include: +• +our access to the capital necessary to drill wells and acquire properties; +• +our ability to acquire and analyze seismic, geological and other information relating to +a property; +• +our ability to retain the personnel necessary to properly evaluate seismic and other +information relating to a property; +• +the location of, and our ability to access, platforms, pipelines and other facilities +used to produce and transport oil and gas production; +• +the standards we establish for the minimum projected return on an investment of our +capital; and +• +the availability of alternate fuel sources. +Our competitors include major integrated oil companies, substantial independent energy companies, +and affiliates of major interstate and intrastate pipelines and national and local gas gatherers, +many of which possess greater financial, technological and other resources than we do. +Our competitors may use superior technology, which we may be unable to afford or which would +require costly investment by us in order to compete. Our industry is subject to rapid and +significant advancements in technology, including the introduction of new products and services +using new technologies. As our competitors use or develop new technologies, we may be placed at a +competitive disadvantage, and competitive pressures may force us to implement new technologies at a +substantial cost. In addition, our competitors may have greater financial, technical and personnel +resources that allow them to enjoy technological advantages and may in the future allow them to +implement new technologies before we can. We cannot be certain that we will be able to implement +technologies on a timely basis or at a cost that is acceptable to us. One or more of the +technologies that we currently use or that we may implement in the future may become obsolete, and +we may be adversely affected. For example, marine seismic acquisition technology has been +characterized by rapid technological advancements in recent years, and further significant +technological developments could substantially impair our 3-D seismic data’s value. +We may not be able to replace our reserves or generate cash flows if we are unable to raise +capital. We will be required to make substantial capital expenditures to develop our existing +reserves, and to discover new oil and gas reserves. Historically, we have financed these +expenditures primarily with cash from operations, proceeds from bank borrowings and proceeds from +the sale of debt and equity securities. See “Management’s Discussion and Analysis of Financial +Condition and Results of Operations — Liquidity and Capital Resources” for a discussion of our +capital budget. We cannot assure you that we will be able to raise capital in the future. We also +make offers to acquire oil and gas properties in the ordinary course of our business. If these +offers are accepted, our capital needs may increase substantially. +We expect to continue using our senior secured credit facility to borrow funds to supplement our +available cash. The amount we may borrow under our senior secured credit facility may not exceed a +borrowing base determined by the lenders under such facility based on their projections of our +future production, production costs, taxes, commodity prices and any other factors deemed relevant +by our lenders. We cannot control the assumptions the lenders use to calculate our borrowing base. +The lenders may, without our consent, adjust the +borrowing base semiannually or in situations where we purchase or sell assets or issue debt +securities. If our borrowings under the senior secured credit facility exceed the borrowing base, +7 +Table of Contents +the lenders may require that we repay the excess. If this were to occur, we might have to sell +assets or seek financing from other sources. Sales of assets could further reduce the amount of +our borrowing base. We cannot assure you that we would be successful in selling assets or arranging +substitute financing. If we were not able to repay borrowings under our senior secured credit +facility to reduce the outstanding amount to less than the borrowing base, we would be in default +under our senior secured credit facility. For a description of our senior secured credit facility +and its principal terms and conditions, see “Management’s Discussion and Analysis of Financial +Condition and Results of Operations —Liquidity and Capital Resources” and Note 7 to our +Consolidated Financial Statements. +Our decision to drill a prospect is subject to a number of factors, and we may decide to alter our +drilling schedule or not drill at all. A prospect is a property on which we have identified what +our geoscientists believe, based on available seismic and geological information, to be indications +of hydrocarbons. Our prospects are in various stages of evaluation, ranging from a prospect which +is ready to drill to a prospect which will require substantial additional seismic data processing +and interpretation. Whether we ultimately drill a prospect may depend on the following factors: +• +receipt of additional seismic data or the reprocessing of existing data; +• +material changes in oil or gas prices; +• +the costs and availability of drilling rigs; +• +the success or failure of wells drilled in similar formations or which would use the +same production facilities; +• +availability and cost of capital; +• +changes in the estimates of the costs to drill or complete wells; +• +our ability to attract other industry partners to acquire a portion of the working +interest to reduce exposure to costs and drilling risks; and +• +decisions of our joint working interest owners. +We will continue to gather data about our prospects and it is possible that additional information +may cause us to alter our drilling schedule or determine that a prospect should not be pursued at +all. You should understand that our plans regarding our prospects are subject to change. +Weather, unexpected subsurface conditions, and other unforeseen operating hazards may adversely +impact our ability to conduct business. There are many operating hazards in exploring for and +producing oil and gas, including: +• +our drilling operations may encounter unexpected formations or pressures, which could +cause damage to equipment or personal injury; +• +we may experience equipment failures which curtail or stop production; +• +we could experience blowouts or other damages to the productive formations that may +require a well to be re-drilled or other corrective action to be taken; and +• +because of these or other events, we could experience environmental hazards, including +oil spills, gas leaks, and ruptures. +In the event of any of the foregoing, we may be subject to interrupted production or substantial +environmental liability due to injury to or loss of life, damage to or destruction of property, +natural resources and equipment, pollution and other environmental damage, investigation and +remediation requirements. Moreover, a substantial +portion of our operations are offshore and are subject to a variety of risks peculiar to the marine +environment such as capsizing, collisions, hurricanes and other adverse +8 +Table of Contents +weather conditions. These +conditions can cause substantial damage to facilities and interrupt production. Offshore +operations are also subject to more extensive governmental regulation. +We cannot assure you that we will be able to maintain adequate insurance at rates we consider +reasonable to cover our possible losses from operating hazards. The occurrence of a significant +event not fully insured or indemnified against could materially and adversely affect our financial +condition and results of operations. +We may not have production to offset hedges; by hedging, we may not benefit from price increases. +Part of our business strategy is to reduce our exposure to the volatility of oil and gas prices by +hedging a portion of our production. In a typical hedge transaction, we will have the right to +receive from the other parties to the hedge the excess of the fixed price specified in the hedge +over a floating price based on a market index, multiplied by the quantity hedged. If the floating +price exceeds the fixed price, we are required to pay the other parties this difference multiplied +by the quantity hedged. We are required to pay the difference between the floating price and the +fixed price when the floating price exceeds the fixed price regardless of whether we have +sufficient production to cover the quantities specified in the hedge. Significant reductions in +production at times when the floating price exceeds the fixed price could require us to make +payments under the hedge agreements even though such payments are not offset by sales of +production. Hedging will also prevent us from receiving the full advantage of increases in oil or +gas prices above the fixed amount specified in the hedge. We also enter into price “collars” to +reduce the risk of changes in oil and gas prices. Under a collar, no payments are due by either +party so long as the market price is above a floor set in the collar and below a ceiling. If the +price falls below the floor, the counter-party to the collar pays the difference to us and if the +price is above the ceiling, we pay the counter-party the difference. Another type of hedging +contract we have entered into is a put contract. Under a put, if the price falls below the set +floor price, the counter-party to the contract pays the difference to us. See “Quantitative and +Qualitative Disclosures About Market Risks” for a discussion of our hedging practices. +Compliance with environmental and other government regulations could be costly and could negatively +impact production. Our operations are subject to numerous laws and regulations governing the +operation and maintenance of our facilities and the discharge of materials into the environment or +otherwise relating to environmental protection. For a discussion of the material regulations +applicable to us, see “Regulations”. These laws and regulations may: +• +require that we acquire permits before commencing drilling; +• +restrict the substances that can be released into the environment in connection with +drilling and production activities; +• +limit or prohibit drilling activities on protected areas such as wetlands or wilderness +areas; and +• +require measures to remediate or mitigate pollution and environmental impacts from +current and former operations, such as cleaning up spills or dismantling abandoned +production facilities. +Under these laws and regulations, we could be liable for personal injury and clean-up costs and +other environmental and property damages, as well as administrative, civil and criminal penalties. +We maintain limited insurance coverage for sudden and accidental environmental damages. We do not +believe that insurance coverage for environmental damages that occur over time is available at a +reasonable cost. Also, we do not believe that insurance coverage for the full potential liability +that could be caused by sudden and accidental environmental damages is available at a reasonable +cost. Accordingly, we may be subject to liability or we may be required to cease production from +properties in the event of environmental damages. +9 +Table of Contents +Factors beyond our control affect our ability to market production and our financial results. The +ability to market oil and gas from our wells depends upon numerous factors beyond our control. +These factors include: +• +the extent of domestic production and imports of oil and gas; +• +the proximity of the gas production to gas pipelines; +• +the availability of pipeline capacity; +• +the demand for oil and gas by utilities and other end users; +• +the availability of alternative fuel sources; +• +the effects of inclement weather; +• +state and federal regulation of oil and gas marketing; and +• +federal regulation of gas sold or transported in interstate commerce. +Because of these factors, we may be unable to market all of the oil or gas we produce. In addition, +we may be unable to obtain favorable prices for the oil and gas we produce. +If oil and gas prices decrease, we may be required to take writedowns of the carrying value of our +oil and gas properties. We may be required to writedown the carrying value of our oil and gas +properties when oil and gas prices are low or if we have substantial downward adjustments to our +estimated net proved reserves, increases in our estimates of development costs or deterioration in +our exploration results. Under the full-cost method which we use to account for our oil and gas +properties, the net capitalized costs of our oil and gas properties may not exceed the present +value, discounted at 10%, of future net cash flows from estimated net proved reserves, using period +end oil and gas prices or prices as of the date of our auditor’s report, plus the lower of cost or +fair market value of our unproved properties. If net capitalized costs of our oil and gas +properties exceed this limit, we must charge the amount of the excess to earnings. This type of +charge will not affect our cash flows, but will reduce the book value of our stockholders’ equity. +We review the carrying value of our properties quarterly, based on prices in effect as of the end +of each quarter or at the time of reporting our results. Once incurred, a writedown of oil and gas +properties is not reversible at a later date, even if prices increase. +There are inherent limitations in all control systems, and misstatements due to error or fraud that +could seriously harm our business may occur and not be detected. Our management, including our +Chief Executive and Financial Officers, do not expect that our internal controls and disclosure +controls will prevent all possible error and all fraud. A control system, no matter how well +conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of +the control system are met. In addition, the design of a control system must reflect the fact that +there are resource constraints and the benefit of controls must be relative to their costs. +Because of the inherent limitations in all control systems, an evaluation of controls can only +provide reasonable assurance that all material control issues and instances of fraud, if any, in +our company have been detected. These inherent limitations include the realities that judgments in +decision-making can be faulty and that breakdowns can occur because of simple error or mistake. +Further, controls can be circumvented by the individual acts of some persons or by collusion of two +or more persons. The design of any system of controls is based in part upon certain assumptions +about the likelihood of future events, and there can be no assurance that any +10 +Table of Contents +design will succeed in achieving its stated goals under all potential future conditions. +Because of inherent limitations in a cost-effective control system, misstatements due to error or +fraud may occur and not be detected. A failure of our controls and procedures to detect error or +fraud could seriously harm our business and results of operations. +Forward-Looking Statements +In this report, we have made many forward-looking statements. We cannot assure you that the plans, +intentions or expectations upon which our forward-looking statements are based will occur. Our +forward-looking statements are subject to risks, uncertainties and assumptions, including those +discussed elsewhere in this report. Forward-looking statements include statements regarding: +• +our oil and gas reserve quantities, and the discounted present value of these +reserves; +• +the amount and nature of our capital expenditures; +• +drilling of wells; +• +the timing and amount of future production and operating costs; +• +business strategies and plans of management; and +• +prospect development and property acquisitions. +Some of the risks, which could affect our future results and could cause results to differ +materially from those expressed in our forward-looking statements, include: +• +general economic conditions; +• +the volatility of oil and natural gas prices; +• +the uncertainty of estimates of oil and natural gas reserves; +• +the impact of competition; +• +the availability and cost of seismic, drilling and other equipment; +• +operating hazards inherent in the exploration for and production of oil and natural +gas; +• +difficulties encountered during the exploration for and production of oil and +natural gas; +• +difficulties encountered in delivering oil and natural gas to commercial markets; +• +changes in customer demand and producers’ supply; +• +the uncertainty of our ability to attract capital; +• +compliance with, or the effect of changes in, the extensive governmental +regulations regarding the oil and natural gas business; +• +actions of operators of our oil and gas properties; and +• +weather conditions. +The information contained in this report, including the information set forth under the heading +“Risk Factors,” identifies additional factors that could affect our operating results and +performance. We urge you to carefully consider these factors and the other cautionary statements in +this report. Our forward-looking statements speak only as of the date made, and we have no +obligation to update these forward-looking statements. +Corporate Offices +Our headquarters are located in Natchez, Mississippi, in approximately 51,500 square feet of owned +space. We also maintain a business office in Houston, Texas, and own or lease field offices in the +area of the major fields in which we operate properties or have a significant interest. Replacement +of any of our leased offices would not +result in material expenditures by us as alternative locations to our leased space are anticipated +to be readily available . +11 +Table of Contents +Employees +We had 86 employees as of December 31, 2006, none of whom are currently represented by a union. We +believe that we have good relations with our employees. We employ six petroleum engineers and +eight petroleum geoscientists. +Regulations +General . The oil and gas industry is subject to regulation at the federal, state and local level, +and some of the laws, rules and regulations that govern our operations carry substantial penalties +for non-compliance. This regulatory burden increases our cost of doing business and, consequently, +affects our profitability. +Exploration and Production. Our operations are subject to federal, state and local regulations +that include requirements for permits to drill and to conduct other operations and for provision of +financial assurances (such as bonds) covering drilling and well operations. Other activities +subject to regulation are: +• +the location of wells, +• +the method of drilling and completing wells, +• +the rate of production, +• +the surface use and restoration of properties upon which wells are drilled, +• +the plugging and abandoning of wells, +• +the disposal of fluids used or other wastes obtained in connection with operations, +• +the marketing, transportation and reporting of production, and +• +the valuation and payment of royalties. +For instance, our OCS leases in federal waters are administered by the Minerals Management Service, +or MMS, and require compliance with detailed MMS regulations and orders. Lessees must obtain MMS +approval for exploration plans and exploitation and production plans prior to the commencement of +such operations. The MMS has promulgated regulations requiring offshore production facilities +located on the OCS to meet stringent engineering and construction specifications. The MMS also has +regulations restricting the flaring or venting of natural gas, and prohibiting the flaring of +liquid hydrocarbons and oil without prior authorization. MMS policies concerning the volume of +production that a lessee must have to maintain an offshore lease beyond its primary term also are +applicable to Callon. Similarly, the MMS has promulgated other regulations governing the plugging +and abandonment of wells located offshore and the installation and removal of all production +facilities. To cover the various obligations of lessees on the OCS, the MMS generally requires +that lessees have substantial net worth or post bonds or other acceptable assurances that such +obligations will be met. The cost of these bonds or other surety can be substantial, and there is +no assurance that bonds or other surety can be obtained in all cases. Under some circumstances, +the MMS may require any of our operations on federal leases to be suspended or terminated. Any +such suspension or termination could materially adversely affect our financial conditions and +results of operations. +Our sales of oil and natural gas are affected by the availability, terms and cost of pipeline +transportation. The price and terms for access to pipeline transportation remain subject to +extensive federal regulation. If +12 +Table of Contents +these regulations change, we could face higher transmission costs +for our production and, possibly, reduced access to transmission capacity. +We do not currently anticipate that compliance with existing laws and regulations governing +exploration and production will have a significantly adverse effect upon our capital expenditures, +earnings or competitive position. +Various proposals and proceedings that might affect the petroleum industry are pending before +Congress, the Federal Energy Regulatory Commission, or FERC, various state legislatures, and the +courts. The industry historically has been heavily regulated and we can offer you no assurance +that the less stringent regulatory approach recently pursued by the FERC and Congress will continue +nor can we predict what effect such proposals or proceedings may have on our operations. +Environmental Regulation. Various federal, state and local laws and regulations concerning the +discharge of contaminants into the environment, the generation, storage, transportation and +disposal of wastes, and the protection of public health, natural resources, wildlife and the +environment affect our exploration, development and production operations, including processing +facilities. We must take into account the cost of complying with environmental regulations in +planning, designing, drilling, constructing, operating and abandoning wells. In most instances, the +regulatory requirements relate to the handling and disposal of drilling and production waste +products, water and air pollution control procedures, and the remediation of petroleum-product +contamination. In addition, our operations may require us to obtain permits for, among other +things, +• +air emissions, +• +discharges into surface waters, and +• +the construction and operations of underground injection wells or surface pits to +dispose of produced saltwater and other nonhazardous oilfield wastes. +In the event of an unauthorized discharge, emission or activity, we may be liable for penalties, +costs and damages and we could be required to cleanup or mitigate the environmental impacts of +unauthorized discharges. Under state and federal laws, we could be required to remove or remediate +previously disposed wastes and remediate contamination, including contamination in surface water, +soil or groundwater, caused by disposal of that waste. We could be responsible for wastes disposed +of or released by us or prior owners or operators at properties owned or leased by us or at +locations where wastes have been taken for disposal. We could also be required to suspend or cease +operations in contaminated areas, or to perform remedial well plugging operations or cleanups to +prevent future contamination. The Environmental Protection Agency and various state agencies have +limited the disposal options for hazardous and nonhazardous wastes. The owner and operator of a +site, and persons that treated, disposed of or arranged for the disposal of hazardous substances +found at a site, may be liable, without regard to fault or the legality of the original conduct, +for the release of a hazardous substance into the environment. The Environmental Protection Agency, +state environmental agencies and, in some cases, third parties are authorized to take actions in +response to threats to human health or the environment and to seek to recover from responsible +classes of persons the costs of such action. Furthermore, certain wastes generated by our oil and +natural gas operations that are currently exempt from treatment as hazardous wastes may in the +future be designated as hazardous wastes and, therefore, be subject to considerably more rigorous +and costly operating and disposal requirements. +Federal and state occupational safety and health laws require us to organize information about +hazardous materials used, released or produced in our operations. Certain portions of this +information must be +13 +Table of Contents +provided to employees, state and local governmental authorities and local +citizens. We are also subject to the requirements and reporting set forth in federal workplace +standards. +We have made and will continue to make expenditures to comply with environmental regulations and +requirements. These are necessary business costs in the oil and gas industry. Although we are not +fully insured against all environmental risks, we maintain insurance coverage which we believe is +customary in the industry. Moreover, it is possible that other developments, such as stricter and +more comprehensive environmental laws and regulations, as well as claims for damages to property or +persons resulting from company operations, could result in substantial costs and liabilities, +including civil and criminal penalties, to Callon. We believe we are in compliance with existing +environmental regulations, and that, absent the occurrence of an extraordinary event the effect of +which cannot be predicted, any noncompliance will not have a material adverse effect on our +operations or earnings. +Commitments and Contingencies +The Company’s activities are subject to federal, state and local laws and regulations governing +environmental quality and pollution control. Although no assurances can be made, the Company +believes that, absent the occurrence of an extraordinary event, compliance with existing federal, +state and local laws, rules and regulations governing the release of materials into the environment +or otherwise relating to the protection of the environment will not have a material effect upon the +capital expenditures, earnings or the competitive position of the Company with respect to its +existing assets and operations. The Company cannot predict what effect additional regulation or +legislation, enforcement polices thereunder, and claims for damages to property, employees, other +persons, and the environment resulting from the Company’s operations could have on its activities. +Property Summary +We are engaged in the exploration, development, acquisition and production of oil and gas +properties. Our properties are concentrated offshore in the Gulf of Mexico and onshore, primarily, +in Louisiana and Alabama. We have historically increased our reserves and production by focusing +primarily on low to moderate risk exploration and acquisition opportunities in the Gulf of Mexico +shelf area. In 1998, we expanded our area of exploration to include the Gulf of Mexico deepwater +area. As of December 31, 2006, our estimated net proved reserves totaled 145.6 Bcfe and included +13.3 million barrels of oil (“MMBbl”) and 66.0 billion cubic feet of natural gas (“Bcf”), with a +pre-tax present value, discounted at 10%, of the estimated future net revenues based on constant +prices in effect at year-end of $534.7 million. Oil constitutes approximately 55% on an equivalent +basis of our total estimated proved reserves and approximately 46% of our total estimated proved +reserves are proved developed reserves. +Our Medusa (Mississippi Canyon Blocks 538/582) and Habanero (Garden Banks Block 341) discoveries +began production in the fourth quarter of 2003. A detailed discussion of each of these properties +is provided in the “Significant Properties” section of this report. These two deepwater discoveries +were responsible for 50% of our total production during 2006. +14 +Table of Contents +Significant Properties +The following table shows discounted cash flows and estimated net proved oil and gas reserves by +major field and for all other properties combined at December 31, 2006. +Pre-tax +Estimated Net Proved Reserves +Discounted +Oil +Gas +Total +Present +Value +Operator +(MBbls) +(MMcf) +(MMcfe) +($000) +(a)(b)(c) +Gulf of Mexico Deepwater: +Garden Banks Block +738/782/826/827 +“Entrada” +BP +3,824 +19,059 +42,003 +$ +134,977 +Mississippi Canyon 538/582 +“Medusa” +Murphy +6,030 +4,139 +40,319 +156,542 +Garden Banks Block 341 +“Habanero” +Shell +2,582 +6,252 +21,747 +121,909 +Gulf of Mexico Shelf and Onshore: +High Island Blocks 165/130 +Hydro GOM +48 +9,594 +9,880 +37,687 +West Cameron 3/LA +Callon +100 +3,393 +3,992 +17,919 +High Island Block A-540 +Walter Oil & Gas Corp. +104 +3,063 +3,686 +16,514 +West Cameron Block 295 +Hydro GOM/Cimarex +12 +4,679 +4,751 +15,990 +North Padre Island Block 913 +Callon +— +1,874 +1,878 +7,834 +East Cameron Block 109 +Energy Partners LTD +48 +1,592 +1,879 +7,515 +Other +Various +517 +12,392 +15,493 +17,856 +Total Net Proved Reserves +13,265 +66,037 +145,628 +$ +534,743 +(a) +Represents the present value of future net cash flows before deduction of federal income +taxes, discounted at 10%, attributable to estimated net proved reserves as of December 31, +2006, as set forth in the Company’s reserve reports prepared by its independent petroleum +reserve engineers, Huddleston & Co., Inc. of Houston, Texas. +(b) +Includes a reduction for estimated plugging and abandonment costs that is reflected as a +liability on our balance sheet at December 31, 2006, in accordance with Statement of Financial +Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”). See +the Oil and Gas Reserve table for the standardized measure of discounted future net cash flow. +(c) +We use the financial measure “present value of estimated +future net revenues from proved reserves, excluding income taxes.” +This is a non-GAAP financial measure. We believe that present value +of estimated future net revenues from proved reserves, excluding +income taxes, while not a financial measure in accordance with +generally accepted accounting principles, is an important financial +measure used by investors and independent oil and gas producers for +evaluating the relative value of oil and natural gas properties and +acquisitions because the tax characteristics of comparable companies +can differ materially. The total standardized measure for our proved +reserves as of December 31, 2006 was $470.8 million. The +standardized measure gives effect to income taxes, and is calculated in accordance with Statement of +Financial Accounting Standards No. 69, “Disclosures About +Oil and Gas Producing Activities.” The standardized measure of +our estimated net proved reserves of $470.8 million equals the +present value of our estimated future net revenue from proved +reserves, excluding income taxes, of $534.7 million, less +discounted estimated future income taxes relating to such future net +revenues of $63.9 million. +15 +Table of Contents +Gulf of Mexico Deepwater +Entrada, Garden Banks Blocks 738/782/826/827 +The Entrada discovery is located in approximately 4,500 feet of water in the Gulf of Mexico. Two +wells and seven sidetracks have been drilled to date. The Entrada Area is characterized by a +northwest plunging salt ridge with multiple stacked amplitudes trapped against the salt and various +faults. At year end 2006, we reclassified a portion of Entrada’s +estimated net proved +reserves to probable as of December 31, 2006 due to new performance data from analogous deepwater reservoirs. +Please refer to Note 15 of our Consolidated Financial Statements for further information regarding +reserves. On December 31, 2006, we owned a 20% working interest +in this discovery with BP Exploration and Production Company +(“BP”), the +operator, holding the remaining working interest. +Subsequent +to December 31, 2006, on March 8, 2007, we entered into an agreement with BP to purchase BP’s 80% working +interest in the Entrada Field for total cash consideration of $190 million. The purchase price +includes $150 million payable at closing and an additional $40 million payable after the +achievement of certain production milestones. The purchased interests include five federal +offshore blocks at Garden Banks Blocks 738, 782, 785, 826 and 827, subject to certain depth +limitations. Upon the completion of the acquisition, we will own a 100% working interest in the +Entrada Field and will become operator. The acquisition is expected to close within the next 45 +days and will add 150 Bcfe to our proved undeveloped reserves. +The Magnolia field is located on blocks adjacent to Entrada. The field and related production +facilities are owned by Conoco/Phillips, the operator, and Devon +Energy Corporation. Work has been +substantially completed on a front-end engineering design study to tie-back Entrada to the Magnolia production +facilities by an integrated project team consisting of a leading engineering firm and personnel +from BP and Callon, along with the Magnolia owners. Negotiations between the Magnolia facility +owners and Entrada owners for a production handling agreement have +been ongoing. We expect to complete +these negotiations in the near future once closing of our acquisition of BP’s interest in Entrada +is complete. Development expenditures are expected to commence in the second half of 2007 with the ordering +of long-lead items. The majority of development costs are anticipated to be incurred in 2008 and +early 2009. First production is projected to commence in the first quarter of 2009. +Medusa, Mississippi Canyon Blocks 538/582 +Our Medusa deepwater discovery was announced in September 1999, after we drilled the initial test +well in 2,235 feet of water to a total depth of 16,241 feet and encountered over 120 feet of pay in +two intervals. Subsequent sidetrack drilling from the wellbore was used to determine the extent of +the discovery and a second well was drilled in the first quarter of 2000 to further delineate the +extent of the pay intervals. We own a 15% +working interest, Murphy Exploration & Production Company (“Murphy”), the operator, owns a 60% +working interest and ENI Deepwater, LLC, owns the remaining 25% working interest. +In 2001 a drilling program began which included four development wells and one sidetrack. The +program included production casing being set on six wells to provide initial production take-points +and was completed in the first half of 2002. The construction of a floating production system, +spar, at Medusa was completed during the second quarter of 2003. The A-1 well was completed and +tied into the spar and commenced production in late November 2003. The remaining five wells were +completed and +16 +Table of Contents +commenced production in 2004. Mississippi Canyon 538 #4, North Medusa, was drilled +in 2003 and was temporarily abandoned after encountering 28 feet of net pay. The well bore was +re-entered in the fourth quarter of 2004, sidetracked and reached an objective depth of 9,600 feet +in January 2005. The sidetrack encountered 46 feet of net pay, was completed and commenced initial +production in April 2005. +During 2006 the field produced 8.2 Bcfe net to us which accounted for 40% of our total production. +Future plans include five recompletions to produce up-hole sands and two sidetracks to undrained +areas of the field up-dip or fault separated from existing productions. +In December 2003, we transferred our undivided 15% working interest in the spar production +facilities to Medusa Spar LLC in exchange for cash proceeds of approximately $25 million and a 10% +ownership interest in the LLC. A detailed discussion of this transaction is included in +“Management’s Discussion and Analysis of Financial Condition and Results of Operations-Off-Balance +Sheet Arrangements”. +Habanero, Garden Banks Block 341 +During February 1999, the initial test well on our Habanero deepwater discovery encountered over +200 feet of net pay in two zones. Located in 2,015 feet of water, the well was drilled to a +measured depth of 21,158 feet. We own an 11.25% working interest in the well. The well is operated +by Shell Deepwater Development Inc., which owns a 55% working interest, with the remaining working +interest being owned by Murphy. +A field delineation program began in mid-year 2001, which included three sidetracks of the +discovery well. Production casing was set on this well through the last of the sidetracks to the +Habanero 52 oil and gas sand and the Habanero 55 gas sand. Also, a development well was drilled in +the summer of 2003 which provides a take-point for production from the Habanero 52 oil sand. By +means of a sub-sea completion and tie back to an existing production facility in the area operated +by Shell, production from the Habanero 52 oil sand commenced in late November 2003 and from the +Habanero 55 gas sand in January 2004. In July 2004 the #2 well producing the Habanero 52 oil sand +developed mechanical difficulties with a subsurface control valve and was shut-in resulting in a +significant loss of production. Repairs were completed and production was restored in late +December 2004. In addition, the #1 well producing the Habanero 55 gas sand was recompleted to the +Habanero 55 oil sand in December 2004. +At the time the field was developed, there was no way to know what the drive mechanism would be, so +the wells were put at a mid-dip position. It is now known the field drive mechanism is water and +the wells need to be at the structural crest for maximum recovery. A sidetrack of the #1 well is +planned for this summer to move that well to an up-dip position. +During 2006 Habanero produced 2.1 Bcfe net to us which accounted for 10% of our total production. +Gulf of Mexico Shelf and Onshore Louisiana +High Island Blocks 165/130 +The High Island 165 #1 well was spud in the fourth quarter of 2005, reached total depth of 17,029 +feet in January 2006 and logged 140 feet of net pay. The well commenced production in October 2006 +and during February 2007 was producing at a gross rate of 44 million cubic feet of natural gas per +day. We have two development wells in progress, the High Island Block 130 #1 and #2 wells. The #1 +well is being +17 +Table of Contents +completed and should commence production at a similar rate late in the first quarter +of 2007. In addition to the productive sands discovered by the High Island 165 #1 well, the High +Island 130 #1 well encountered two deeper productive sands. The High Island 130 #2 well is drilling +and if successful should commence production in the second half of 2007. The High Island 165 #1 +well produced 0.4 Bcfe net to our interest in the fourth quarter of 2006. We have a 16.7% working +interest in the shallower productive zones and an 11.7% interest in the deeper discovered by the +High Island 130 #1 well and the operator of the field is Hydro Gulf of Mexico, LLC. +West Cameron 3/LA +We drilled our Prairie Beach prospect during the first half of 2006 which is located onshore in the +state waters of Cameron Parish, Louisiana. The well encountered 37 feet of net pay and began +production in October 2006. During 2006, the field produced 0.3 Bcfe net to us. We operate and own +a 75% working interest. +High Island Block A-540 +The #1 well was spud in November 2005 and reached a total depth of 9,450 feet the following month +after logging 32 feet of net pay in the objective section. First production commenced in late +September 2006 and during 2006 the field produced 0.3 Bcfe net to us. The company owns a 60% +working interest and Walter Oil and Gas is the operator. +West Cameron Block 295 +During the third quarter of 2005, the #2 well reached a total depth of 15,775 feet and logged 150 +feet of net pay in two zones. Each zone was encountered at the predicted depth and exceeded +anticipated thickness. The #2 well commenced production in the second quarter of 2006 and +encountered mechanical difficulties which were corrected. Sustained production was achieved by the +third quarter of 2006. In 2006, we drilled the #4 well, an offset to the #2 well. The #4 well +commenced production during December 2006 in a deeper, secondary zone. After this zone is depleted +we expect to recomplete the well in the main pay zone. Callon holds a 20.5% working interest in the +block and Hydro Gulf of Mexico, LLC is the operator. +A second prospect on this block was also drilled during 2005. The #3 well was drilled to a depth +of 16,286 feet in December 2005 and logged 110 feet of net (94 feet true vertical depth) pay in two +zones. The well was completed in a deeper secondary zone and will probably be recompleted to the +main pay zone in early 2008. The well commenced production in August 2006. Callon holds a 20.5% +working interest in the block and Cimarex Energy Company is the operator. +During 2006, the West Cameron 295 field produced 0.8 Bcfe net to us. +North Padre Island Block 913 +An exploratory well was drilled to a vertical depth of 8,082 feet in the fourth quarter of 2004 and +found natural gas pay in multiple intervals. The well is tied back to existing infrastructure on a +nearby block. We are the operator and own a 50% working interest. First production commenced in +March 2006 and during 2006 the field produced 1.5 Bcfe net to us. +18 +Table of Contents +East Cameron 109 +During +2006, an exploratory well was drilled to a vertical depth of 13,110 +feet and encountered 54 feet +of net pay. The well commenced production during the second half of 2006 and produced 0.1 Bcfe +before encountering mechanical problems. Production was restored in January 2007. Callon owns a +25% working interest and Energy Partners, LTD is the operator. +Oil and Gas Reserves +The following table sets forth certain information about our estimated proved reserves as reported +by Huddleston & Co., Inc. as of the dates set forth below. +Years Ended December 31, +2006 +2005 +2004 +(In thousands) +Proved developed: +Oil (Bbls) +5,159 +7,323 +10,292 +Gas (Mcf) +36,750 +30,982 +33,982 +Mcfe +67,704 +74,921 +95,735 +Proved undeveloped: +Oil (Bbls) +8,106 +11,105 +9,456 +Gas (Mcf) +29,287 +47,039 +38,637 +Mcfe +77,924 +113,667 +95,373 +Total proved: +Oil (Bbls) +13,265 +18,428 +19,748 +Gas (Mcf) +66,037 +78,021 +72,619 +Mcfe +145,628 +188,588 +191,108 +Estimated pre-tax future net cash flows (a) +$ +775,742 +$ +1,487,817 +$ +892,145 +Pre-tax +discounted present value (a)(b) +$ +534,743 +$ +1,088,714 +$ +612,595 +Standardized measure of discounted future +net cash flows(a)(b) +$ +470,791 +$ +837,552 +$ +515,893 +(a) +Includes a reduction for estimated plugging and abandonment costs that is reflected as +a liability on our balance sheet at December 31, 2006, in accordance with SFAS 143. +(b) +We use the financial measure “present value of estimated +future net revenues from proved reserves, excluding income taxes.” +This is a non-GAAP financial measure. We believe that present value +of estimated future net revenues from proved reserves, excluding +income taxes, while not a financial measure in accordance with +generally accepted accounting principles, is an important financial +measure used by investors and independent oil and gas producers for +evaluating the relative value of oil and natural gas properties and +acquisitions because the tax characteristics of comparable companies +can differ materially. The total standardized measure for our proved +reserves as of December 31, 2006 was $470.8 million. The standardized measure gives effect to +income taxes, and is calculated in accordance with Statement of +Financial Accounting Standards No. 69, “Disclosures About +Oil and Gas Producing Activities.” The standardized measure of +our estimated net proved reserves of $470.8 million equals the +present value of our estimated future net revenue from proved +reserves, excluding income taxes, of $534.7 million, less +discounted estimated future income taxes relating to such future net +revenues of $63.9 million. +19 +Table of Contents +Our independent reserve engineers, Huddleston & Co., Inc., prepared the estimates of the proved +reserves and the future net cash flows and present value thereof attributable to such proved +reserves. Reserves were estimated using oil and gas prices and production and development costs in +effect on December 31 of each such year, without escalation, and were otherwise prepared in +accordance with SEC regulations regarding disclosure of oil and gas reserve information. +There are numerous uncertainties inherent in estimating quantities of proved reserves, including +many factors beyond our control or the control of the reserve engineers. Reserve engineering is a +subjective process of estimating underground accumulations of oil and gas that cannot be measured +in an exact manner. The accuracy of any reserve or cash flow estimate is a function of the quality +of available data and of engineering and geological interpretation and judgment. Estimates by +different engineers often vary, sometimes significantly. In addition, physical factors, such as +the results of drilling, testing and production subsequent to the date of an estimate, as well as +economic factors, such as an increase or decrease in product prices that renders production of such +reserves more or less economic, may justify revision of such estimates. Accordingly, reserve +estimates could be different from the quantities of oil and gas that are ultimately recovered. +We have not filed any reports with other federal agencies which contain an estimate of total proved +net oil and gas reserves during our last fiscal year. +Present Activities and Productive Wells +The following table sets forth the wells we have drilled and completed during the periods +indicated. All such wells were drilled in the continental United States primarily in federal and +state waters in the Gulf of Mexico. +Years Ended December 31, +2006 +2005 +2004 +Gross +Net +Gross +Net +Gross +Net +Development: +Oil +— +— +1 +0.15 +— +— +Gas +2 +0.37 +— +— +2 +1.22 +Non-productive +— +— +— +— +— +— +Total +2 +0.37 +1 +0.15 +2 +1.22 +Exploration: +Oil +— +— +— +— +— +— +Gas +5 +2.05 +7 +2.42 +2 +0.72 +Non-productive +8 +2.98 +4 +1.25 +5 +1.24 +Total +13 +5.03 +11 +3.67 +7 +1.96 +20 +Table of Contents +The following table sets forth our productive wells as of December 31, 2006: +Wells +Gross +Net +Oil: +Working interest +40.00 +3.90 +Royalty interest +193.00 +3.15 +Total +233.00 +7.05 +Gas: +Working interest +35.00 +14.40 +Royalty interest +211.00 +1.49 +Total +246.00 +15.89 +A well is categorized as an oil well or a natural gas well based upon the ratio of oil to gas +reserves on a Mcfe basis. However, some of our wells produce both oil and gas. At December 31, +2006, we had no wells with multiple completions. At December 31, 2006, 1 gross (0.033 net) +exploration oil well, 1 gross (0.255 net) exploration gas well and 1 gross (0.117 net) development +gas well were in progress. +Leasehold Acreage +The following table shows our approximate developed and undeveloped (gross and net) leasehold +acreage as of December 31, 2006. +Leasehold Acreage +Developed +Undeveloped +Location +Gross +Net +Gross +Net +Louisiana +6,274 +4,019 +10,706 +4,454 +Texas +78 +— +15,150 +7,616 +Other states +— +— +681 +509 +Federal waters +107,029 +53,930 +357,270 +152,105 +Total +113,381 +57,949 +383,807 +164,684 +As of December 31, 2006, we owned various royalty and overriding royalty interests in 553 net +developed and 7,645 net undeveloped acres. In addition, we owned 4,071 developed and 121,929 +undeveloped mineral acres. +21 +Table of Contents +Major Customers +Our production is sold generally on month-to-month contracts at prevailing prices. The following +table identifies customers to whom we sold a significant percentage of our total oil and gas +production during each of the 12-month periods ended: +December 31 +2006 +2005 +2004 +Shell Trading Company +41 +% +34 +% +30 +% +Louis Dreyfus Energy Services +25 +% +16 +% +23 +% +Plains Marketing, L.P. +11 +% +16 +% +13 +% +Chevron Texaco Natural Gas +3 +% +10 +% +6 +% +Because alternative purchasers of oil and gas are readily available, we believe that the loss of +any of these purchasers would not result in a material adverse effect on our ability to market +future oil and gas production. +Title to Properties +We believe that the title to our oil and gas properties is good and defensible in accordance with +standards generally accepted in the oil and gas industry, subject to such exceptions which, in our +opinion, are not so material as to detract substantially from the use or value of such properties. +Our properties are typically subject, in one degree or another, to one or more of the following: +• +royalties and other burdens and obligations, express or implied, under oil and gas leases; +• +overriding royalties and other burdens created by us or our predecessors in title; +• +a variety of contractual obligations (including, in some cases, development obligations) +arising under operating agreements, farmout agreements, production sales contracts and +other agreements that may affect the properties or their titles; +• +back-ins and reversionary interests existing under purchase agreements and leasehold +assignments; +• +liens that arise in the normal course of operations, such as those for unpaid taxes, +statutory liens securing obligations to unpaid suppliers and contractors and contractual +liens under operating agreements; +• +pooling, unitization and communitization agreements, declarations and orders; and +• +easements, restrictions, rights-of-way and other matters that commonly affect property. +To the extent that such burdens and obligations affect our rights to production revenues, they have +been taken into account in calculating our net revenue interests and in estimating the size and +value of our reserves. We believe that the burdens and obligations affecting our properties are +conventional in the industry for properties of the kind owned by us. +22 +Table of Contents +ITEM 3. LEGAL PROCEEDINGS +We are a defendant in various legal proceedings and claims, which arise in the ordinary course of +our business. We do not believe the ultimate resolution of any such actions will have a material +affect on our financial position or results of operations. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +There were no matters submitted to a vote of security holders during the fourth quarter of 2006. +23 +Table of Contents +PART II. +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED +STOCKHOLDER MATTERS +Our common stock trades on the New York Stock Exchange under the symbol “CPE”. The following table +sets forth the high and low sale prices per share as reported for the periods indicated. +Quarter Ended +High +Low +2005: +First quarter +$ +18.00 +$ +13.22 +Second quarter +16.12 +12.42 +Third quarter +21.25 +14.81 +Fourth quarter +22.29 +16.65 +2006: +First quarter +$ +21.25 +$ +17.01 +Second quarter +21.99 +15.12 +Third quarter +19.96 +12.54 +Fourth quarter +17.44 +12.48 +As of March 5, 2007 there were approximately 4,057 common stockholders of record. +We have never paid dividends on our common stock and intend to retain our cash flow from +operations, net of preferred stock dividends, for the future operation and development of our +business. In addition, our primary credit facility and the terms of our outstanding subordinated +debt prohibit the payment of cash dividends on our common stock. +24 +Table of Contents +Performance Graph +The following graph compares the yearly percentage change for the five years ended December 31, +2006, in the cumulative total shareholder return on the Company’s Common Stock against the +cumulative total return for the (i) Hemscott Industry and Market Index of SIC Group 123 (the +“Hemscott Group Index”) consisting of independent oil and gas drilling and exploration companies +and (ii) the New York Stock Exchange Market Index. The comparison of total return on an investment +for each of the periods assumes that $100 was invested on December 31, 2001 in the Company, the +Hemscott Group Index and the New York Stock Exchange Market Index, and that all dividends were +reinvested. +COMPARE 5-YEAR CUMULATIVE TOTAL RETURN +AMONG CALLON PETROLEUM COMPANY +NYSE MARKET INDEX AND HEMSCOTT GROUP INDEX +ASSUMES $100 INVESTED ON DEC. 31, 2001 +ASSUMES DIVIDEND REINVESTED +FISCAL YEAR ENDING DEC. 31, 2006 +2001 +2002 +2003 +2004 +2005 +2006 +Callon Petroleum Company +$ +100 +$ +49 +$ +151 +$ +211 +$ +258 +$ +219 +Hemscott Group Index +$ +100 +$ +93 +$ +121 +$ +170 +$ +268 +$ +318 +NYSE Market Index +$ +100 +$ +82 +$ +106 +$ +119 +$ +129 +$ +152 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth, as of the dates and for the periods indicated, selected financial +information about us. The financial information for each of the five years in the period ended +December 31, 2006 has been derived from our audited Consolidated Financial Statements for such +periods. The information should be read in conjunction with “Management’s Discussion and Analysis +of Financial Condition and Results of Operations” and the Consolidated Financial Statements and +Notes thereto. The following information is not necessarily indicative of our future results. +25 +Table of Contents +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(In thousands, except per share amounts) +Years Ended December 31, +2006 +2005 +2004 +2003 +2002 +Statement of Operations Data: +Operating revenues: +Oil and gas sales +$ +182,268 +$ +141,290 +$ +119,802 +$ +73,697 +$ +61,171 +Operating expenses: +Lease operating expenses +28,881 +24,377 +22,308 +11,301 +11,030 +Depreciation, depletion and amortization +65,283 +44,946 +47,453 +28,253 +27,096 +General and administrative +8,591 +8,085 +8,758 +4,713 +4,705 +Accretion expense +4,960 +3,549 +3,400 +2,884 +— +Derivative expense +150 +6,028 +1,371 +535 +708 +Total operating expenses +107,865 +86,985 +83,290 +47,686 +43,539 +Income from operations +74,403 +54,305 +36,512 +26,011 +17,632 +Other (income) expenses: +Interest expense +16,480 +16,660 +20,137 +30,614 +26,140 +Other (income) +(1,869 +) +(998 +) +(357 +) +(444 +) +(1,004 +) +Loss on early extinguishment of debt +— +— +3,004 +5,573 +— +Gain on sale of pipeline +— +— +— +— +(2,454 +) +Gain on sale of Enron derivatives +— +— +— +— +(2,479 +) +Total other (income) expenses +14,611 +15,662 +22,784 +35,743 +20,203 +Income (loss) before income taxes +59,792 +38,643 +13,728 +(9,732 +) +(2,571 +) +Income tax expense (benefit) +20,707 +13,209 +(6,697 +) +8,432 +(900 +) +Income (loss) before equity in earnings of Medusa Spar LLC +and cumulative effect of change in accounting principle +39,085 +25,434 +20,425 +(18,164 +) +(1,671 +) +Equity in earnings of Medusa Spar LLC, net of tax +1,475 +1,342 +1,076 +(8 +) +— +Income (loss) before cumulative effect of change in +in accounting principle +40,560 +26,776 +21,501 +(18,172 +) +(1,671 +) +Cumulative effect of change in accounting principle, +net of tax +— +— +— +181 +— +Net income (loss) +40,560 +26,776 +21,501 +(17,991 +) +(1,671 +) +Preferred stock dividends +— +318 +1,272 +1,277 +1,277 +Net income (loss) available to common shares +$ +40,560 +$ +26,458 +$ +20,229 +$ +(19,268 +) +$ +(2,948 +) +26 +Table of Contents +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(In thousands, except per share amounts) +Years Ended December 31, +2006 +2005 +2004 +2003 +2002 +Net income (loss) per common share: +Basic: +Net income (loss) available to common before +cumulative effect of change in accounting principle +$ +2.00 +$ +1.43 +$ +1.28 +$ +(1.42 +) +$ +(.22 +) +Cumulative effect of change in accounting principle, +net of tax +— +— +— +.01 +— +Net income (loss) available to common +$ +2.00 +$ +1.43 +$ +1.28 +$ +(1.41 +) +$ +(.22 +) +Diluted: +Net income (loss) available to common before +cumulative effect of change in accounting principle +$ +1.90 +$ +1.28 +$ +1.22 +$ +(1.42 +) +$ +(.22 +) +Cumulative effect of change in accounting principle, +net of tax +— +— +— +.01 +— +Net income (loss) available to common +$ +1.90 +$ +1.28 +$ +1.22 +$ +(1.41 +) +$ +(.22 +) +Shares used in computing net income (loss) per common share: +Basic +20,270 +18,453 +15,796 +13,662 +13,387 +Diluted +21,363 +20,883 +17,678 +13,662 +13,387 +Balance Sheet Data (end of period): +Oil and gas properties, net +$ +547,027 +$ +447,364 +$ +406,690 +$ +390,163 +$ +377,661 +Total assets +$ +625,527 +$ +533,776 +$ +457,523 +$ +496,032 +$ +410,613 +Long-term debt, less current portion +$ +225,521 +$ +188,813 +$ +192,351 +$ +214,885 +$ +248,269 +Stockholders’ equity +$ +281,363 +$ +228,048 +$ +198,312 +$ +133,261 +$ +140,960 +We follow the full-cost method of accounting for oil and gas properties. Under this method of +accounting, our net capitalized costs to acquire, explore and develop oil and gas properties may +not exceed the sum of (1) the estimated future net revenues from proved reserves at current prices +discounted at 10% and (2) the lower of cost or market of unevaluated properties, net of tax (the +full-cost ceiling amount). If these capitalized costs exceed the full-cost ceiling amount, the +excess is charged to expense. +27 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +The following discussion is intended to assist in an understanding of our financial condition and +results of operations. Our Consolidated Financial Statements and Notes thereto contain detailed +information that should be referred to in conjunction with the following discussion. See Item 8 +“Financial Statements and Supplementary Data.” +General +We have been engaged in the exploration, development, acquisition and production of oil and gas +properties since 1950. Our revenues, profitability and future growth and the carrying value of our +oil and gas properties are substantially dependent on prevailing prices of oil and gas and our +ability to find, develop and acquire additional oil and gas reserves that are economically +recoverable. Our ability to maintain or increase our borrowing capacity and to obtain additional +capital on attractive terms is also influenced by oil and gas prices. +Significant events relating to our financial and operating results for the year ended December 31, +2006 included the closing of our four-year amended and restated senior secured credit facility +which was underwritten by Union Bank of California, N.A. The credit facility has an initial +borrowing base of $75 million, which will be reviewed and redetermined semi-annually and can be +increased to a maximum of $175 million. We expect planned 2007 capital expenditures of +approximately $125 million will be funded with cash flows from operations and supplemented, if +necessary, with our senior secured credit facility, which had $40 million available at December 31, +2006. For a more detailed discussion of outstanding debt see Note 7 to our Consolidated Financial +Statements. +Our estimated net proved oil and gas reserves decreased at December 31, 2006 to 145.6 Bcfe. This +represents a decrease of 23% from previous year-end 2005 estimated proved reserves of 188.6 Bcfe. +Prices for oil and gas are subject to large fluctuations in response to relatively minor changes in +the supply of and demand for oil and gas, market uncertainty and a variety of additional factors +beyond our control. These factors include weather conditions in the United States, the condition +of the United States economy, the actions of the Organization of Petroleum Exporting Countries, +governmental regulation, political stability in the Middle East and elsewhere, the foreign supply +of crude oil and natural gas, the price of foreign imports and the availability of alternate fuel +sources. Any substantial and extended decline in the price of crude oil or natural gas would have +an adverse effect on our carrying value of the proved reserves, borrowing capacity, revenues, +profitability and cash flows from operations. We use derivative financial instruments (see Note 8 +to our Consolidated Financial Statements and Item 7A. “Quantitative and Qualitative Disclosures +About Market Risks”) for price protection purposes on a limited amount of our future production and +do not use these instruments for trading purposes. On a Mcfe basis, natural gas represents +approximately 73% of budgeted 2007 production and 45% of proved reserves at year-end 2006. +Inflation has not had a material impact on us and is not expected to have a material impact on us +in the future. +Summary of Significant Accounting Policies +Property and Equipment. We follow the full-cost method of accounting for oil and gas properties +whereby all costs incurred in connection with the acquisition, exploration and development of oil +and gas reserves, including certain overhead costs, are capitalized into the “full-cost pool.” The +amounts we capitalize into the full-cost pool are depleted (charged against earnings) using the +unit-of-production method. The full-cost +28 +Table of Contents +method of accounting for our proved oil and gas +properties requires that we make estimates based on assumptions as to future events that could +change. These estimates are described below. +Depreciation, Depletion and Amortization (DD&A) of Oil and Gas Properties . We calculate depletion +by using the net capitalized costs in our full-cost pool plus future development costs (combined, +the depletable base) and our estimated net proved reserve quantities. Capitalized costs added to +the full-cost pool include the following: +• +the cost of drilling and equipping productive wells, dry hole costs, acquisition costs +of properties with proved reserves, delay rentals and other costs related to exploration +and development of our oil and gas properties; +• +our payroll and general and administrative costs and costs related to fringe benefits +paid to employees directly engaged in the acquisition, exploration and/or development of +oil and gas properties as well as other directly identifiable general and administrative +costs associated with such activities. Such capitalized costs do not include any costs +related to our production of oil and gas or our general corporate overhead; +• +costs associated with properties that do not have proved reserves classified as +unevaluated property costs and are excluded from the depletable base. These unevaluated +property costs are added to the depletable base at such time as wells are completed on the +properties, the properties are sold or we determine these costs have been impaired. Our +determination that a property has or has not been impaired (which is discussed below) +requires that we make assumptions about future events; +• +estimated costs to dismantle, abandon and restore properties that are capitalized to the +full-cost pool when the related liabilities are incurred under SFAS 143; and +• +our estimates of future costs to develop proved properties are added to the full-cost +pool for purposes of the DD&A computation. We use assumptions based on the latest +geologic, engineering, regulatory and cost data available to us to estimate these amounts. +However, the estimates we make are subjective and may change over time. Our estimates of +future development costs are periodically updated as additional information becomes +available. +Capitalized costs included in the full-cost pool are depleted and charged against earnings using +the unit-of-production method. Under this method, we estimate the proved reserves quantities at +the beginning of each accounting period. For each barrel of Mcfe produced during the period, we +record a depletion charge equal to the amount included in the depletable base (net of accumulated +depreciation, depletion and amortization) divided by our estimated net proved reserve quantities. +Because we use estimates and assumptions to calculate proved reserves (as discussed below) and the +amounts included in the full-cost pool, our depletion rates may change if the estimates and +assumptions are not realized. Such changes may be material. +Ceiling Test . Under the full-cost accounting rules of the SEC, we review the carrying value of our +proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and +gas properties, net of +accumulated depreciation, depletion and amortization and deferred income taxes, may not exceed the +present value of estimated future net cash flows from proved oil and gas reserves, discounted at +10%, plus the lower of cost or fair value of unevaluated properties, net of related tax effects +(the full-cost ceiling amount). These rules generally require pricing future oil and gas +production at the unescalated market price for oil and gas at the end of each fiscal quarter and +require a write-down if the “ceiling” is exceeded. However, if prices recover sufficiently +subsequent to the balance sheet date before the release of the financial statements then use of the +subsequent pricing is allowed and no write-down would be required if same pricing was used. Given +the volatility of oil and gas prices, it is reasonably possible that our estimate of discounted +future net cash flows from proved oil and gas reserves could change in the near term. If oil and +gas prices decline significantly, +29 +Table of Contents +even if only for a short period of time, it is possible that +write-downs of oil and gas properties could occur in the future. +Estimating Reserves and Present Values . The estimates of quantities of proved oil and gas reserves +and the discounted present value of estimated future net cash flows from such reserves at the end +of each quarter are based on numerous assumptions, which are likely to change over time. These +assumptions include: +• +the prices at which we can sell our oil and gas production in the future. Oil and gas +prices are volatile, but we are required to assume that they will not change from the +prices in effect at the end of the quarter. In general, higher oil and gas prices will +increase quantities of proved reserves and the present value of estimated future net cash +flows from such reserves, while lower prices will decrease these amounts. Because our +properties have relatively short productive lives, changes in prices will affect the +present value of estimated future net cash flows more than the estimated quantities of oil +and gas reserves; +• +the costs to develop and produce our reserves and the costs to dismantle our production +facilities when reserves are depleted. These costs are likely to change over time, but we +are required to assume that costs in effect at the end of the quarter will not change. +Increases in costs will reduce estimated oil and gas quantities and the present value of +estimated future net cash flows, while decreases in costs will increase such amounts. +Because our properties have relatively short productive lives, changes in costs will affect +the present value of estimated future net cash flows more than the estimated quantities of +oil and gas reserves; and +• +the potential royalties payable to the Mineral Management Service. See Note 9 of our +Consolidated Financial Statements for a more detailed discussion of this potential +liability. +In addition, the process of estimating proved oil and gas reserves requires that our independent +and internal reserve engineers exercise judgment based on available geological, geophysical and +technical information. We have described the risks associated with reserve estimation and the +volatility of oil and gas prices under “Risk Factors”. +Unproved Properties . Costs associated with properties that do not have proved reserves, including +capitalized interest, are excluded from the depletable base. These unproved properties are +included in the line item “Unevaluated properties excluded from amortization.” Unproved property +costs are transferred to the depletable base when wells are completed on the properties or the +properties are sold. In addition, we are required to determine whether our unproved properties are +impaired and, if so, include the costs of such properties in the depletable base. We determine +whether an unproved property should be impaired by periodically reviewing our exploration program +on a property by property basis. This determination may require the exercise of substantial +judgment by our management. +Asset Retirement Obligations. We account for asset retirement obligations in accordance with +Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” +(“SFAS 143”), which +essentially requires entities to record the fair value of a liability for obligations associated +with the retirement of tangible long-lived assets and the associated asset retirement costs. +Interest is accreted on the present value of the asset retirement obligation and reported as +accretion expense within operating expenses in the Consolidated Statements of Operations. See Note +10 to our Consolidated Financial Statements. +Derivatives. We periodically use derivative financial instruments to manage oil and gas price risk +on a limited amount of our future production and do not use these instruments for trading purposes. +Settlement of derivative contracts are generally based on the difference between the contract +price or prices specified in the derivative instrument and a NYMEX price or other cash or futures +index price. Such derivatives are +30 +Table of Contents +accounted for under Statement of Financial Accounting Standards +No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) as amended. +Our derivative contracts that are accounted for as cash flow hedges under SFAS 133 are recorded at +fair market value and the changes in fair value are recorded through other comprehensive income +(loss), net of tax, in stockholders’ equity. The cash settlements on these contracts are recorded +as an increase or decrease in oil and gas sales. The changes in fair value related to ineffective +derivative contracts are recognized as derivative expense (income). The cash settlement on these +contracts is also recorded within derivative expense (income). The changes in fair value of the +our derivative contracts that are not designated as effective cash flow hedges are recorded through +the statement of operations as derivative expense (income). See Note 8 to our Consolidated +Financial Statements. +Income Taxes. We follow the asset and liability method of accounting for deferred income taxes +prescribed by Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes” +(“SFAS 109”). SFAS 109 provides for the recognition of a deferred tax asset for deductible +temporary timing differences, capital and operating loss carryforwards, statutory depletion +carryforward and tax credit carryforwards, net of a “valuation allowance”. The valuation allowance +is provided for that portion of the asset, for which it is deemed more likely than not, that it +will not be realized. +Share-Based Compensation. Effective January 1, 2006, we adopted Statement of Financial Accounting +Standard No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”) utilizing the modified +prospective transition method. Prior to the adoption of SFAS 123R, we accounted for stock option +grants in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued +to Employees” (the intrinsic value method) and, accordingly, recognized no compensation expense for +stock option grants. +Under the modified prospective transition method, SFAS 123R applies to new awards, unvested awards +as of January 1, 2006 and awards that were outstanding on January 1, 2006 that are subsequently +modified, repurchased or cancelled. Under the modified prospective transition method, compensation +cost recognized in 2006 includes compensation cost for all share-based payments granted prior to, +but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in +accordance with the original provisions of Statement of Financial Accounting Standard No. 123 +“Accounting for Stock-Based Compensation,” (“SFAS 123”) and compensation cost for all share-based +payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in +accordance with the provisions of SFAS 123R. Prior periods were not restated to reflect the impact +of adopting the new standard. +SFAS 123R requires the cash flows from tax benefits resulting from tax deductions in excess of +compensation cost recognized for stock options exercised (excess tax benefits) to be classified as +financing cash flows. The $1.4 million of excess tax benefits classified as a financing cash +inflow for the year ended December 31, 2006 +would have been classified as an operating cash flow had we not adopted SFAS 123R. There were no +cash proceeds from the exercise of stock options for the year ended December 31, 2006 due to the +fact that all options were exercised through net-share settlements. As a result of most of our +stock-based compensation being in the form of restricted stock, the impact of the adoption of SFAS +123R on income before taxes, net income and basic and diluted earnings per share for the year ended +December 31, 2006 was immaterial. See Note 3 to our Consolidated Financial Statements. +New Accounting Standards +In June 2006, the Financial Accounting Standards Board (“FASB”) released interpretation No. 48, +Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 clarifies the accounting for income +taxes by prescribing the minimum recognition threshold a tax position must meet before being +recognized in the financial statements. FIN 48 also provides guidance on derecognition, +measurement, classification, interest +31 +Table of Contents +and penalties, accounting in interim periods, disclosure and +transition. The effective date for FIN 48 is fiscal years beginning after December 15, 2006. We +are currently reviewing the provisions of FIN 48 and have not yet determined the impact of +adoption. +In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, Fair Value +Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair +value and requires enhanced disclosures about fair value measurements. SFAS 157 is effective for +fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We +are still reviewing the provisions of SFAS 157 and have not yet determined the impact of adoption. +Liquidity and Capital Resources +Historically, our primary sources of capital have been cash flows from operations, borrowings from +financial institutions and the sale of debt and equity securities. Net cash and cash equivalents +decreased by $669,000 during 2006 to $1.9 million. Cash provided from operating activities during +2006 totaled $135.5 million, an increase of 83% from $74.0 million in 2005. +On August 30, 2006, we closed on a four-year amended and restated senior secured credit facility +underwritten by Union Bank of California, N.A. The credit facility includes an initial borrowing +base of $75 million, which will be reviewed and redetermined semi-annually and can be increased to +a maximum of $175 million. During 2006 we drew $35 million under our facility which was +outstanding as of December 31, 2006 and $40 million was +available for future borrowings. In connection with the anticipated +financing of the acquisition of BP’s interest in the Entrada +Field, the borrowing base under this facility would be reduced to +$50 million at closing until the next borrowing base +redetermination date. Please refer to “Subsequent Events” +below for more discussion on the Entrada acquisition. +In December 2003 and March 2004, we closed on our 9.75% senior notes due 2010 in the aggregate +principal amount of $200 million. The net proceeds from these notes and the public offering of +3,450,000 shares of common stock in the second quarter of 2004 were used to restructure our debt +that was maturing in 2004 and 2005. See Note 7 to the Consolidated Financial Statements for a more +detail discussion of long-term debt. +The indenture governing our 9.75% senior notes due 2010 and our senior secured credit facility +contain various covenants including restrictions on additional indebtedness and payment of cash +dividends. In addition, our senior secured credit facility contains covenants for maintenance of +certain financial ratios. We were in compliance with these covenants at December 31, 2006. +Our oil and gas reserves as estimated by Huddleston & Co., Inc. were 145.6 Bcfe of natural gas +equivalents on December 31, 2006. Our cash flow from operations during 2006 was generated by the +production of 20.8 Bcfe. +Production of our reserves during 2007, without weather-related downtime, is projected to be +higher than 2006 due to new discoveries that are projected to commence initial production during +the year, which is expected to offset anticipated declines from our current producing properties. +In +addition to the acquisition of BP’s interest in the Entrada +field, our planned capital expenditures for 2007 total $125 million and include capitalized interest and +general and administrative expenses. The current portion of our asset retirement obligation will +require an additional $10 million resulting in total capital expenditures of $135 million for 2007. +Capital expenditure plans for 2007 include: +• +the discretionary drilling of up to 17 exploratory and development wells; +• +lease and seismic acquisition; and +• +capitalized interest and overhead. +32 +Table of Contents +We believe that our operating cash flow and our credit facility will be adequate to meet our +capital, debt repayment, and operating requirements for 2007. We fund our day-to-day operating +expenses and capital expenditures from operating cash flows, supplemented as needed by borrowings +under our credit facility. In addition, we have sold debt and equity in both public and private +offerings in the past, and we expect that these sources of capital will continue to be available to +us in the future. Because of the liquidity and capital resources alternatives available to us, +including internally generated cash flows, our management believes that our short-term and +long-term liquidity is adequate to fund operations, including our capital spending program and +repayment of maturing debt. +Our cash flow, both in the short and long-term, is impacted by highly volatile oil and natural gas +prices, production levels, industry trends impacting operating expenses and our ability to continue +to acquire or find reserves at competitive prices. Cash flow forecasts for internal use by +management are revised monthly in response to changing market conditions and production +projections. We may adjust capital expenditure budgets within the planned total amount in response +to the adjusted cash flow forecasts and market trends in drilling and acquisitions costs. +The following table describes our outstanding contractual obligations as of December 31, 2006 (in +thousands): +Payments due by Period +More +Contractual +Less Than +One-Three +Three-Five +Than-Five +Obligations +Total +One Year +Years +Years +Years +Senior Secured Credit Facility +$ +35,000 +$ +— +$ +— +$ +35,000 +$ +— +9.75% Senior Notes +200,000 +— +— +200,000 +— +Capital lease (future minimum payments) +1,270 +348 +457 +446 +19 +Throughput Commitments: +Medusa Spar LLC +8,848 +3,152 +5,696 +— +— +Medusa Oil Pipeline +400 +105 +132 +101 +62 +$ +245,518 +$ +3,605 +$ +6,285 +$ +235,547 +$ +81 +Subsequent +Events +Subsequent +to December 31, 2006, on March 8, 2007, we entered into an agreement with BP to purchase BP’s 80% working interest in the Entrada Field for total cash +consideration of $190 million. The purchase price includes $150 million payable at closing and an +additional $40 million payable after the achievement of certain production milestones. The +purchased interests include five federal offshore blocks at Garden Banks Blocks 738, 782, 785, 826 +and 827, subject to certain depth limitations. Upon the completion of the acquisition, we will own a 100% working interest in the Entrada Field and will become operator. +The acquisition is expected to close within the next 45 days and will add 150 Bcfe to our proved +undeveloped reserves. +To finance +the initial $150 million payment of the purchase price, a commitment has been received from Merrill +Lynch Capital Corporation to make available to us a 7-year, $200 million revolving credit facility +secured by a lien on the Entrada properties. We plan to borrow the full commitment amount at closing +to cover the required $150 million payment to BP and, expenses +and fees, and the balance of the funds can be used for +Entrada development cost or general corporate purposes. +Off-Balance Sheet Arrangements +We have a 10% ownership interest in Medusa Spar LLC (“LLC”), which is a limited liability company +that owns a 75% undivided ownership interest in the deepwater spar production facilities on our +Medusa +33 +Table of Contents +Field in the Gulf of Mexico. We contributed a 15% undivided ownership interest in the +production facility to the LLC in return for approximately $25 million in cash and a 10% ownership +interest in the LLC. The LLC earns a tariff based upon production volume throughput from the Medusa +area. We are obligated to process our share of production from the Medusa Field and any future +discoveries in the area through the spar production facilities. This arrangement allows us to defer +the cost of the spar production facility over the life of the Medusa Field. Our cash proceeds were +used to reduce the balance outstanding under our senior secured credit facility. The LLC used the +cash proceeds from $83.7 million of non-recourse financing and a cash contribution by one of the +LLC owners to acquire its 75% interest in the spar. On December 31, 2006, $33.2 million of the +financing was outstanding. The balance of Medusa Spar LLC is owned by Oceaneering International, +Inc. and Murphy. We are accounting for its 10% ownership interest in the LLC under the equity +method. +Results of Operations +The following table sets forth certain operating information with respect to our oil and gas +operations for each of the three years in the period ended December 31, 2006. +December 31, +2006 +2005 +2004 +Production: +Oil (MBbls) +1,634 +1,837 +1,736 +Gas (MMcf) +10,977 +7,768 +11,387 +Total production (MMcfe) +20,780 +18,787 +21,801 +Average daily production (MMcfe) +56.9 +51.5 +59.6 +Average sales price: +Oil (per Bbl) (a) +$ +57.33 +$ +41.61 +$ +28.71 +Gas (per Mcf) +$ +8.07 +$ +8.35 +$ +6.15 +Total (per Mcfe) +$ +8.77 +$ +7.52 +$ +5.50 +Oil and gas revenues (in thousands): +Oil revenue +$ +93,665 +$ +76,425 +$ +49,826 +Gas revenue +88,603 +64,865 +69,976 +Total +$ +182,268 +$ +141,290 +$ +119,802 +Lease operating expenses (in thousands) +$ +28,881 +$ +24,377 +$ +22,308 +Additional per Mcfe data: +Sales price +$ +8.77 +$ +7.52 +$ +5.50 +Lease operating expenses +1.39 +1.30 +1.02 +Operating margin +$ +7.38 +$ +6.22 +$ +4.48 +Depletion +$ +3.14 +$ +2.39 +$ +2.18 +General and administrative (net of management fees) +$ +.41 +$ +.43 +$ +.40 +(a) Below is a reconciliation of the average NYMEX +price to the average realized sales price per +barrel of oil: +Average NYMEX oil price +$ +66.22 +$ +56.57 +$ +41.38 +Basis differential and quality adjustments +(7.03 +) +(8.45 +) +(4.60 +) +Transportation +(1.25 +) +(1.26 +) +(1.27 +) +Hedging +(0.61 +) +(5.25 +) +(6.80 +) +Average realized oil price +$ +57.33 +$ +41.61 +$ +28.71 +34 +Table of Contents +Comparison of Results of Operations for the Years Ended December 31, 2006 and 2005 +Oil and Gas Revenues +Total oil and gas revenues increased 29% from $141.3 million in 2005 to $182.3 million in 2006 +primarily due to higher gas production and oil pricing. Total production for 2006 increased by 11% +versus 2005, which was impacted by downtime for inclement weather. +Gas production during 2006 totaled 11.0 Bcf and generated $88.6 million in revenues compared to 7.8 +Bcf and $64.9 million in revenues during the same period in 2005. Average gas prices realized for +2006 were $8.07 per Mcf compared to $8.35 per Mcf during the same period in 2005. The increase in +production was primarily due to production from our new wells at East Cameron Block 90, North Padre +Island Block 913, High Island Block 73, Brazos Block 405, West Cameron Block 295, High Island 165 +and West Cameron 3/LA and 2005 production being negatively impacted by inclement weather. The +increase in production from new properties was partially offset by normal and expected declines in +production from our Habanero, High Island Block 119 and Mobile Bay area fields and older +properties. +Oil production during 2006 totaled 1,634,000 barrels and generated $93.7 million in revenues +compared to 1,837,000 barrels and $76.4 million in revenues for the same period in 2005. Average +oil prices realized in 2006 were $57.33 per barrel compared to $41.61 per barrel in 2005. Oil +production decreased during 2006 primarily due to a normal and expected decline at Habanero. See +the Results of Operations table for a reconciliation of the realized oil prices to average NYMEX. +Lease Operating Expenses +Lease operating expenses for 2006 increased by 18% to $28.9 million compared to $24.4 million for +the same period in 2005. The increase was primarily due to new wells coming on line, higher costs +for fuel and marine transportation and an increase in insurance rates for our policies which were +renewed on April 1, 2006. In addition, we incurred approximately $1.5 million for pipeline repairs +at our South Marsh Island Block 261 field and had downhole repairs at our Medusa field. +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization for 2006 and 2005 was $65.3 million and $44.9 million, +respectively. The 45% increase was due to higher production volumes and a higher average depletion +rate for 2006 compared to 2005. The higher rate is primarily attributable to an increase in +finding costs, estimated costs of future development and capitalized asset retirement costs. +Accretion Expense +Accretion expense for 2006 and 2005 of $5.0 million and $3.5 million, respectively, represents +accretion of our asset retirement obligations. The increase was due to the addition of plugging +and abandonment obligations associated with new discoveries and an increase in plugging and +abandonment cost estimates. See Note 10 to the Consolidated Financial Statements. +General and Administrative +General and administrative expenses for 2006, net of amounts capitalized, were $8.6 million +compared to $8.1 million in 2005. The $500,000 (6%) increase in +general and administrative expenses was due +to increased overall cost. We recognized non-cash charges of approximately $1.1 million in the +third quarter of 2006 for the vesting of 20% of restricted shares granted in August 2006. General +and administrative expenses for 2005 included non-cash charges of +$930,000 recognized in the +second quarter of 2005 for the accelerated vesting of performance shares pursuant to the terms of +the plan due to deaths or disability for an executive officer and two directors of the Company. See +Note 3 for more details. +Interest Expense +Interest expense was relatively consistent in 2006 in the amount of $16.5 million compared to $16.7 +million in 2005. +Income Taxes +For 2006, we had income tax expense of $20.7 million compared to $13.2 million in 2005. The 57% +increase was due to an increase in income before income taxes. +35 +Table of Contents +Comparison of Results of Operations for the Years Ended December 31, 2005 and 2004 +Oil and Gas Revenues +Total oil and gas revenues increased 18% from $119.8 million in 2004 to $141.3 million in 2005 +primarily due to increased pricing. Total production for 2005 decreased by 14% as compared to 2004 +as a result of downtime associated with the tropical storm and hurricane activity in 2005. +Gas production during 2005 totaled 7.8 Bcf and generated $64.9 million in revenues compared to 11.4 +Bcf and $70.0 million in revenues during the same period in 2004. Average gas prices realized for +2005 were $8.35 per Mcf compared to $6.15 per Mcf during the same period last year. The decrease +in production was primarily due to significant downtime related to tropical storm and hurricane +activity and the normal and expected decline in production from our Mobile area fields and older +properties. +Oil production during 2005 totaled 1,837,000 barrels and generated $76.4 million in revenues +compared to 1,736,000 barrels and $49.8 million in revenues for the same period in 2004. Average +oil prices realized in 2005 were $41.61 per barrel compared to $28.71 per barrel in 2004. Oil +production increased during 2005 despite significant downtime resulting from tropical storms and +hurricanes. The increase was primarily attributable to our deepwater property Medusa which began +production in 2003 from a single well with five others being brought online during 2004 and all six +producing during 2005. In addition, our North Medusa discovery was completed and initial +production commenced through the field facilities in April 2005. See the Results of Operations +table for a reconciliation of the realized oil prices to average NYMEX. +Lease Operating Expenses +Lease operating expenses for 2005 increased by 9% to $24.4 million compared to $22.3 million for +the same period in 2004. The increase was primarily due to lease operating expenses related to our +deepwater discovery Medusa, which had higher throughput charges as a result of higher production +rates and the addition of our High Island Block 119 field, which began producing late in the third +quarter of 2004. +In addition, lease operating expenses for 2005 included the cost of repairs to our properties for +damages caused by tropical storms and hurricanes in the net amount of $1.2 million. This amount +includes the deductibles and an estimate of repairs not expected to be reimbursed by our property +insurance carrier. +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization for 2005 and 2004 were $44.9 million and $47.5 million, +respectively. The 5% decrease was primarily due to lower production volumes for 2005 compared to +2004. The decrease was partially offset by a higher average depletion rate. +Accretion Expense +Accretion expense for 2005 and 2004 of $3.5 million and $3.4 million, respectively, represents +accretion of our asset retirement obligations. See Note 10 to the Consolidated Financial +Statements. +General and Administrative +General and administrative expenses for 2005, net of amounts capitalized, were $8.1 million +compared to $8.8 million in 2004. Expenses for 2004 included a $2.6 million charge that was +incurred in the first quarter of 2004 for the early retirement of two executive officers of the +Company. Expenses for 2005 included a $930,000 non-cash charge for the accelerated vesting of +performance shares pursuant to the terms of the plan due to death or disability for an executive +officer and two directors of the Company. Expenses for 2005 also increased due to a reduction in +the amount of overhead which was capitalized. +Interest Expense +Interest expense decreased by 17% in 2005 to $16.7 million compared to $20.1 million in 2004. This +decrease is primarily attributable to an equity offering completed in the second quarter of 2004 in +which a portion of the proceeds were used to redeem $33 million of 11% Senior Subordinated Notes. +Loss on Early Extinguishment of Debt +A loss on early extinguishment of debt of $3.0 million was recognized in 2004 for the write-off of +deferred financing costs and bond discounts as well as pre-payment premiums associated with the +early extinguishment of debt. +Income Taxes +For 2005, we had an income tax expense of $13.2 million compared to an income tax benefit of $6.7 +million in 2004. The income tax benefit for 2004 resulted primarily from the reversal of the +valuation allowance established in 2003 against our deferred tax asset. As a result of production +from the Company’s first two deepwater projects starting in November 2003, as well as refinancing +our highest cost debt in 2004, we achieved profitable +operations and had income on an aggregate basis for the three-year period ended December 31, 2004. +As a result, we reversed the valuation allowance as of December 31, 2004. See Note 5 to our +Consolidated Financial Statements for a more detailed discussion. +36 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS +The Company’s revenues are derived from the sale of its crude oil and natural gas production. The +prices for oil and gas remain extremely volatile and sometimes experience large fluctuations as a +result of relatively small changes in supply, weather conditions, economic conditions and +government actions. From time to time, the Company enters into derivative financial instruments to +manage oil and gas price risk. +The Company may utilize fixed price “swaps”, which reduce the Company’s exposure to decreases in +commodity prices and limit the benefit the Company might otherwise have received from any increases +in commodity prices. +The Company may utilize price “collars” to reduce the risk of changes in oil and gas prices. Under +these arrangements, no payments are due by either party as long as the market price is above the +floor price and below the ceiling price set in the collar. If the price falls below the floor, the +counter-party to the collar pays the difference to the Company, and if the price rises above the +ceiling, the counter-party receives the difference from the Company. +Callon may purchase “puts” which reduce the Company’s exposure to decreases in oil and gas prices +while allowing realization of the full benefit from any increases in oil and gas prices. If the +price falls below the floor, the counter-party pays the difference to the Company. +The Company enters into these various agreements from time to time to reduce the effects of +volatile oil and gas prices and does not enter into derivative transactions for speculative +purposes. However, certain of the Company’s derivative positions may not be designated as hedges +for accounting purposes. See Note 8 to the +Consolidated Financial Statements for a description of the Company’s hedged position at December +31, 2006. There have been no significant changes in market risks faced by the Company since the +end of 2005. +Based on projected annual sales volumes for 2007 (excluding incremental production from 2007 +exploratory drilling), a 10% decline in the prices Callon receives for its crude oil and natural +gas production would have an approximate $12 million impact on our revenues. +37 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +Report of Independent Registered Public Accounting Firm +39 +Consolidated +Balance Sheets as of December 31, 2006 and 2005 +40 +Consolidated Statements of Operations for Each of the Three Years +in the Period Ended December 31, 2006 +41 +Consolidated Statements of Stockholders’ Equity +for Each of the Three Years in the Period Ended December 31, 2006 +42 +Consolidated Statements of Cash Flows for Each of the Three Years +in the Period Ended December 31, 2006 +43 +Notes to Consolidated Financial Statements +44 +38 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Stockholders and Board of Directors +Callon Petroleum Company +We have audited the accompanying consolidated balance sheets of Callon Petroleum Company as of +December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ +equity and cash flows for each of the three years in the period ended December 31, 2006. These +financial statements are the responsibility of the Company’s management. Our responsibility is to +express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting +Oversight Board (United States). Those standards require that we plan and perform the audit to +obtain reasonable assurance about whether the financial statements are free of material +misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and +disclosures in the financial statements. An audit also includes assessing the accounting +principles used and significant estimates made by management, as well as evaluating the overall +financial statement presentation. We believe that our audits provide a reasonable basis for our +opinion. +In our opinion, the financial statements referred to above present fairly, in all material +respects, the consolidated financial position of Callon Petroleum Company as of December 31, 2006 +and 2005, and the results of its operations and its cash flows for each of the three years in the +period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. +As discussed in Note 2 to the financial statements, in 2006 the Company changed its method of +accounting for stock-based compensation. +We also have audited, in accordance with the standards of the Public Company Accounting +Oversight Board (United States), the effectiveness of Callon Petroleum Company’s internal control +over financial reporting as of December 31, 2006, based on criteria established in Internal +Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission and our report dated March 15, 2007, expressed an unqualified opinion thereon. +/s/ +Ernst & Young LLP +New Orleans, Louisiana +March 15, 2007 +39 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(In thousands, except share data) +December 31, +2006 +2005 +ASSETS +Current assets: +Cash and cash equivalents +$ +1,896 +$ +2,565 +Accounts receivable +32,166 +33,195 +Deferred tax asset +— +26,770 +Restricted investments +4,306 +4,110 +Fair market value of derivatives +13,311 +889 +Other current assets +5,973 +1,998 +Total current assets +57,652 +69,527 +Oil and gas properties, full-cost accounting method: +Evaluated properties +1,096,907 +937,698 +Less accumulated depreciation, depletion and amortization +(604,682 +) +(539,399 +) +492,225 +398,299 +Unevaluated properties excluded from amortization +54,802 +49,065 +Total oil and gas properties +547,027 +447,364 +Other property and equipment, net +1,996 +1,605 +Long-term gas balancing receivable +714 +403 +Restricted investments +1,935 +1,858 +Investment in Medusa Spar LLC +12,580 +11,389 +Other assets, net +3,623 +1,630 +Total assets +$ +625,527 +$ +533,776 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable and accrued liabilities +$ +43,086 +$ +39,323 +Fair market value of derivatives +— +1,247 +Undistributed oil and gas revenues +3,525 +721 +Asset retirement obligations +14,355 +21,660 +Current maturities of long-term debt +213 +263 +Total current liabilities +61,179 +63,214 +Long-term debt +225,521 +188,813 +Asset retirement obligations +26,824 +16,613 +Deferred tax liability +30,054 +31,633 +Accrued liabilities to be refinanced +— +5,000 +Other long-term liabilities +586 +455 +Total liabilities +344,164 +305,728 +Stockholders’ equity: +Preferred Stock, $.01 par value; 2,500,000 shares authorized; +— +— +Common Stock, $.01 par value; 30,000,000 shares +authorized; 20,747,773 shares and 19,357,138 shares issued and +outstanding at December 31, 2006 and 2005, respectively +207 +194 +Unearned compensation-restricted stock +— +(3,334 +) +Capital in excess of par value +220,785 +220,360 +Other comprehensive income (loss) +8,652 +(331 +) +Retained earnings +51,719 +11,159 +Total stockholders’ equity +281,363 +228,048 +Total liabilities and stockholders’ equity +$ +625,527 +$ +533,776 +The accompanying notes are an integral part of these financial statements. +40 +Table of Contents +Callon Petroleum Company +Consolidated Statements of Operations +For the Years Ended December 31, 2006, 2005 and 2004 +(In thousands, except per share amounts) +2006 +2005 +2004 +Operating revenues: +Oil sales +$ +93,665 +$ +76,425 +$ +49,826 +Gas sales +88,603 +64,865 +69,976 +Total operating revenues +182,268 +141,290 +119,802 +Operating expenses: +Lease operating expenses +28,881 +24,377 +22,308 +Depreciation, depletion and amortization +65,283 +44,946 +47,453 +General and administrative +8,591 +8,085 +8,758 +Accretion expense +4,960 +3,549 +3,400 +Derivative expense +150 +6,028 +1,371 +Total operating expenses +107,865 +86,985 +83,290 +Income from operations +74,403 +54,305 +36,512 +Other (income) expenses: +Interest expense +16,480 +16,660 +20,137 +Other (income) +(1,869 +) +(998 +) +(357 +) +Loss on early extinguishment of debt +— +— +3,004 +Total other (income) expenses +14,611 +15,662 +22,784 +Income before income taxes +59,792 +38,643 +13,728 +Income tax expense (benefit) +20,707 +13,209 +(6,697 +) +Income before equity in earnings of Medusa Spar LLC +39,085 +25,434 +20,425 +Equity in earnings of Medusa Spar LLC, net of tax +1,475 +1,342 +1,076 +Net income +40,560 +26,776 +21,501 +Preferred stock dividends +— +318 +1,272 +Net income available to common shares +$ +40,560 +$ +26,458 +$ +20,229 +Net income per common share: +Basic +$ +2.00 +$ +1.43 +$ +1.28 +Diluted +$ +1.90 +$ +1.28 +$ +1.22 +Shares used in computing net income per share amounts: +Basic +20,270 +18,453 +15,796 +Diluted +21,363 +20,883 +17,678 +The accompanying notes are an integral part of these financial statements. +41 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(In thousands) +Unearned +Accumulated +Total +Restricted +Capital in +Other +Retained +Stock- +Preferred +Common +Stock +Excess of +Comprehensive +Earnings +holders’ +Stock +Stock +Compensation +Par Value +Income (Loss) +(Deficit) +Equity +Balances, December 31, 2003 +$ +6 +$ +139 +$ +(372 +) +$ +169,036 +$ +(20 +) +$ +(35,528 +) +$ +133,261 +Comprehensive income (loss): +Net income +— +— +— +— +— +21,501 +Other comprehensive (loss) +— +— +— +— +(1,863 +) +— +Total comprehensive income +19,638 +Preferred stock dividend +— +— +— +— +— +(1,272 +) +(1,272 +) +Sale of common stock +— +35 +— +44,012 +— +— +44,047 +Shares issued pursuant to employee +benefit and option plan +— +1 +— +720 +— +— +721 +Employee stock purchase plan +— +1 +— +208 +— +— +209 +Tax benefits related to stock +compensation plans +— +— +— +1,214 +— +— +1,214 +Restricted stock +— +— +(4,980 +) +5,474 +— +— +494 +Balances, December 31, 2004 +6 +176 +(5,352 +) +220,664 +(1,883 +) +(15,299 +) +198,312 +Comprehensive income: +Net income +— +— +— +— +— +26,776 +Other comprehensive income +— +— +— +— +1,552 +— +Total comprehensive income +28,328 +Preferred stock dividend +— +— +— +— +— +(318 +) +(318 +) +Conversion of preferred shares +to common stock +(6 +) +13 +— +(643 +) +— +— +(636 +) +Shares issued pursuant to employee +benefit and option plan +— +1 +— +(325 +) +— +— +(324 +) +Employee stock purchase plan +— +— +— +(33 +) +— +— +(33 +) +Tax benefits related to stock +compensation plans +— +— +— +1,029 +— +— +1,029 +Restricted stock +— +2 +2,018 +(330 +) +— +— +1,690 +Warrants +— +2 +— +(2 +) +— +— +— +Balances, December 31, 2005 +— +194 +(3,334 +) +220,360 +(331 +) +11,159 +228,048 +Comprehensive income: +Net income +— +— +— +— +— +40,560 +Other comprehensive income +— +— +— +— +8,983 +— +Total comprehensive income +49,543 +Shares issued pursuant to employee +benefit and option plan +— +2 +— +(441 +) +— +— +(439 +) +Tax benefits related to stock +compensation plans +— +— +— +1,356 +— +— +1,356 +Adoption of 123R +3,334 +(3,334 +) +— +— +— +Restricted stock +— +1 +— +2,854 +— +— +2,855 +Warrants +— +10 +— +(10 +) +— +— +— +Balances, December 31, 2006 +$ +— +$ +207 +$ +— +$ +220,785 +$ +8,652 +$ +51,719 +$ +281,363 +The accompanying notes are an integral part of these financial statements. +42 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2006, 2005 and 2004 +(In thousands) +2006 +2005 +2004 +Cash flows from operating activities: +Net income +$ +40,560 +$ +26,776 +$ +21,501 +Adjustments to reconcile net income to +cash provided by operating activities: +Depreciation, depletion and amortization +65,929 +45,657 +48,164 +Accretion expense +4,960 +3,549 +3,400 +Amortization of deferred financing costs +2,221 +2,062 +1,929 +Non-cash loss on extinguishment of debt +— +— +2,910 +Equity in earnings of Medusa Spar, LLC +(1,475 +) +(1,342 +) +(1,076 +) +Non-cash derivative expense +150 +1,635 +(135 +) +Deferred income tax expense (benefit) +20,707 +13,209 +(6,697 +) +Non-cash charge related to compensation plans +1,420 +1,906 +1,225 +Excess tax benefits from share-based payment arrangements +(1,449 +) +— +— +Changes in current assets and liabilities: +Accounts receivable, trade +(2,107 +) +(11,169 +) +(4,495 +) +Other current assets +(3,975 +) +670 +971 +Current liabilities +11,311 +(8,666 +) +2,903 +Change in gas balancing receivable +(311 +) +322 +376 +Change in gas balancing payable +133 +(289 +) +400 +Change in other long-term liabilities +(2 +) +(18 +) +(20 +) +Change in other assets, net +(2,588 +) +(292 +) +(448 +) +Cash provided by operating activities +135,484 +74,010 +70,908 +Cash flows from investing activities: +Capital expenditures +(167,979 +) +(73,072 +) +(64,649 +) +Distribution from Medusa Spar, LLC +1,078 +463 +339 +Cash used by investing activities +(166,901 +) +(72,609 +) +(64,310 +) +Cash flows from financing activities: +Change in accrued liabilities to be refinanced +(5,000 +) +5,000 +— +Increases in debt +88,000 +7,000 +90,000 +Payments on debt +(53,000 +) +(12,000 +) +(205,915 +) +Restricted cash +— +— +63,345 +Debt issuance cost +— +— +(984 +) +Issuance of common stock +— +2 +44,047 +Buyout of preferred stock +— +(637 +) +— +Equity issued related to employee stock plans +(438 +) +(573 +) +199 +Excess tax benefits from share-based payment arrangements +1,449 +— +— +Capital leases +(263 +) +(576 +) +(1,452 +) +Cash dividends on preferred stock +— +(318 +) +(1,272 +) +Cash +provided (used) by financing activities +30,748 +(2,102 +) +(12,032 +) +Net decrease in cash and cash equivalents +(669 +) +(701 +) +(5,434 +) +Cash and cash equivalents: +Balance, beginning of period +2,565 +3,266 +8,700 +Balance, end of period +$ +1,896 +$ +2,565 +$ +3,266 +The accompanying notes are an integral part of these financial statements. +43 +Table of Contents +CALLON PETROLEUM COMPANY +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +General +Callon Petroleum Company (“the Company” or “Callon”) was organized under the laws of the state of +Delaware in March 1994 to serve as the surviving entity in the consolidation and combination of +several related entities (referred to herein collectively as the “Constituent Entities”). The +combination of the businesses and properties of the Constituent Entities with the Company was +completed on September 16, 1994 (“Consolidation”). +As a result of the Consolidation, all of the businesses and properties of the Constituent Entities +are owned (directly or indirectly) by the Company. Certain registration rights were granted to the +stockholders of certain of the Constituent Entities. See Note 9. +The Company and its predecessors have been engaged in the acquisition, development and exploration +of crude oil and natural gas since 1950. The Company’s properties are geographically concentrated +in Louisiana, Alabama and offshore Gulf of Mexico. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Principles of Consolidation and Reporting +The Consolidated Financial Statements include the accounts of the Company, and its subsidiary, +Callon Petroleum Operating Company (“CPOC”). CPOC also has subsidiaries, namely Callon Offshore +Production, Inc. and Mississippi Marketing, Inc. All intercompany accounts and transactions have +been eliminated. Certain prior year amounts have been reclassified to conform to presentation in +the current year. +Use of Estimates +The preparation of financial statements in conformity with U.S. generally accepted accounting +principles requires management to make estimates and assumptions that affect the reported amounts +of assets and liabilities and disclosure of contingent assets and liabilities at the date of the +financial statements and the reported amounts of revenues and expenses during the reporting period. +Actual results could differ from those estimates. +Asset Retirement Obligations +The Company accounts for asset retirement obligations in accordance with Statement of Financial +Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”), which +essentially requires entities to record the fair value of a liability for obligations associated +with the retirement of tangible long-lived assets and the associated asset retirement costs. +Interest is accreted on the present value of the asset retirement obligation and reported as +accretion expense within operating expenses in the Consolidated Statements of Operations. See Note +10. +44 +Table of Contents +Oil and Gas Properties +The Company follows the full-cost method of accounting for oil and gas properties whereby all costs +incurred in connection with the acquisition, exploration and development of oil and gas reserves, +including certain overhead costs, are capitalized. Such amounts include the cost of drilling and +equipping productive wells, dry hole costs, lease acquisition costs, delay rentals, interest +capitalized on unevaluated leases and other costs related to exploration and development +activities. General and administrative costs capitalized include salaries and related fringe +benefits paid to employees directly engaged in the acquisition, exploration and/or development of +oil and gas properties as well as other directly identifiable general and administrative costs +associated with such activities. Such capitalized costs ($9.6 million in 2006, $7.1 million in 2005 +and $7.2 million in 2004) do not include any costs related to production or general corporate +overhead. Costs associated with unevaluated properties, including capitalized interest on such +costs, are excluded from amortization. Unevaluated property costs are transferred to evaluated +property costs at such time as wells are completed on the properties, the properties are sold or +management determines that these costs have been impaired. +Costs of oil and gas properties, including future development and future site restoration, +dismantlement and abandonment costs, which have proved reserves and properties which have been +determined to be worthless, are depleted using the unit-of-production method based on proved +reserves. If the total capitalized costs of oil and gas properties, net of accumulated +amortization and deferred taxes relating to oil and gas properties, exceed the sum of (1) the +estimated future net revenues from proved reserves at current prices discounted at 10% and (2) the +lower of cost or market of unevaluated properties, net of tax effects (the full-cost ceiling +amount), then such excess is charged to expense during the period in which the excess occurs. See +Note 11. +Upon the acquisition or discovery of oil and gas properties, management estimates the future net +costs to be incurred to dismantle, abandon and restore the property using available geological, +engineering and regulatory data. Such cost estimates are periodically updated for changes in +conditions and requirements. In accordance with SFAS 143, such costs +are capitalized to the full-cost pool when the related liabilities are incurred. In accordance with Staff Accounting +Bulletin No. 106, assets recorded in connection with the recognition of an asset retirement +obligation pursuant to SFAS 143 are included as part of the costs subject to the full-cost ceiling +limitation. The future cash outflows associated with settling the recorded asset retirement +obligations are excluded from the computation of the present value of estimated future net revenues +used in applying the ceiling test. +Property and Equipment +Depreciation of other property and equipment is provided using the straight-line method over +estimated lives of three to 20 years. Depreciation of pipeline and other facilities is provided +using the straight-line method over estimated lives of 15 to 27 years. Depreciation expense of +$351,000, $355,000 and $346,000 relating to other property and equipment was included in general +and administrative expenses in the Company’s statements of operations for the years ended December +31, 2006, 2005 and 2004, respectively. The accumulated depreciation on other property and +equipment was $10.8 million and $10.6 million as of December 31, 2006 and 2005, respectively. +45 +Table of Contents +Investment in Medusa Spar LLC +The +Company has a 10% ownership interest in Medusa Spar, LLC +(“LLC”), which is a limited liability company +that owns a 75% undivided ownership interest in the deepwater spar production facilities on +Callon’s Medusa Field in the Gulf of Mexico. The Company contributed a 15% undivided ownership +interest in the production facility to the LLC in return for approximately $25 million in cash and +a 10% ownership interest in the LLC. The LLC earns a tariff based upon production volume throughput +from the Medusa area. Callon is obligated to process its share of production from the Medusa Field +and any future discoveries in the area through the spar production facilities. This arrangement +allows Callon to defer the cost of the spar production facility over the life of the Medusa Field. +The Company’s cash proceeds were used to reduce the balance outstanding under its senior secured +credit facility. The LLC used the cash proceeds from $83.7 million of non-recourse financing and a +cash contribution by one of the LLC owners to acquire its 75% interest in the spar. On December 31, +2006, $33.2 million of the financing was outstanding. The balance of Medusa Spar LLC is owned by +Oceaneering International, Inc. (NYSE:OII) and Murphy Oil Corporation (NYSE:MUR). The Company is +accounting for its 10% ownership interest in the LLC under the equity method. +Natural Gas Imbalances +The Company follows the entitlement method of accounting for its proportionate share of gas +production on a well-by-well basis, recording a receivable to the extent that a well is in an +“undertake” position and recording a liability to the extent that a well is in an “overtake” +position. Gas balancing receivables were $714,000 and $403,000 as of December 31, 2006 and 2005, +respectively. Gas balancing payables were $437,000 and $304,000 as of December 31, 2006 and 2005, +respectively. +Derivatives +The Company periodically uses derivative financial instruments to manage oil and gas price risk on +a limited amount of its future production and does not use these instruments for trading purposes. +Settlement of derivative contracts are generally based on the difference between the contract price +or prices specified in the derivative instrument and a NYMEX price or other cash or futures index +price. Such derivatives are accounted for under Statement of Financial Accounting Standards No. +133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) as amended. +The Company’s derivative contracts that are accounted for as cash flow hedges under SFAS 133 are +recorded at fair market value and the changes in fair value are recorded through other +comprehensive income (loss), net of tax, in stockholders’ equity. The cash settlements on these +contracts are recorded as an increase or decrease in oil and gas sales. The changes in fair value +related to ineffective derivative contracts are recognized as derivative expense (income). The +cash settlement on these contracts is also recorded within derivative expense (income). The +changes in fair value of the Company’s derivative contracts that are not designated as effective +cash flow hedges are recorded through the statement of operations as derivative expense (income). +See Note 8. +Income Tax +The Company follows the asset and liability method of accounting for deferred income taxes +prescribed by Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” +(“SFAS 109”). SFAS 109 provides for the recognition of a deferred tax asset for deductible +temporary timing differences, capital and operating loss carryforwards, statutory depletion +carryforward and tax credit carryforwards, net of a valuation allowance. The valuation allowance +is provided for that portion of the asset for which it is deemed more likely than not will not be +realized. See Note 5. +46 +Table of Contents +Stock-Based Compensation +Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standard No. 123 +(revised 2004), “Share-Based Payment,” (“SFAS 123R”) utilizing the modified prospective transition +method. Prior to the adoption of SFAS 123R, the Company accounted for stock option grants in +accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to +Employees” (the intrinsic value method) and, accordingly, recognized no compensation expense for +stock option grants. +Under the modified prospective transition method, SFAS 123R applies to new awards, unvested awards +as of January 1, 2006 and awards that were outstanding on January 1, 2006 that are subsequently +modified, repurchased or cancelled. Under the modified prospective transition method, compensation +cost recognized in 2006 includes compensation cost for all share-based payments granted prior to, +but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in +accordance with the original provisions of Statement of Financial Accounting Standard No. 123 +“Accounting for Stock-Based Compensation,” (“SFAS 123”) and compensation cost for all share-based +payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in +accordance with the provisions of SFAS 123R. Prior periods were not restated to reflect the impact +of adopting the new standard. +SFAS 123R requires the cash flows from tax benefits resulting from tax deductions in excess of +compensation cost recognized for stock options exercised (excess tax benefits) to be classified as +financing cash flows. The $1.4 million of excess tax benefits classified as a financing cash +inflow for the year ended December 31, 2006 would have been classified as an operating cash flow +had the Company not adopted SFAS 123R. There were no cash proceeds from the exercise of stock +options for the year ended December 31, 2006 due to the fact that all options were exercised +through net-share settlements. As a result of most of the Company’s stock-based compensation being +in the form of restricted stock, the impact of the adoption of SFAS 123R on income before taxes, +net income and basic and diluted earnings per share for the year ended December 31, 2006 was +not significant. See Note 3. +Accounts Receivable +Accounts receivable consists primarily of accrued oil and gas production receivables. The balance +in the reserve for doubtful accounts included in accounts receivable was $66,000 at both December +31, 2006 and 2005, respectively. There were no net charge offs recorded against the reserve for +doubtful accounts and no provisions to expense in the three-year period ended December 31, 2006. +Accrued Liabilities to be Refinanced +Amounts included in accrued liabilities to be refinanced at December 31, 2005 represent capital +expenditures that were refinanced with the availability under the Company’s senior secured credit +facility subsequent to December 31, 2005. +Major Customers +The Company’s production is generally sold on month-to-month contracts at prevailing prices. The +following table identifies customers to whom it sold a significant percentage of its total oil and +gas production during each of the years ended: +December 31, +2006 +2005 +2004 +Shell Trading Company +41 +% +34 +% +30 +% +Louis Dreyfus Energy Services +25 +% +16 +% +23 +% +Plains Marketing, L.P. +11 +% +16 +% +13 +% +Chevron Texaco Natural Gas +3 +% +10 +% +6 +% +47 +Table of Contents +Because alternative purchasers of oil and gas are readily available, the Company believes that the +loss of any of these purchasers would not result in a material adverse effect on its ability to +market future oil and gas production. +Statements of Cash Flows +For purposes of the Consolidated Financial Statements, the Company considers all highly liquid +investments with an original maturity of three months or less to be cash equivalents. +The Company paid no federal income taxes for the three years in the period ended December 31, 2006. +During the years ended December 31, 2006, 2005 and 2004, the Company made cash payments for +interest of $20,468,000, $19,854,000 and $23,197,000, respectively. +Fair Value of Financial Instruments +Fair value of cash and cash equivalents, accounts receivable, accounts payable, the capital lease +and the senior secured credit facility approximates book value at December 31, 2006 and 2005. The +Company’s 9.75% Senior Notes due 2010 had an estimated fair value of 101.5% and 103% of face value +at December 31, 2006 and 2005, respectively. +Accounting Pronouncements +In June 2006, the Financial Accounting Standards Board (“FASB”) released interpretation No. 48, +Accounting for Uncertainty in Income Taxes, (“FIN 48”). FIN 48 clarifies the accounting for income +taxes by prescribing the minimum recognition threshold a tax position must meet before being +recognized in the financial statements. FIN 48 also provides guidance on derecognition, +measurement, classification, interest and penalties, accounting in interim periods, disclosure and +transition. The effective date for FIN 48 is fiscal years beginning after December 15, 2006. The +Company is currently reviewing the provisions of FIN 48 and has not yet determined the impact of +adoption. +In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, Fair Value +Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair +value and requires enhanced disclosures about fair value measurements. SFAS 157 is effective for +fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The +Company is still reviewing the provisions of SFAS 157 and has not yet determined the impact of +adoption. +3. STOCK-BASED COMPENSATION +The Company has various stock plans (“Plans”) under which employees of the Company and its +subsidiaries and non-employee members of the Board of Directors of the Company have been or may be +granted certain stock-based compensation. For further discussion of the Plans, refer to Note 12. +For the +year ended December 31, 2006, the Company recorded stock-based compensation expense of $3.5 million, +of which $1.8 million was included in general and administrative expenses and $1.7 million was +capitalized to +48 +Table of Contents +oil and gas properties. Shares available for future stock option or restricted stock grants to +employees and directors under existing plans were 490,666 at December 31, 2006. +The following table illustrates the effect on operating results and net income per share had the +Company accounted for stock-based compensation in accordance with SFAS 123 for the years ended +December 31, 2005 and 2004: +2005 +2004 +(In thousands, except per share data) +Net income available to common shares, +as reported +$ +26,458 +$ +20,229 +Stock-based compensation expense included +in net income as reported, net of tax +1,313 +348 +Deduct: Total stock-based +compensation expense under fair +value based method, net of tax +(1,497 +) +(549 +) +Pro forma net income available to +common shares +$ +26,274 +$ +20,028 +Basic net income per share: As Reported +1.43 +1.28 +Pro Forma +1.42 +1.27 +Diluted net income per share: As Reported +1.28 +1.22 +Pro Forma +1.27 +1.20 +Stock Options +The +Company uses the Black-Scholes option pricing model to estimate the fair value of +stock option awards with the following weighted-average assumptions for the indicated periods. +For the Years Ended +December 31, +2006 +2005 +2004 +Dividend yield +— +— +— +Expected volatility +38.9 +% +37.5 +% +45.1 +% +Risk-free interest rate +4.6 +% +4.3 +% +3.7 +% +Expected life of option (in years) +5 +5 +5 +Weighted-average grant-date fair value +$ +7.72 +$ +5.93 +$ +5.48 +Forfeiture rate +7.5 +% +— +— +The assumptions above are based on multiple factors, including historical exercise patterns of +employees with respect to exercise and post-vesting employment termination behaviors, expected +future exercising patterns and the historical volatility of the +Company’s stock price. +49 +Table of Contents +The +following table represents stock option activity and weighted average +exercised prices for the three years ended December 31, 2006: +2006 +2005 +2004 +Wtd Avg +Wtd Avg +Wtd Avg +Shares +Ex Price +Shares +Ex Price +Shares +Ex Price +Outstanding, beginning of year +1,205,558 +$ +10.11 +1,512,599 +$ +9.93 +2,450,867 +$ +9.84 +Granted (at market) +15,000 +18.69 +65,000 +15.79 +25,000 +12.40 +Exercised +(480,333 +) +10.66 +(329,441 +) +10.34 +(437,918 +) +9.74 +Forfeited +— +— +— +— +(525,350 +) +9.80 +Expired +— +— +(42,600 +) +10.60 +— +— +Outstanding, end of year +740,225 +$ +9.93 +1,205,558 +$ +10.11 +1,512,599 +$ +9.93 +Exercisable, end of year +695,225 +$ +9.44 +1,166,558 +$ +9.88 +1,446,486 +$ +10.20 +Weighted-average remaining +Contract life: +Outstanding options at end of period +4.06 +yrs. +3.98 +yrs. +4.48 +yrs. +Outstanding exercisable at end of period +3.76 +yrs. +3.79 +yrs. +4.34 +yrs. +The aggregate intrinsic value of options outstanding was $3.9 million and the aggregate +intrinsic value of options exercisable was $3.9 million. Total intrinsic value of options +exercised was $4.1 million for the year ended December 31, +2006. At December 31, 2006, there was $231,000 of unrecognized compensation cost related to nonvested +stock options, which is expected to be recognized over a +weighted-average period of two years. +Restricted Stock +The Plans allow for the issuance of restricted stock awards. The unearned stock-based compensation +related to these awards is being amortized to compensation expense on +a straight-line basis over the requisite service period for the +entire award. The +compensation expense for these awards was determined based on the market price of our stock at the +date of grant applied to the total numbers of shares that were anticipated to fully vest. As of +December 31, 2006, there was $9.1 million of unrecognized compensation cost associated with these +awards, which is expected to be recognized over a weighted average +period of 3.3 years. +The following table represents unvested restricted stock activity for the year ended December 31, +2006: +Weighted-Average +Number of +Grant-Date +Shares +Fair Value +Outstanding shares at beginning of period +272,000 +$ +13.66 +Granted +582,500 +15.77 +Vested +(191,500 +) +15.02 +Forfeited +(4,200 +) +13.82 +Outstanding shares at end of period +658,800 +$ +15.13 +For the years ended December 31, 2006, 2005 and 2004 the Company recognized non-cash compensation +expense associated with the restricted stock awards of $3.4 million, $2.0 million and $906,000, +respectively. Included in 2005 was $1.0 million of accelerated vesting of performance shares +pursuant to the terms of the plan due to the deaths or disability for an executive officer and two +directors of the Company. There were no restricted stock grants +during the year ended December 31, 2005 and +the weighted average grant-date fair value +of restricted stock granted during the year ended December 31, 2004 was +$13.69. +50 +Table of Contents +4. NET INCOME PER SHARE +Basic net income per common share was computed by dividing net income by the weighted average +number of shares of common stock outstanding during the year. Diluted net income per common share +was determined on a weighted average basis using common shares issued and outstanding adjusted for +the effect of stock options considered common stock equivalents computed using the treasury stock +method and the effect of the convertible preferred stock (if dilutive). +A reconciliation of the basic and diluted net income per share computation is as follows (in +thousands, except per share amounts): +2006 +2005 +2004 +(a) Net income available to common shares +$ +40,560 +$ +26,458 +$ +20,229 +Preferred dividends assuming conversion of +preferred stock (if dilutive) +— +318 +1,272 +(b) Net income available to common shares assum- +ing conversion of preferred stock +(if dilutive) +$ +40,560 +$ +26,776 +$ +21,501 +(c) Weighted average shares outstanding +20,270 +18,453 +15,796 +Dilutive impact of stock options +238 +348 +233 +Dilutive impact of restricted stock +78 +69 +75 +Dilutive impact of warrants +777 +1,375 +894 +Convertible preferred stock (if dilutive) +— +638 +680 +(d) Weighted average shares outstanding for diluted +net income per share +21,363 +20,883 +17,678 +Stock options and warrants excluded due to the +exercise price being greater than the stock price +28 +1 +89 +Basic net income per share (a ¸ c) +$ +2.00 +$ +1.43 +$ +1.28 +Diluted net income per share (b ¸ d) +$ +1.90 +$ +1.28 +$ +1.22 +51 +Table of Contents +5. INCOME TAXES +Below is an analysis of the net deferred tax liability as of December 31, 2006 and 2005. +December 31, +2006 +2005 +(In thousands) +Deferred Tax Asset: +Federal net operating loss carryforwards +$ +58,051 +$ +58,240 +Statutory depletion carryforward +4,651 +4,443 +Alternative minimum tax credit carryforward +332 +547 +Asset retirement obligations +12,228 +11,307 +Other +2,443 +1,389 +Total deferred tax asset +77,705 +75,926 +Deferred Tax Liability: +Oil and gas properties +(101,921 +) +(80,565 +) +Other +(5,838 +) +(224 +) +Total deferred tax liability +(107,759 +) +(80,789 +) +Net deferred tax liability +$ +(30,054 +) +$ +(4,863 +) +If not utilized, the Company’s federal net operating loss carryforwards will expire in 2013 through +2021. The Company has significant state net operating loss carryforwards that are not included in +the deferred tax asset above, as the Company does not anticipate generating taxable state income in +the states in which these loss carryforwards apply. The Company has very limited state taxable +income as primarily all of its revenue is generated in federal waters not subject to state income +taxes. +The Company incurred losses in 2002 and 2003 and had losses on an aggregate basis for the +three-year period ended December 31, 2003. Because of these cumulative losses the Company +established a full valuation allowance of $11.5 million as of December 31, 2003. For the +three-year period ended December 31, 2004, the Company had income on an aggregate basis resulting +from the Company achieving profitable operations in 2004 due to the Company’s first two deepwater +projects starting in November 2003 and the refinancing of the Company’s highest cost debt. As a +result, the Company reversed the valuation allowance, which had a balance of $7.0 million, as of +December 31, 2004. +Below is a reconciliation of the reported amount of income tax expense attributable to continuing +operations for the year to the amount of income tax expense that would result from applying +domestic federal statutory tax rates to pretax income from continuing operations. +Years Ended December 31, +2006 +2005 +2004 +Income tax expense computed at the statutory +federal income tax rate +35 +% +35 +% +35 +% +Change in valuation allowance +— +— +(84 +)% +Other +— +(1 +)% +— +Effective income tax rate +35 +% +34 +% +(49 +)% +6. OTHER COMPREHENSIVE INCOME +The Company’s other comprehensive income (loss) of $9.0 million, $1.6 million and $(1.9) million +for the years ended December 31, 2006, 2005 and 2004 respectively, relates to the change in fair +value of its +52 +Table of Contents +derivatives. Other comprehensive income (loss) was net of income tax expense +(benefit) of $4.7 million, $835,000 and ($1.0) million for the years ended December 31, 2006, 2005 +and 2004, respectively. +7. LONG-TERM DEBT +Long-term debt consisted of the following at: +December 31, +2006 +2005 +(In thousands) +Senior secured credit facility +$ +35,000 +$ +— +9.75% Senior Notes (due 2010) net of +discount +189,862 +187,941 +Capital lease +872 +1,135 +Total long-term debt +225,734 +189,076 +Less current portion +213 +263 +Long-term portion +$ +225,521 +$ +188,813 +Senior +Secured Credit Facility. On August 30, 2006, the Company closed on a four-year amended and +restated senior secured credit facility underwritten by Union Bank of California, N.A. The initial +borrowing base is $75 million, which will be reviewed and redetermined semi-annually and can be +increased to a maximum of $175 million. Borrowings under the credit facility are secured by +mortgages covering the Company’s major producing fields. As of December 31, 2006 there was $35 +million outstanding under the facility with a weighted average interest rate of 6.73% and $40 +million was available for future borrowings. In connection with the +anticipated financing of the acquisition of BP’s interest in the +Entrada Field, the borrowing base under this facility would be +reduced to $50 million at closing until the next borrowing base +redetermination date. See Note 14 for more discussion on the Entrada +acquisition. +The credit facility bears interest at 0% to 0.50% above a defined base rate depending on +utilization of the borrowing base or, at the option of the Company, LIBOR plus 1.375% to 2.0% based +on utilization of the borrowing base. Under the senior secured credit facility, a commitment fee +of 0.25% or 0.375% per annum, depending on the amount of the unused portion of the borrowing base, +is payable quarterly. The range of interest rates on the senior secured credit facility during +2006 was 6.24% to 8.50%. +9.75% Senior Notes (due 2010). In December 2003, the Company borrowed $185 million pursuant to a +senior unsecured credit facility. The loans under the credit facility have a stated interest rate +of 9.75% and a seven-year maturity. In conjunction with the new senior unsecured notes, the Company +issued detachable warrants to purchase 2.775 million shares of its common stock at an exercise +price of $10 per share and an expiration date of December 2010. The warrants were valued at $10.6 +million and were treated as a discount on the debt. This senior unsecured debt matures December 8, +2010 and has an effective interest rate of 11.4%. The Company recorded the issuance of these new +securities at a fair value of $171 million. Deferred costs of $14 million associated with the +notes are being amortized over the life of the notes. +During March 2004, Callon borrowed an additional $15 million under its 9.75% senior unsecured +credit facility bringing the total outstanding under the facility to $200 million. The net proceeds +of approximately $14 million were primarily used to retire the remaining $10 million of 12% senior +loans due March 31, 2005 plus a 1% call premium of $100,000. The Company recorded the issuance of +these additional new securities at a fair value of $14 million. Deferred costs of $1 million +associated with the notes are being amortized over the life of the notes. +53 +Table of Contents +In March 2004, the $200 million in aggregate principal amount of loans outstanding under the 9.75% +senior unsecured credit facility were exchanged for 9.75% Senior Notes due 2010, Series A, (“Series +A notes”), issued pursuant to a senior indenture between Callon and American Stock Transfer & Trust +Company dated March 15, 2004. On August 12, 2004, the Company completed an offer to exchange its +9.75% Senior Notes due 2010, Series B, that have been registered under the Securities Act of 1933, +for all outstanding Series A notes. +As of December 31, 2006, 1.617 million of the 2.775 million detachable warrants issued with the +9.75% Senior Notes due 2010 were exercised. In addition, 265,210 of the $0.01 warrants associated +with the 12% senior loans, which were redeemed in 2004, were exercised in June 2006. +Certain of the Company’s subsidiaries guarantee the Company’s obligations under the $200 million +9.75% Senior Notes due 2010. The subsidiary guarantors are 100% owned, all of the guarantees are +full and unconditional and joint and several, the parent company has no independent assets or +operations and any subsidiaries of the parent company other than the subsidiary guarantors are +minor. +Loss on Early Extinguishment of Debt. In the first half of 2004, the Company completed several +transactions that restructured certain debt that was maturing through 2005 resulting in a loss on +early extinguishment of debt for the year ended December 31, 2004 of $3.0 million. +Capital +Lease. In December 2001, the Company entered into a 10-year gas processing agreement +associated with a production facility on Callon’s Mobile Block 952 Field with Hanover Compression +Limited Partnership, which is being accounted for as a capital lease. +Restrictive +Covenants. The Indenture governing our 9.75% senior notes due 2010 and our senior +secured credit facility contains various covenants including restrictions on additional +indebtedness and payment of cash dividends. In addition, our senior secured credit facility +contains covenants for maintenance of certain financial ratios. The Company was in compliance with +these covenants at December 31, 2006. +Future minimum lease payments and debt maturities are as follows (in thousands): +Capital Lease +Year +Payments +Debt +2007 +$ +348 +$ +— +2008 +228 +— +2009 +229 +— +2010 +220 +235,000 +Thereafter +245 +— +54 +Table of Contents +8. DERIVATIVES +The following table summarizes derivative expense for the periods presented (in thousands): +December 31, +2006 +2005 +2004 +Amortization of derivative contract premiums +$ +150 +$ +1,634 +$ +— +Change in fair value and settlements of ineffective +derivative contracts +— +4,394 +1,209 +Change in fair value and settlements of +non-designated +derivative contracts +— +— +162 +$ +150 +$ +6,028 +$ +1,371 +The change in fair value and settlements on ineffective derivative contracts in 2005 and 2004 +relate to contracts that were deemed ineffective as a result of a shortfall in production volumes +due to downtime resulting from damages caused by Hurricanes Katrina and Rita in 2005 and tropical +storms and Hurricane Ivan in 2004. Cash settlements on effective cash flow hedges for the year +ended December 31, 2006 resulted in an increase in oil and gas sales of $8.9 million. For the +years ended December 31, 2005 and 2004, cash settlements on effective cash flow hedges resulted in +a reduction in oil and gas sales of $10.3 million and $13.8 million, respectively. +Listed in the table below are the outstanding derivative contracts as of December 31, 2006: +Collars +Average +Average +Volumes per +Quantity +Floor +Ceiling +Product +Month +Type +Price +Price +Period +Oil +50,000 +Bbls +$ +65.00 +$ +88.75 +01/07-12/07 +Natural Gas +600,000 +MMBtu +$ +8.00 +$ +12.70 +01/07-12/07 +9. COMMITMENTS AND CONTINGENCIES +From time to time, the Company, as part of the Consolidation and other capital transactions, +entered into registration rights agreements whereby certain parties to the transactions are +entitled to require the Company to register common stock of the Company owned by them with the SEC +for sale to the public in firm commitment public offerings and generally to include shares owned by +them, at no cost, in registration statements filed by the Company. Costs of the offering will not +include broker’s discounts and commissions, which will be paid by the respective sellers of the +common stock. +55 +Table of Contents +The Company is involved in various claims and lawsuits incidental to its business. In the opinion +of management, the ultimate liability thereunder, if any, will not have a material adverse effect +on the financial position or results of operations of the Company. +The Company’s Medusa deepwater property is eligible for royalty suspensions pursuant to the Deep +Water Royalty Relief Act. In addition, the Company has several shallow water, deep natural gas +properties and prospects that are eligible for royalty suspensions. However, the federal offshore +leases covering these properties contain “price threshold” provisions for oil and gas prices. +Under these “price threshold” provisions, if the average monthly New York Mercantile Exchange +(NYMEX) sales price for oil or gas during a fiscal year exceeds the price threshold for oil or gas, +respectively, then royalties on the associated production must be paid to the Minerals Management +Service (MMS) at the rate stipulated in the lease. The price thresholds are adjusted annually by +the implicit price deflator for the GDP. The determination of whether or not royalties are due as +a result of the average NYMEX price exceeding the price threshold is made during the first quarter +of the succeeding year. Any royalty payments due must be made shortly after this determination is +made. If a royalty payment is due for all production during a year as a result of exceeding the +price threshold, the lessee is required to make monthly royalty payments during the succeeding +fiscal year for the succeeding year’s production. If at the end of any year the average NYMEX +price is below the price threshold, the lessee can apply for a refund for any associated royalties +paid during that year and the lessee will not be required to pay royalties monthly during the +succeeding year for the succeeding year’s production. +The Company was required to make monthly royalty payments for 2006 deepwater oil and gas production +and will be required to make monthly royalty payments for 2007. With regard to the shallow water, +deep natural gas royalty relief, the Company was not required to make royalty payments for 2006 and +will not be required to make royalty payments for 2007. +In the year succeeding the year in which any of the Company’s properties became subject to +royalties as the result of the average NYMEX price exceeding the price threshold, the portion of +reserves attributable to potential future royalties would not be included in a year-end reserve +report. However, if the average NYMEX prices were below the price thresholds in subsequent years, +our reserves would be increased to reflect reserves previously attributed to future royalties. As +a result, reported oil and gas reserves could materially increase or decrease, depending on the +relation of price thresholds versus the average NYMEX prices. The reduction in revenues resulting +from an obligation to pay these royalties and subsequent reduction of proved reserves could have a +material adverse effect on the Company’s results of operations and financial condition. The +Company’s reserve report as of December 31, 2006 excluded oil and gas reserves for Medusa that are +subject to MMS royalties as a result of the average 2006 NYMEX prices for oil and gas exceeding the +deepwater price thresholds. With regard to the shallow water, deep natural gas properties, there +was no reduction in reserves for potential future royalties as of December 31, 2006 as a result of +the average 2006 NYMEX price for gas being below the price threshold. +The Company’s Entrada Field is governed by leases from the MMS. These leases granted royalty +suspension without provisions for pricing thresholds for crude oil and natural gas which would +require us to pay royalties to the MMS if the thresholds were exceeded by the current year average +of NYMEX prices. The MMS has notified us the exclusion of the provisions occurred in error in the +lease issuance process and was not the MMS’s intention. Congress is considering various bills to +address this issue and if a bill were to pass to amend the leases to provide thresholds for crude +oil and natural gas prices the reserves for Entrada could be subject to such royalties. However, +the MMS stated in their correspondence to the Company that they will continue to honor the terms of +the leases as issued unless notified otherwise. This correspondence applies only to Callon’s 20% working interest +in the Entrada Field. +56 +Table of Contents +The Company’s activities are subject to federal, state and local laws and regulations governing +environmental quality and pollution control. Although no assurances can be made, the Company +believes that, absent the occurrence of an extraordinary event, compliance with existing federal, +state and local laws, rules and regulations governing the release of materials into the environment +or otherwise relating to the protection of the environment will not have a material effect upon the +capital expenditures, earnings or the competitive position of the Company with respect to its +existing assets and operations. The Company cannot predict what effect additional regulation or +legislation, enforcement polices thereunder, and claims for damages to property, employees, other +persons and the environment resulting from the Company’s operations could have on its activities. +10. ASSET RETIREMENT OBLIGATIONS +The following table summarizes the activity for the Company’s asset retirement obligations: +Twelve Months Ended +December 31, 2006 +December 31, 2005 +Asset retirement obligations at +beginning of period +$ +38,273 +$ +38,282 +Accretion expense +4,960 +3,549 +Net profits interest accretion +— +331 +Liabilities incurred +1,440 +2,365 +Liabilities settled +(16,970 +) +(5,184 +) +Revisions to estimate +13,476 +(1,070 +) +Asset retirement obligation at end of period +41,179 +38,273 +Less: current retirement obligations +(14,355 +) +(21,660 +) +Long-term retirement obligations +$ +26,824 +$ +16,613 +Assets, primarily short-term U.S. Government securities, of approximately $6.2 million at December +31, 2006, of which $4.3 million was current, were recorded as restricted investments. These assets +are held in abandonment trusts (“Trusts”) dedicated to pay future abandonment costs for several of +the Company’s oil and gas properties. +57 +Table of Contents +11. OIL AND GAS PROPERTIES +The following table discloses certain financial data relating to the Company’s oil and gas +activities, all of which are located in the United States. +Years Ended December 31, +2006 +2005 +2004 +(In thousands) +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance +$ +937,698 +$ +862,101 +$ +802,912 +Property acquisition costs +4,053 +6,627 +1,355 +Exploration costs +73,659 +46,379 +26,749 +Development costs +81,497 +22,591 +31,086 +Sale of mineral interests +— +— +(1 +) +End of period balance +$ +1,096,907 +$ +937,698 +$ +862,101 +Unevaluated Properties (excluded from +amortization) - +Beginning of period balance +$ +49,065 +$ +39,042 +$ +34,251 +Additions +19,103 +18,739 +16,367 +Capitalized interest +6,477 +5,655 +4,577 +Transfers to evaluated +(19,843 +) +(14,371 +) +(16,153 +) +End of period balance +$ +54,802 +$ +49,065 +$ +39,042 +Accumulated depreciation, depletion +and amortization- +Beginning of period balance +$ +539,399 +$ +494,453 +$ +447,000 +Provision charged to expense +65,283 +44,946 +47,453 +End of period balance +$ +604,682 +$ +539,399 +$ +494,453 +Unevaluated property costs, primarily lease acquisition costs incurred at federal and state lease +sales, unevaluated drilling costs, capitalized interest and general and administrative costs being +excluded from the amortizable evaluated property base, consisted of $24.7 million incurred in 2006, +$17.8 million incurred in 2005, $3.5 million incurred in +2004 and $8.8 million incurred in 2003 +and prior. These costs are directly related to the acquisition and evaluation of unproved +properties and major development projects. The excluded costs and related reserves are included in +the amortization base as the properties are evaluated and proved reserves are established or +impairment is determined. The Company expects that the majority of these costs will be evaluated +over the next three to five years. +Depletion per unit-of-production (thousand cubic feet of gas equivalent) amounted to $3.14, $2.39 +and $2.18 for the years ended December 31, 2006, 2005, and 2004, respectively. +Under the full-cost accounting rules of the SEC, the Company reviews the carrying value of its +proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and +gas properties, net of accumulated depreciation, depletion and amortization and deferred income +taxes, may not exceed the present value of estimated future net cash flows from proved oil and gas +reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of +related tax effects (the full-cost ceiling amount). These rules generally require pricing future +oil and gas production at the unescalated market price for oil and gas at the end of each fiscal +quarter and require a write-down if the “ceiling” is exceeded. However, if prices recover +sufficiently subsequent to the balance sheet date before the release of the financial statements +then use of the subsequent pricing is allowed and no write-down would be required if such pricing +was used. Given the volatility of oil and gas prices, it is reasonably possible that the Company’s +estimate of discounted future net cash flows from proved oil and gas reserves could change in the +near term. If oil and gas prices decline significantly, even if only for a short period of time, +it is possible that write-downs of oil and gas properties could occur in the future. +12. EMPLOYEE BENEFIT PLANS +The Company has adopted a series of incentive compensation plans designed to align the interest of +the executives and employees with those of its stockholders. The following is a brief description +of each plan: +58 +Table of Contents +Savings and Protection Plan +The Savings and Protection Plan (“401-K Plan”) provides employees with the +option to defer receipt of a portion of their compensation and the Company may, at +its discretion, match a portion of the employee’s deferral with cash and Company +Common Stock. The Company may also elect, at its discretion, to contribute a +non-matching amount in cash and Company Common Stock to employees. The amounts held +under the 401-K Plan are invested in various funds maintained by a third party in accordance with the directions of each +employee. An employee is fully vested, including Company discretionary +contributions, immediately upon participation in the 401-K Plan. The total amounts +contributed by the Company, including the value of the common stock contributed, +were $615,000, $557,000 and $528,000 in the years 2006, 2005 and 2004, respectively. +1996 Stock Incentive Plan +On August 23, 1996, the Board of Directors of the Company approved and adopted +the Callon Petroleum Company 1996 Stock Incentive Plan (the “1996 Plan”). The 1996 +Plan was approved by the shareholders in 1997 and limited to a maximum of 1,200,000 +shares (as amended from the original 900,000 shares) of common stock subject to +outstanding awards. The 1996 Plan was amended again and approved on May 9, 2000 at +the Annual Meeting of Shareholders, increasing the number of shares reserved for +issuance under the 1996 plan to 2,200,000 shares. Unvested options are subject to +forfeiture upon certain termination of employment events and expire 10 years from +the date of grant. +In August 2006, the Board of Directors approved the award of 520,000 shares of +restricted stock from the 1996 Plan. Of the 520,000 shares, 20,000 shares were +granted to non-employee members of the Board of Directors and vested immediately. +The remaining 500,000 shares were issued to employees of the Company with 20% vesting +immediately and the remaining 80% vesting ratably over the next four +years. The compensation cost with respect to the 20% that vested +immediately was recognized as an expense on the grant date and the +compensation cost with respect to the remaining 80% is being amortized to expense over the +vesting period. +2002 Stock Incentive Plan +On February 14, 2002, the Board of Directors of the Company approved and adopted +the 2002 Stock Incentive Plan (the “2002 Plan”). Pursuant to the 2002 Plan, 350,000 +shares of common stock shall be reserved for issuance upon the exercise of options or +for grants of stock options, stock appreciation rights or units, bonus stock, or +performance shares or units. This Plan qualified as a “broadly based” plan under the +provisions of the New York Stock Exchange’s rules and regulations and therefore did +not require shareholder approval. Because the 2002 Plan is a broadly based plan, the +aggregate number of shares underlying awards granted to officers and directors cannot +exceed 50% of the total number of shares underlying the awards granted to all +employees during any three-year period. +In 2006, 17,500 shares were awarded as restricted stock with 20% vesting immediately +and the remaining 80% vesting ratably over the next four years. The +compensation cost with respect to the 20% that vested immediately was +recognized as an expense on the grant date and the compensation cost +with respect to the remainging 80% is being amortized to expense over the vesting +period. +2006 Stock Incentive Plan +On March 9, 2006, the Board of Directors of the Company approved the 2006 Stock +Incentive Plan (“2006 Plan”). The 2006 Plan was approved by the shareholders at the +May 4, 2006 +59 +Table of Contents +annual meeting. Pursuant to the 2006 Plan, 500,000 shares of common +stock shall be reserved for issuance upon exercise of stock options, restricted +stock or other stock-based awards. In 2006, 45,000 shares were awarded as +restricted stock that will vest ratably over the next four years. The +compensation cost with respect to this grant is being amortized to expense over the +vesting period. +13. EQUITY TRANSACTIONS +On June 13, 2005, Callon called for redemption all of the Company’s outstanding shares of $2.125 +Convertible Exchange Preferred Stock, Series A. A notice of redemption and letter of transmittal +was mailed to all holders of record as of the close of business on June 10, 2005. Between June 13, +2005 and June 30, 2005, 180,173 shares of preferred stock were converted into 409,496 shares of the +Company’s common stock. Subsequent to June 30, 2005, 392,935 shares of preferred stock were +converted into 893,076 shares of the Company’s common stock. In addition, 23,563 shares of the +Company’s preferred stock were redeemed for $606,000 on July 14, 2005. As a result of the +redemption, we will benefit from an annual cash savings of $1.3 million in dividend payments. +On June 22, 2004, Callon closed the public offering of three million shares of common stock priced at +$13.25 per share raising net proceeds of approximately $38.2 million, after expenses. In addition, +the Company granted the underwriter, Johnson Rice & Company L.L.C., an over-allotment option to purchase an +additional 450,000 shares. On June 30, 2004, the underwriter exercised the over-allotment option +for an additional 450,000 shares priced at $13.25 per share, raising the net proceeds of the +offering by approximately $5.7 million, after expenses. The proceeds from the transactions were +used to redeem $33 million of the 11% Senior Subordinated Notes due December 15, 2005 and for +general corporate purposes. +The Company adopted a stockholder rights plan on March 30, 2000, designed to assure that the +Company’s stockholders receive fair and equal treatment in the event of any proposed takeover of +the Company and to guard against partial tender offers, squeeze-outs, open market accumulations, +and other abusive tactics to gain control without paying all stockholders a fair price. The rights +plan was not adopted in response to any specific takeover proposal. Under the rights plan, the +Company declared a dividend of one right (“Right”) on each share of the Company’s Common Stock. +Each Right will entitle the holder to purchase one one-thousandth of a share of a Series B +Preferred Stock, par value $0.01 per share, at an exercise price of $90 per one one-thousandth of a +share. +The Rights are not currently exercisable and will become exercisable only in the event a person or +group acquires, or engages in a tender or exchange offer to acquire, beneficial ownership of 15 +percent or more (one existing stockholder was granted an exception for up to 21 percent) of the +Company’s common stock. After the Rights become exercisable, each Right will also entitle its +holder to purchase a number of common shares of the Company having a market value of twice the +exercise price. The dividend distribution was made to stockholders of record at the close of +business on April 10, 2000. The Rights will expire on March 30, 2010. +14. SUBSEQUENT EVENTS +Subsequent to December 31, 2006, the Company entered into an agreement with BP Exploration and +Production Company (“BP”) to purchase BP’s 80% working interest in the Entrada Field for total cash +consideration of $190 million. The purchase price includes $150 million payable at closing and an +additional $40 million payable after the achievement of certain production milestones. The +purchased interests include five federal offshore blocks at Garden Banks Blocks 738, 782, 785, 826 +and 827, subject to certain depth +60 +Table of Contents +limitations. Upon the completion of the acquisition, Callon will +own a 100% working interest in the Entrada Field and will become operator. The acquisition is +expected to close within the next 45 days and will add 150 Bcfe to Callon’s proved undeveloped +reserves. +To finance +the initial $150 million payment of the purchase price, a commitment has been received from Merrill +Lynch Capital Corporation to make available to Callon a 7-year, $200 million revolving credit +facility secured by a lien on the Entrada properties. We plan to +borrow the full commitment amount at +closing to cover the required $150 +million payment to BP and, expenses and fees, and the balance of the funds can be used for Entrada development costs or +general corporate purposes. In connection with the closing of the +financing of the acquisition of BP’s interest in the Entrada +Field, the borrowing base of our senior secured credit facility will +be reduced to $50 million. +15. SUPPLEMENTAL OIL AND GAS RESERVE DATA (UNAUDITED) +The Company’s proved oil and gas reserves at December 31, 2006, 2005 and 2004 have been estimated +by Huddleston & Co., Inc who are the Company’s independent petroleum consultants. The reserves +were prepared in accordance with guidelines established by the SEC. Accordingly, the following +reserve estimates are based upon existing economic and operating conditions. +There are numerous uncertainties inherent in establishing quantities of proved reserves. The +following reserve data represents estimates only and should not be construed as being exact. In +addition, the standardized measure of discounted future net cash flows should not be construed as +the current market value of the Company’s oil and gas properties or the cost that would be incurred +to obtain equivalent reserves. See Note 9 regarding the provisions for royalty relief and the +effect on reserves. +Estimated Reserves +Changes in the estimated net quantities of crude oil and natural gas reserves, all of which are +located onshore and offshore in the continental United States, are as follows: +Reserve Quantities +Years Ended December 31, +2006 +2005 +2004 +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period +18,428 +19,748 +23,709 +Revisions to previous estimates +(3,733 +) +316 +(2,370 +)(a) +Purchase of reserves in place +— +71 +— +Extensions and discoveries +204 +129 +145 +Production +(1,634 +) +(1,836 +) +(1,736 +) +End of period +13,265 +18,428 +19,748 +Natural Gas (MMcf): +Beginning of period +78,021 +72,619 +74,691 +Revisions to previous estimates +(15,557 +) +(4,946 +) +2,138 +Purchase of reserves in place +— +1,308 +— +Extensions and discoveries +14,550 +16,808 +7,177 +Production +(10,977) +(7,768) +(11,387) +End of period +66,037 +78,021 +72,619 +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period +7,323 +10,292 +9,919 +End of period +5,159 +7,323 +10,292 +Natural Gas (MMcf): +Beginning of period +30,982 +33,982 +31,415 +End of period +36,750 +30,982 +33,982 +(a) +Includes Medusa royalty adjustment +61 +Table of Contents +Standardized Measure +The following tables present the Company’s standardized measure of discounted future net cash flows +and changes therein relating to proved oil and gas reserves and were computed using reserve +valuations based on regulations prescribed by the SEC. These regulations provide that the oil, +condensate and gas price structure utilized to project future net cash flows reflect period-end +prices (approximately $5.78 per Mcf for natural gas and $54.07 per Bbl for oil for the 2006 +disclosures, $10.13 per Mcf and $55.44 per Bbl for 2005 disclosures, and $6.51 per Mcf and $36.72 +per Bbl for 2004 disclosures) at each date presented with no escalation. Future production and +development costs are based on current costs without escalation. The resulting net future cash +flows have been discounted to their present values based on a 10% annual discount factor. +Standardized Measure +Years Ended December 31, +2006 +2005 +2004 +(In thousands) +Future cash inflows +$ +1,101,182 +$ +1,814,208 +$ +1,198,096 +Future costs - +Production +(243,740 +) +(238,321 +) +(231,616 +) +Development and net abandonment +(81,700 +) +(88,070 +) +(74,335 +) +Future net inflows before income taxes +775,742 +1,487,817 +892,145 +Future income taxes +(119,685 +) +(379,287 +) +(166,284 +) +Future net cash flows +656,057 +1,108,530 +725,861 +10% discount factor +(185,266 +) +(270,978 +) +(209,968 +) +Standardized measure of discounted +future net cash flows +$ +470,791 +$ +837,552 +$ +515,893 +Changes in Standardized Measure +Years Ended December 31, +2006 +2005 +2004 +(In thousands) +Standardized measure – beginning of period +$ +837,552 +$ +515,893 +$ +519,026 +Sales and transfers, net of production costs +(153,387 +) +(116,913 +) +(97,494 +) +Net change in sales and transfer prices, +net of production costs +(347,193 +) +391,570 +86,551 +Exchange and sale of in place reserves +— +— +— +Purchases, extensions, discoveries, and +improved +recovery, net of future production and +development costs incurred +122,862 +127,848 +77,576 +Revisions of quantity estimates +(155,342 +) +(17,241 +) +(41,314 +) +Accretion of discount +108,871 +61,259 +57,046 +Net change in income taxes +187,209 +(154,460 +) +(45,262 +) +Changes in production rates, timing and other +(129,781 +) +29,596 +(40,236 +) +Standardized measure — end of period +$ +470,791 +$ +837,552 +$ +515,893 +At year +end 2006, a downward revision was made by the Company’s +independent petroleum engineers to Entrada’s estimated net proved +reserves as of December 31, 2006 due to new performance data from analogous deepwater reservoirs. +16. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) +First +Second +Third +Fourth +Quarter +Quarter +Quarter +Quarter +(In thousands, except per share data) +2006 +Total revenues +$ +45,581 +$ +47,057 +$ +44,878 +$ +44,752 +Income from operations +22,605 +21,616 +17,815 +12,367 +Net income +12,767 +12,303 +9,630 +5,860 +Net income per common share-basic +$ +0.66 +$ +0.61 +$ +0.47 +$ +0.28 +Net income per common share-diluted +0.60 +0.57 +0.45 +0.27 +First +Second +Third +Fourth +Quarter +Quarter +Quarter(a) +Quarter(a) +(In thousands, except per share data) +2005 +Total revenues +$ +43,012 +$ +41,668 +$ +31,722 +$ +24,888 +Income from operations +18,134 +17,696 +8,692 +9,783 +Net income +9,475 +9,311 +3,683 +4,307 +Net income per common share-basic +$ +0.52 +$ +0.52 +$ +0.19 +$ +0.22 +Net income per common share-diluted +0.46 +0.46 +0.17 +0.20 +(a) +These quarters were impacted by tropical storm and hurricane activity. +62 +Table of Contents +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +There have been no disagreements with the independent auditors on any matters of accounting +principles or practices, financial statement disclosure, or auditing scope or procedures. +ITEM 9.A CONTROLS AND PROCEDURES +The term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the +Securities Exchange Act of 1934, or the Exchange Act. This term refers to the controls and +procedures of a company that are designed to ensure that information required to be disclosed by a +company in the reports that it files or submits under the Exchange Act is recorded, processed, +summarized and reported within the time periods specified by the Securities and Exchange +Commission. Our management, including our Chief Executive Officer and Chief Financial Officer, +have evaluated the effectiveness of our disclosure controls and procedures as of the end of the +period covered by this annual report. Based upon that evaluation, our Chief Executive Officer and +Chief Financial Officer have concluded that our disclosure controls and procedures were effective +as of the end of the period covered by this annual report. There were no changes to our internal +control over financial reporting during our last fiscal quarter that have materially affected, or +are reasonable likely to materially affect, our internal control over financial reporting. +Management’s Report On Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over +financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the +supervision and with the participation of our management, including our principal executive and +financial officers, we conducted an evaluation of the effectiveness of our internal control over +financial reporting as of December 31, 2006 based on the frame work in the Internal +Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our evaluation under the framework in Internal Control-Integrated Framework, +our management concluded that our internal control over financial reporting was effective as of +December 31, 2006. +Ernst & Young LLP, our independent registered public accounting firm, has issued an attestation +report on our management’s assessment of the effectiveness of our internal control over financial +reporting which is included herein. +63 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Stockholders and Board of Directors +Callon Petroleum Company +We have audited management’s assessment, included in the accompanying Management’s Report on +Internal Control over Financial Reporting, that Callon Petroleum Company maintained effective +internal control over financial reporting as of December 31, 2006, based on criteria established in +Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the +Treadway Commission (COSO). Callon Petroleum Company’s management is responsible for maintaining +effective internal control over financial reporting and for its assessment of the effectiveness of +internal control over financial reporting. Our responsibility is to express an opinion on +management’s assessment and an opinion on the effectiveness of the Company’s internal control over +financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight +Board (United States). Those standards require that we plan and perform the audit to obtain +reasonable assurance about whether effective internal control over financial reporting was +maintained in all material respects. Our audit included obtaining an understanding of internal +control over financial reporting, evaluating management’s assessment, testing and evaluating the +design and operating effectiveness of internal control, and performing such other procedures as we +considered necessary in the circumstances. We believe that our audit provides a reasonable basis +for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable +assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A +company’s internal control over financial reporting includes those policies and procedures that (1) +pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the +transactions and dispositions of the assets of the company; (2) provide reasonable assurance that +transactions are recorded as necessary to permit preparation of financial statements in accordance +with generally accepted accounting principles, and that receipts and expenditures of the company +are being made only in accordance with authorizations of management and directors of the company; +and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the +financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or +detect misstatements. Also, projections of any evaluation of effectiveness to future periods are +subject to the risk that controls may become inadequate because of changes in conditions, or that +the degree of compliance with the policies or procedures may deteriorate. +In our opinion, management’s assessment that Callon Petroleum Company maintained effective internal +control over financial reporting as of December 31, 2006, is fairly stated, in all material +respects, based on criteria established in Internal Control-Integrated Framework issued by the +Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, Callon +Petroleum Company maintained, in all material respects, effective internal control over financial +reporting as of December 31, 2006, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight +Board (United States), the consolidated balance sheets of Callon Petroleum Company as of December +31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and +cash flows for each of the three years in the period ended December 31, 2006 of Callon Petroleum +Company and our report dated March 15, 2007, expressed an unqualified opinion thereon. +/s/ +Ernst & Young LLP +New Orleans, Louisiana +March 15, 2007 +64 +Table of Contents +ITEM 9.B OTHER INFORMATION +We have disclosed all information required to be disclosed in a current report on Form 8-K during +the fourth quarter of the year ended December 31, 2006 in previously filed reports on Form 8-K. +65 +Table of Contents +PART III. +ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. +For information concerning Item 10, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 3, 2007 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +The Company has adopted a code of ethics that applies to the Company’s chief executive officer, +chief financial officer and chief accounting officer. The full text of such code of ethics has +been posted on the Company’s website at www.callon.com, and is available free of charge in print to +any shareholder who requests it. Request for copies should be addressed to the Secretary at 200 +North Canal Street, Natchez, Mississippi 39120. +66 +Table of Contents +ITEM 11. EXECUTIVE COMPENSATION. +For information concerning Item 11, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 3, 2007 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED +STOCKHOLDER MATTERS. +For information concerning the security ownership of certain beneficial owners and management, see +the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of +Stockholders to be held on May 3, 2007 which will be filed with the Securities and Exchange +Commission and is incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 3, 2007 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES. +For information concerning Item 14, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 3, 2007 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +PART IV. +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K +(a) 1. The following is an index to the financial statements and financial statement schedules +that are filed as part of this Form 10-K on pages 38 through 63. +Report of Independent Registered Public Accounting Firm +Consolidated Balance Sheets as of the Years Ended December 31, 2006 and 2005 +Consolidated Statements of Operations for the Three Years in the Period Ended +December 31, 2006 +Consolidated Statements of Stockholders’ Equity for the Three Years in the Period Ended +December 31, 2006 +67 +Table of Contents +Consolidated Statements of Cash Flows for the Three Years in the Period Ended +December 31, 2006 +Notes to Consolidated Financial Statements +(a) 2. Schedules other than those listed above are omitted because they are not required, not +applicable or the required information is included in the financial statements or notes thereto. +(a) 3. Exhibits: +2. +Plan of acquisition, reorganization, arrangement, liquidation or succession* +3. +Articles of Incorporation and Bylaws +3.1 +Certificate of Incorporation of the Company, as amended (incorporated by +reference to Exhibit 3.1 of the Company’s Annual Report on Form 10-K for the year +ended December 31, 2003, File No. 001-14039) +3.2 +Bylaws of the Company (incorporated by reference from Exhibit 3.2 of the +Company’s Registration Statement on Form S-4, filed August 4, 1994, Reg. No. +33-82408) +3.3 +Certificate of Amendment to Certificate of Incorporation of the Company +(incorporated by reference to Exhibit 3.3 of the Company’s Annual Report on Form +10-K for the year ended December 31, 2003, File No. 001-14039) +4. +Instruments defining the rights of security holders, including indentures +4.1 +Specimen Common Stock Certificate (incorporated by reference from Exhibit +4.1 of the Company’s Registration Statement on Form S-4, filed August 4, 1994, Reg. +No. 33-82408) +4.2 +Rights Agreement between Callon Petroleum Company and American Stock Transfer +& Trust Company, Rights Agent, dated March 30, 2000 (incorporated by reference from +Exhibit 99.1 of the Company’s Registration Statement on Form 8-A, filed April 6, 2000, +File No. 001-14039) +4.3 +Form of Warrants dated December 8, 2003 and December 29, 2003 entitling lenders under +the Company’s $185 million amended and restated senior unsecured credit agreement dated +December 23, 2003 to purchase common stock from the Company (incorporated by reference +to Exhibit 4.14 of the Company’s Annual Report on Form 10-K for the year ended December +31, 2003, File No. 001-14039) +4.4 +Indenture for the Company’s 9.75% Senior Notes due 2010, dated March 15, 2004 between +Callon Petroleum Company and American Stock Transfer and Trust Company (incorporated by +reference to Exhibit 4.16 of the Company’s Quarterly Report on Form 10-Q for the period +ended March 31, 2004, File No. 001-14039) +68 +Table of Contents +9. +Voting trust agreement +None. +10. +Material contracts +10.1 +Registration Rights Agreement dated September 16, 1994 between the Company +and NOCO Enterprises, L. P. (incorporated by reference from Exhibit 10.2 of the +Company’s Registration Statement on Form 8-B filed October 3, +1994) +10.2 +Counterpart to Registration Rights Agreement by and between the Company, +Ganger Rolf ASA and Bonheur ASA. (incorporated by reference from Exhibit 10.2 +of the Company’s Report on Form 10-K for the fiscal year ended December 31, +2000, File No. 001-14039) +10.3 +Registration Rights Agreement dated September 16, 1994 between the Company +and Callon Stockholders (incorporated by reference from Exhibit 10.3 of the Company’s +Registration Statement on Form 8-B filed October 3, 1994) +10.4 +Callon Petroleum Company 1994 Stock Incentive Plan (incorporated by +reference from Exhibit 10.5 of the Company’s Registration Statement on Form 8-B filed +October 3, 1994 +10.5 +Callon Petroleum Company 1996 Stock Incentive Plan as amended on May 9, 2000 +(incorporated by reference from Appendix I of the Company’s Definitive +Proxy Statement of Schedule 14A filed March 28, 2000) +10.6 +Conveyance of Overriding Royalty Interest from the Company to Duke Capital +Partners, LLC, dated June 29, 2001 (incorporated by reference to Exhibit 10.03 of the +Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2001, File No. +001-14039) +10.7 +Callon Petroleum Company 2002 Stock Incentive Plan (incorporated by reference to +Exhibit 10.13 of the Company’s Annual Report on Form 10-K for the year ended December 31, +2001, File No. 001-14039) +10.8 +Change of Control Severance Compensation Agreement by and between Callon Petroleum +Company and Fred L. Callon, dated January 1, 2002 (incorporated by reference to +Exhibit 10.15 of the Company’s Annual Report on Form 10-K for the year +ended December 31, 2001, File No. 001-14039) +10.9 +Medusa Spar Agreement dated as of August 8, 2003, among Callon Petroleum Operating +Company, Murphy Exploration & Production Company-USA and Oceaneering +International, Inc. (incorporated by reference to Exhibit 10.19 of the Company’s Annual Report on +Form 10-K for the year ended December 31, 2003, File No. 001-14039) +10.10 +Credit Agreement dated as of December 18, 2003 among Medusa Spar LLC, The Bank of +Nova Scotia, as Administrative Agent, Bank One, N.A., Sun Trust Bank, as +Syndication Agents and other Lenders Party. (incorporated by reference to +Exhibit 10.20 of the Company’s Annual Report on Form 10-K for +the year ended December 31, 2003, File No. 001-14039) +69 +Table of Contents +10.11 +Amended and Restated Credit Agreement dated as of August 30, 2006 between the Company +and Union Bank of California, N.A., as Administrative Agent (incorporated by +reference to Exhibit 10.11 of the Company’s Current Report on Form 8-K dated +August 31, 2006, File No. 001-14039) +11. +Statement re computation of per share earnings* +12. +Statements re computation of ratios* +13. +Annual Report to security holders, Form 10-Q or quarterly reports* +14. +Code of Ethics +14.1 +Code of Ethics for Chief Executive Officers and Senior Financial Officers +(incorporated by reference to Exhibit 14.1 of the Company’s Annual Report +on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +16. +Letter re change in certifying accountant* +18. +Letter re change in accounting principles* +21. +Subsidiaries of the Company +21.1 +Subsidiaries of the Company (incorporated by reference from Exhibit 21.1 of +the Company’s Registration Statement on Form 8-B filed October 3, 1994) +22. +Published report regarding matters submitted to vote of security holders* +23. +Consents of experts and counsel +23.1 +Consent of Ernst & Young LLP +23.2 +Consent of Huddleston & Co., Inc. +24. +Power of attorney* +31. +Rule 13a-14(a) Certifications +31.1 +Certification of Chief Executive Officer pursuant to Rule 13(a)-14(a) +31.2 +Certification of Chief Financial Officer pursuant to Rule 13(a)-14(a) +32. +Section 1350 Certifications +32.1 +Certification of Chief Executive Officer pursuant to Rule 13(a)-14(b) +32.2 +Certification of Chief Financial Officer pursuant to Rule 13(a)-14(b) +99. +Additional Exhibits* +* +Inapplicable to this filing. +70 +Table of Contents +SIGNATURES +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed +below by the following persons on behalf of the registrant and in the capacities and on the dates +indicated. +CALLON PETROLEUM COMPANY +Date: March 16, 2007 +/s/ Fred L. Callon +Fred L. Callon (principal executive officer, director) +Date: March 16, 2007 +/s/ B. F. Weatherly +B. F. Weatherly (principal financial officer, director) +Date: March 16, 2007 +/s/ Rodger W. Smith +Rodger W. Smith (principal accounting officer) +Date: March 16, 2007 +/s/ Richard Flury +Richard Flury (director) +Date: March 16, 2007 +/s/ John C. Wallace +John C. Wallace (director) +Date: March 16, 2007 +/s/ Richard O. Wilson +Richard O. Wilson (director) +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the +registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto +duly authorized. +CALLON PETROLEUM COMPANY +Date: March 16, 2007 +By: +/s/ B. F. Weatherly +B. F. Weatherly, Executive Vice-President and +Chief Financial Officer +71 \ No newline at end of file diff --git a/raw/filings/0000928022/2006/0000950134-07-005981/filing_metadata.csv b/raw/filings/0000928022/2006/0000950134-07-005981/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..c21a0d8654b927fc5ccd0f1430811a4d2e138aa6 --- /dev/null +++ b/raw/filings/0000928022/2006/0000950134-07-005981/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000928022,CPE,Callon Petroleum Co,10-K,2007-03-16,2006-12-31,2007-03-16T21:29:14.000Z,0000950134-07-005981,d44549e10vk.htm,FORM 10-K,724615,0,0,https://www.sec.gov/Archives/edgar/data/928022/000095013407005981/d44549e10vk.htm,https://www.sec.gov/Archives/edgar/data/928022/000095013407005981/,2006,2006,1 diff --git a/raw/filings/0000928022/2006/0000950134-07-005981/item1.txt b/raw/filings/0000928022/2006/0000950134-07-005981/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..cc65e8b5d2a841b2fd81ac5cc926d74d8d4126cc --- /dev/null +++ b/raw/filings/0000928022/2006/0000950134-07-005981/item1.txt @@ -0,0 +1,4872 @@ +ITEM 1 and 2. BUSINESS and PROPERTIES +Overview +Callon Petroleum Company has been engaged in the exploration, development, acquisition and +production of oil and gas properties since 1950. Our properties are geographically +concentrated primarily offshore in the Gulf of Mexico and onshore in Louisiana and Alabama. We +were incorporated under the laws of the state of Delaware in 1994 and succeeded to the business of +a publicly traded limited partnership, a joint venture with a consortium of European investors and +an independent energy company owned by members of current management. As used herein, the +“Company,” “Callon,” “we,” “us,” and “our” refer to Callon Petroleum Company and its predecessors +and subsidiaries unless the context requires otherwise. +In 1989, we began increasing our reserves through the acquisition of producing properties that were +geologically complex, had (or were analogous to fields with) an established production history from +stacked pay zones and were candidates for exploitation. We focused on reducing operating costs and +implementing production enhancements through the application of technologically advanced production +and recompletion techniques. +Over the past 11 years, we have placed emphasis on the acquisition of acreage with exploration and +development drilling opportunities in the Gulf of Mexico shelf and deepwater areas. At December +31, 2006, we owned working interests in a total of 112 blocks/leases covering 223,000 net acres. +To minimize risk we join with industry partners to explore federal offshore blocks acquired in the +Gulf of Mexico. We perform extensive geological and geophysical studies using computer-aided +exploration techniques (CAEX), including, where appropriate, the acquisition of 3-D seismic or +high-resolution 2-D data to facilitate these efforts. We continue to develop prospects on the +shelf through our 3-D seismic partnership using Amplitude versus Offset (“AVO”) technology. We +have 8,000 square miles of 3-D seismic data and have invested in pre-stack time migration in order +to apply AVO de-risking to our prospects. In 1998, we began exploration in the Gulf of Mexico +deepwater area (generally 900 to 5,500 feet of water) and during the fourth quarter of 2003, our +first two deepwater projects, the Medusa and Habanero fields, began production. Please see +“Significant Properties” for a more detailed discussion. +We ended the year 2006 with estimated net proved reserves of 145.6 billion cubic feet of natural +gas equivalent (“Bcfe”). This represents a decrease of 23% from 2005 year-end estimated net proved +reserves of 188.6 Bcfe. +The major focus of our future operations is expected to continue to be the exploration for and +development of oil and gas properties, primarily in the Gulf of Mexico. +Availability of Reports +All of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form +8-K, and amendments to such reports as well as other filings we make pursuant to Section 13(a) and +15(d) of the Securities Exchange Act of 1934 are available free of charge on our Internet website. +The address of our +Internet website is www.callon.com. Our Securities and Exchange Commission (“SEC”) filings are +available on our website as soon as they are posted to the EDGAR database on the SEC’s website. +2 +Table of Contents +Business Strategy +Our goal is to increase shareholder value by increasing our reserves, production, cash flow and +earnings. We seek to achieve these goals through the following strategies: +• +focus on Gulf of Mexico exploration with a balance between shelf and deepwater areas, +and onshore Louisiana; +• +aggressively explore our existing prospect inventory; +• +replenish our prospect inventory with increasing emphasis on prospect generation using +AVO technology to reduce the risks associated with our exploratory drilling; and +• +acquire producing properties with infrastructure in areas of focus that contain upside +potential. +Exploration and Development Activities +In 2006, capital expenditures for exploration and development costs related to oil and gas +properties totaled approximately $167 million. These expenditures included: +• +$107 million in the Gulf of Mexico shelf, onshore south Louisiana and Texas State waters +areas which included the drilling of 10 exploratory wells, five of which were unsuccessful, +two development wells and completion costs for our successful wells; +• +$15 million in our deepwater area, which included four exploratory wells, three of which +were unsuccessful and one temporarily abandoned; +• +$16 million for leasehold and seismic costs; +• +$13 million for plugging and abandonment costs; and +• +$6 million for capitalized interest and $10 million for capitalized general and +administration costs allocable directly to exploration and development projects. +Risk Factors +A decrease in oil and gas prices may adversely affect our results of operations and financial +condition . Our success is highly dependent on prices for oil and gas, which are extremely volatile. +Any substantial or extended decline in the price of oil or gas would have a material adverse effect +on us. Oil and gas markets are both seasonal and cyclical. The prices of oil and gas depend on +factors we cannot control such as weather, economic conditions, and levels of production, actions +by OPEC and other countries and government actions. Prices of oil and gas will affect the following +aspects of our business: +• +our revenues, cash flows and earnings; +• +the amount of oil and gas that we are economically able to produce; +• +our ability to attract capital to finance our operations and the cost of the capital; +• +the amount we are allowed to borrow under our senior secured credit facility; +• +the value of our oil and gas properties; and +• +the profit or loss we incur in exploring for and developing our reserves. +3 +Table of Contents +Our reserve information represents estimates that may turn out to be incorrect if the assumptions +upon which these estimates are based are inaccurate. Any material inaccuracies in these reserve +estimates or underlying assumptions will materially affect the quantities and present value of our +reserves. The process of estimating oil and gas reserves is complex. It requires interpretations +of available technical data and various assumptions, including assumptions relating to economic +factors. Any significant inaccuracies in these interpretations or assumptions could materially +affect the estimated quantities and present value of reserves shown in this annual report. +In order to prepare these estimates, we must project production rates and the timing of development +expenditures. The assumptions regarding the timing and costs to commence production from our +deepwater wells used in preparing our reserves are often subject to revisions over time as +described under “Our deepwater operations have special operational risks that may negatively affect +the value of those assets.” We must also analyze available geological, geophysical, production and +engineering data, the extent, quality and reliability of which can vary. The process also requires +us to make economic assumptions, such as oil and gas prices, drilling and operating expenses, +capital expenditures, taxes and availability of funds. Therefore, estimates of oil and gas +reserves are inherently imprecise. +Actual future production, oil and gas prices, revenues, taxes, development expenditures, operating +expenses and quantities of recoverable oil and gas reserves most likely will vary from the +estimates. Any significant variance could materially affect the estimated quantities and present +value of reserves shown in this report. In addition, estimates of proved reserves may be adjusted +to reflect production history, results of exploration and development, prevailing oil and gas +prices and other factors, many of which are beyond our control. +Also, under Mineral Management Services (“MMS”) rules governing our deepwater Medusa property and +several of our shallow water, deep natural gas properties and prospects, we are eligible for +royalty suspensions depending on the difference between the average monthly New York Mercantile +Exchange (NYMEX) sales price for oil or gas and price thresholds set by the MMS. As a result, our +reserve estimates may increase or decrease depending upon the relation of price thresholds versus +the average NYMEX prices. +Our Entrada field is governed by leases from the MMS. These leases granted royalty suspension +without provisions for pricing thresholds for crude oil and natural gas which would require us to +pay royalties to the MMS if the thresholds were exceeded by the current year average of NYMEX +prices. The MMS has notified us the exclusion of the provisions occurred in error in the lease +issuance process and was not the MMS’s intention. Congress is considering various bills to address +this issue and if a bill were to pass to amend the leases to provide thresholds for crude oil and +natural gas prices the reserves for Entrada could be subject to royalties. However, the MMS stated +in their correspondence to us they will continue to honor the terms of the leases as issued unless +notified otherwise. This correspondence applies only to our 20% working interest in the Entrada field. +4 +Table of Contents +You should not assume that the present value of future net cash flows from our proved reserves +referred to in this report is the current market value of our estimated oil and gas reserves. In +accordance with SEC requirements, we generally base the estimated discounted future net cash flows +from our proved reserves on prices and costs on the date of the estimate. Actual future prices and +costs may differ materially from those used in the present value estimate. +The discounted present value of our oil and gas reserves is prepared in accordance with guidelines +established by the SEC. A purchaser of reserves would use numerous other factors to value the +reserves. The discounted present value of reserves, therefore, does not necessarily represent the +fair market value of those reserves. +On December 31, 2006, approximately 57% of the discounted present value of our estimated net proved +reserves were proved undeveloped. Proved undeveloped reserves represented 54% of total proved +reserves. Most of these proved undeveloped reserves were attributable to our deepwater properties. +Development of these properties is subject to additional risks as described above. +Information about reserves constitutes forward-looking information. See “Forward-Looking +Statements” for information regarding forward-looking information. +Unless we are able to replace reserves which we have produced, our cash flows and production will +decrease over time. Our future success depends upon our ability to find, develop and acquire oil +and gas reserves that are economically recoverable. As is generally the case for Gulf properties, +our producing properties usually have high initial production rates, followed by a steep decline in +production. As a result, we must continually locate and develop or acquire new oil and gas reserves +to replace those being depleted by production. We must do this even during periods of low oil and +gas prices when it is difficult to raise the capital necessary to finance these activities and +during periods of high operating costs when it is expensive to contract for drilling rigs and other +equipment and personnel necessary +to explore for oil and gas. Without successful +exploration or acquisition activities, our reserves, production and revenues will decline rapidly. +We cannot assure you that we will be able to find and develop or acquire additional reserves at an +acceptable cost. +Also, because of the aggregate short life of our reserves, our return on the investment we make in +our oil and gas wells and the value of our oil and gas wells will depend significantly on prices +prevailing during relatively short production periods. +A significant part of the value of our production and reserves is concentrated in a small number of +offshore properties, and any production problems or inaccuracies in reserve estimates related to +those properties would adversely impact our business. During 2006, approximately 80% of our daily +production came from eight of our properties in the Gulf of Mexico. Moreover, one property +accounted for 40% of our production during this period. In addition, at December 31, 2006, most of +our proved reserves were located in three fields in the Gulf of Mexico, with approximately 72% of +our total net proved reserves attributable to these properties. If mechanical problems, storms or +other events curtailed a substantial portion of this production or if the actual reserves +associated with any one of these producing properties are less than our estimated reserves, our +results of operations and financial condition could be adversely affected. +Our focus on exploration projects increases the risks inherent in our oil and gas activities. Our +business strategy focuses on replacing reserves through exploration, where the risks are greater +than in acquisitions and development drilling. Although we have been successful in exploration in +the past, we cannot assure you that we will continue to increase reserves through exploration or at +an acceptable cost. Additionally, we are often +uncertain as to the future costs and timing of drilling, completing and +5 +Table of Contents +producing wells. Our +drilling operations may be curtailed, delayed or canceled as a result of a variety of factors, +including: +• +unexpected drilling conditions; +• +pressure or inequalities in formations; +• +equipment failures or accidents; +• +adverse weather conditions; +• +compliance with governmental requirements; and +• +shortages or delays in the availability of drilling rigs and the delivery of equipment. +We do not operate all of our properties and have limited influence over the operations of some of +these properties, particularly our deepwater properties. Our lack of control could result in the +following: +• +the operator may initiate exploration or development at a faster or slower pace than we +prefer; +• +the operator may propose to drill more wells or build more facilities on a project than +we have funds for or that we deem appropriate, which may mean that we are unable to +participate in the project or share in the revenues generated by the project even though we +paid our share of exploration costs; and +• +if an operator refuses to initiate a project, we may be unable to pursue the project. +Any of these events could materially reduce the value of our non-operated properties. +Our deepwater operations have special operational risks that may negatively affect the value of +those assets. Drilling operations in the deepwater area are by their nature more difficult and +costly than drilling operations in shallow water. Deepwater drilling operations require the +application of more advanced drilling technologies involving a higher risk of technological failure +and usually have significantly higher drilling costs than shallow water drilling operations. +Deepwater wells are completed using sub-sea completion techniques that require substantial time and +the use of advanced remote installation equipment. These operations involve a high risk of +mechanical difficulties and equipment failures that could result in significant cost overruns. +In deepwater, the time required to commence production following a discovery is much longer than in +shallow water and on-shore. Deepwater discoveries require the construction of expensive production +facilities and pipelines prior to production. We cannot estimate the costs and timing of the +construction of these facilities with certainty, and the accuracy of our estimates will be affected +by a number of factors beyond our control, including the following: +• +decisions made by the operators of our deepwater wells; +• +the availability of materials necessary to construct the facilities; +• +the proximity of our discoveries to pipelines; and +• +the price of oil and natural gas. +Delays and cost overruns in the commencement of production will affect the value of our deepwater +prospects and the discounted present value of reserves attributable to those prospects. +Competitive industry conditions may negatively affect our ability to conduct operations. We +operate in the highly competitive areas of oil and gas exploration, development and production. We +compete for the purchase of leases in the Gulf of Mexico from the U. S. government and from other +oil and gas +6 +Table of Contents +companies. These leases include exploration prospects as well as properties with proved reserves. Factors that +affect our ability to compete in the marketplace include: +• +our access to the capital necessary to drill wells and acquire properties; +• +our ability to acquire and analyze seismic, geological and other information relating to +a property; +• +our ability to retain the personnel necessary to properly evaluate seismic and other +information relating to a property; +• +the location of, and our ability to access, platforms, pipelines and other facilities +used to produce and transport oil and gas production; +• +the standards we establish for the minimum projected return on an investment of our +capital; and +• +the availability of alternate fuel sources. +Our competitors include major integrated oil companies, substantial independent energy companies, +and affiliates of major interstate and intrastate pipelines and national and local gas gatherers, +many of which possess greater financial, technological and other resources than we do. +Our competitors may use superior technology, which we may be unable to afford or which would +require costly investment by us in order to compete. Our industry is subject to rapid and +significant advancements in technology, including the introduction of new products and services +using new technologies. As our competitors use or develop new technologies, we may be placed at a +competitive disadvantage, and competitive pressures may force us to implement new technologies at a +substantial cost. In addition, our competitors may have greater financial, technical and personnel +resources that allow them to enjoy technological advantages and may in the future allow them to +implement new technologies before we can. We cannot be certain that we will be able to implement +technologies on a timely basis or at a cost that is acceptable to us. One or more of the +technologies that we currently use or that we may implement in the future may become obsolete, and +we may be adversely affected. For example, marine seismic acquisition technology has been +characterized by rapid technological advancements in recent years, and further significant +technological developments could substantially impair our 3-D seismic data’s value. +We may not be able to replace our reserves or generate cash flows if we are unable to raise +capital. We will be required to make substantial capital expenditures to develop our existing +reserves, and to discover new oil and gas reserves. Historically, we have financed these +expenditures primarily with cash from operations, proceeds from bank borrowings and proceeds from +the sale of debt and equity securities. See “Management’s Discussion and Analysis of Financial +Condition and Results of Operations — Liquidity and Capital Resources” for a discussion of our +capital budget. We cannot assure you that we will be able to raise capital in the future. We also +make offers to acquire oil and gas properties in the ordinary course of our business. If these +offers are accepted, our capital needs may increase substantially. +We expect to continue using our senior secured credit facility to borrow funds to supplement our +available cash. The amount we may borrow under our senior secured credit facility may not exceed a +borrowing base determined by the lenders under such facility based on their projections of our +future production, production costs, taxes, commodity prices and any other factors deemed relevant +by our lenders. We cannot control the assumptions the lenders use to calculate our borrowing base. +The lenders may, without our consent, adjust the +borrowing base semiannually or in situations where we purchase or sell assets or issue debt +securities. If our borrowings under the senior secured credit facility exceed the borrowing base, +7 +Table of Contents +the lenders may require that we repay the excess. If this were to occur, we might have to sell +assets or seek financing from other sources. Sales of assets could further reduce the amount of +our borrowing base. We cannot assure you that we would be successful in selling assets or arranging +substitute financing. If we were not able to repay borrowings under our senior secured credit +facility to reduce the outstanding amount to less than the borrowing base, we would be in default +under our senior secured credit facility. For a description of our senior secured credit facility +and its principal terms and conditions, see “Management’s Discussion and Analysis of Financial +Condition and Results of Operations —Liquidity and Capital Resources” and Note 7 to our +Consolidated Financial Statements. +Our decision to drill a prospect is subject to a number of factors, and we may decide to alter our +drilling schedule or not drill at all. A prospect is a property on which we have identified what +our geoscientists believe, based on available seismic and geological information, to be indications +of hydrocarbons. Our prospects are in various stages of evaluation, ranging from a prospect which +is ready to drill to a prospect which will require substantial additional seismic data processing +and interpretation. Whether we ultimately drill a prospect may depend on the following factors: +• +receipt of additional seismic data or the reprocessing of existing data; +• +material changes in oil or gas prices; +• +the costs and availability of drilling rigs; +• +the success or failure of wells drilled in similar formations or which would use the +same production facilities; +• +availability and cost of capital; +• +changes in the estimates of the costs to drill or complete wells; +• +our ability to attract other industry partners to acquire a portion of the working +interest to reduce exposure to costs and drilling risks; and +• +decisions of our joint working interest owners. +We will continue to gather data about our prospects and it is possible that additional information +may cause us to alter our drilling schedule or determine that a prospect should not be pursued at +all. You should understand that our plans regarding our prospects are subject to change. +Weather, unexpected subsurface conditions, and other unforeseen operating hazards may adversely +impact our ability to conduct business. There are many operating hazards in exploring for and +producing oil and gas, including: +• +our drilling operations may encounter unexpected formations or pressures, which could +cause damage to equipment or personal injury; +• +we may experience equipment failures which curtail or stop production; +• +we could experience blowouts or other damages to the productive formations that may +require a well to be re-drilled or other corrective action to be taken; and +• +because of these or other events, we could experience environmental hazards, including +oil spills, gas leaks, and ruptures. +In the event of any of the foregoing, we may be subject to interrupted production or substantial +environmental liability due to injury to or loss of life, damage to or destruction of property, +natural resources and equipment, pollution and other environmental damage, investigation and +remediation requirements. Moreover, a substantial +portion of our operations are offshore and are subject to a variety of risks peculiar to the marine +environment such as capsizing, collisions, hurricanes and other adverse +8 +Table of Contents +weather conditions. These +conditions can cause substantial damage to facilities and interrupt production. Offshore +operations are also subject to more extensive governmental regulation. +We cannot assure you that we will be able to maintain adequate insurance at rates we consider +reasonable to cover our possible losses from operating hazards. The occurrence of a significant +event not fully insured or indemnified against could materially and adversely affect our financial +condition and results of operations. +We may not have production to offset hedges; by hedging, we may not benefit from price increases. +Part of our business strategy is to reduce our exposure to the volatility of oil and gas prices by +hedging a portion of our production. In a typical hedge transaction, we will have the right to +receive from the other parties to the hedge the excess of the fixed price specified in the hedge +over a floating price based on a market index, multiplied by the quantity hedged. If the floating +price exceeds the fixed price, we are required to pay the other parties this difference multiplied +by the quantity hedged. We are required to pay the difference between the floating price and the +fixed price when the floating price exceeds the fixed price regardless of whether we have +sufficient production to cover the quantities specified in the hedge. Significant reductions in +production at times when the floating price exceeds the fixed price could require us to make +payments under the hedge agreements even though such payments are not offset by sales of +production. Hedging will also prevent us from receiving the full advantage of increases in oil or +gas prices above the fixed amount specified in the hedge. We also enter into price “collars” to +reduce the risk of changes in oil and gas prices. Under a collar, no payments are due by either +party so long as the market price is above a floor set in the collar and below a ceiling. If the +price falls below the floor, the counter-party to the collar pays the difference to us and if the +price is above the ceiling, we pay the counter-party the difference. Another type of hedging +contract we have entered into is a put contract. Under a put, if the price falls below the set +floor price, the counter-party to the contract pays the difference to us. See “Quantitative and +Qualitative Disclosures About Market Risks” for a discussion of our hedging practices. +Compliance with environmental and other government regulations could be costly and could negatively +impact production. Our operations are subject to numerous laws and regulations governing the +operation and maintenance of our facilities and the discharge of materials into the environment or +otherwise relating to environmental protection. For a discussion of the material regulations +applicable to us, see “Regulations”. These laws and regulations may: +• +require that we acquire permits before commencing drilling; +• +restrict the substances that can be released into the environment in connection with +drilling and production activities; +• +limit or prohibit drilling activities on protected areas such as wetlands or wilderness +areas; and +• +require measures to remediate or mitigate pollution and environmental impacts from +current and former operations, such as cleaning up spills or dismantling abandoned +production facilities. +Under these laws and regulations, we could be liable for personal injury and clean-up costs and +other environmental and property damages, as well as administrative, civil and criminal penalties. +We maintain limited insurance coverage for sudden and accidental environmental damages. We do not +believe that insurance coverage for environmental damages that occur over time is available at a +reasonable cost. Also, we do not believe that insurance coverage for the full potential liability +that could be caused by sudden and accidental environmental damages is available at a reasonable +cost. Accordingly, we may be subject to liability or we may be required to cease production from +properties in the event of environmental damages. +9 +Table of Contents +Factors beyond our control affect our ability to market production and our financial results. The +ability to market oil and gas from our wells depends upon numerous factors beyond our control. +These factors include: +• +the extent of domestic production and imports of oil and gas; +• +the proximity of the gas production to gas pipelines; +• +the availability of pipeline capacity; +• +the demand for oil and gas by utilities and other end users; +• +the availability of alternative fuel sources; +• +the effects of inclement weather; +• +state and federal regulation of oil and gas marketing; and +• +federal regulation of gas sold or transported in interstate commerce. +Because of these factors, we may be unable to market all of the oil or gas we produce. In addition, +we may be unable to obtain favorable prices for the oil and gas we produce. +If oil and gas prices decrease, we may be required to take writedowns of the carrying value of our +oil and gas properties. We may be required to writedown the carrying value of our oil and gas +properties when oil and gas prices are low or if we have substantial downward adjustments to our +estimated net proved reserves, increases in our estimates of development costs or deterioration in +our exploration results. Under the full-cost method which we use to account for our oil and gas +properties, the net capitalized costs of our oil and gas properties may not exceed the present +value, discounted at 10%, of future net cash flows from estimated net proved reserves, using period +end oil and gas prices or prices as of the date of our auditor’s report, plus the lower of cost or +fair market value of our unproved properties. If net capitalized costs of our oil and gas +properties exceed this limit, we must charge the amount of the excess to earnings. This type of +charge will not affect our cash flows, but will reduce the book value of our stockholders’ equity. +We review the carrying value of our properties quarterly, based on prices in effect as of the end +of each quarter or at the time of reporting our results. Once incurred, a writedown of oil and gas +properties is not reversible at a later date, even if prices increase. +There are inherent limitations in all control systems, and misstatements due to error or fraud that +could seriously harm our business may occur and not be detected. Our management, including our +Chief Executive and Financial Officers, do not expect that our internal controls and disclosure +controls will prevent all possible error and all fraud. A control system, no matter how well +conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of +the control system are met. In addition, the design of a control system must reflect the fact that +there are resource constraints and the benefit of controls must be relative to their costs. +Because of the inherent limitations in all control systems, an evaluation of controls can only +provide reasonable assurance that all material control issues and instances of fraud, if any, in +our company have been detected. These inherent limitations include the realities that judgments in +decision-making can be faulty and that breakdowns can occur because of simple error or mistake. +Further, controls can be circumvented by the individual acts of some persons or by collusion of two +or more persons. The design of any system of controls is based in part upon certain assumptions +about the likelihood of future events, and there can be no assurance that any +10 +Table of Contents +design will succeed in achieving its stated goals under all potential future conditions. +Because of inherent limitations in a cost-effective control system, misstatements due to error or +fraud may occur and not be detected. A failure of our controls and procedures to detect error or +fraud could seriously harm our business and results of operations. +Forward-Looking Statements +In this report, we have made many forward-looking statements. We cannot assure you that the plans, +intentions or expectations upon which our forward-looking statements are based will occur. Our +forward-looking statements are subject to risks, uncertainties and assumptions, including those +discussed elsewhere in this report. Forward-looking statements include statements regarding: +• +our oil and gas reserve quantities, and the discounted present value of these +reserves; +• +the amount and nature of our capital expenditures; +• +drilling of wells; +• +the timing and amount of future production and operating costs; +• +business strategies and plans of management; and +• +prospect development and property acquisitions. +Some of the risks, which could affect our future results and could cause results to differ +materially from those expressed in our forward-looking statements, include: +• +general economic conditions; +• +the volatility of oil and natural gas prices; +• +the uncertainty of estimates of oil and natural gas reserves; +• +the impact of competition; +• +the availability and cost of seismic, drilling and other equipment; +• +operating hazards inherent in the exploration for and production of oil and natural +gas; +• +difficulties encountered during the exploration for and production of oil and +natural gas; +• +difficulties encountered in delivering oil and natural gas to commercial markets; +• +changes in customer demand and producers’ supply; +• +the uncertainty of our ability to attract capital; +• +compliance with, or the effect of changes in, the extensive governmental +regulations regarding the oil and natural gas business; +• +actions of operators of our oil and gas properties; and +• +weather conditions. +The information contained in this report, including the information set forth under the heading +“Risk Factors,” identifies additional factors that could affect our operating results and +performance. We urge you to carefully consider these factors and the other cautionary statements in +this report. Our forward-looking statements speak only as of the date made, and we have no +obligation to update these forward-looking statements. +Corporate Offices +Our headquarters are located in Natchez, Mississippi, in approximately 51,500 square feet of owned +space. We also maintain a business office in Houston, Texas, and own or lease field offices in the +area of the major fields in which we operate properties or have a significant interest. Replacement +of any of our leased offices would not +result in material expenditures by us as alternative locations to our leased space are anticipated +to be readily available . +11 +Table of Contents +Employees +We had 86 employees as of December 31, 2006, none of whom are currently represented by a union. We +believe that we have good relations with our employees. We employ six petroleum engineers and +eight petroleum geoscientists. +Regulations +General . The oil and gas industry is subject to regulation at the federal, state and local level, +and some of the laws, rules and regulations that govern our operations carry substantial penalties +for non-compliance. This regulatory burden increases our cost of doing business and, consequently, +affects our profitability. +Exploration and Production. Our operations are subject to federal, state and local regulations +that include requirements for permits to drill and to conduct other operations and for provision of +financial assurances (such as bonds) covering drilling and well operations. Other activities +subject to regulation are: +• +the location of wells, +• +the method of drilling and completing wells, +• +the rate of production, +• +the surface use and restoration of properties upon which wells are drilled, +• +the plugging and abandoning of wells, +• +the disposal of fluids used or other wastes obtained in connection with operations, +• +the marketing, transportation and reporting of production, and +• +the valuation and payment of royalties. +For instance, our OCS leases in federal waters are administered by the Minerals Management Service, +or MMS, and require compliance with detailed MMS regulations and orders. Lessees must obtain MMS +approval for exploration plans and exploitation and production plans prior to the commencement of +such operations. The MMS has promulgated regulations requiring offshore production facilities +located on the OCS to meet stringent engineering and construction specifications. The MMS also has +regulations restricting the flaring or venting of natural gas, and prohibiting the flaring of +liquid hydrocarbons and oil without prior authorization. MMS policies concerning the volume of +production that a lessee must have to maintain an offshore lease beyond its primary term also are +applicable to Callon. Similarly, the MMS has promulgated other regulations governing the plugging +and abandonment of wells located offshore and the installation and removal of all production +facilities. To cover the various obligations of lessees on the OCS, the MMS generally requires +that lessees have substantial net worth or post bonds or other acceptable assurances that such +obligations will be met. The cost of these bonds or other surety can be substantial, and there is +no assurance that bonds or other surety can be obtained in all cases. Under some circumstances, +the MMS may require any of our operations on federal leases to be suspended or terminated. Any +such suspension or termination could materially adversely affect our financial conditions and +results of operations. +Our sales of oil and natural gas are affected by the availability, terms and cost of pipeline +transportation. The price and terms for access to pipeline transportation remain subject to +extensive federal regulation. If +12 +Table of Contents +these regulations change, we could face higher transmission costs +for our production and, possibly, reduced access to transmission capacity. +We do not currently anticipate that compliance with existing laws and regulations governing +exploration and production will have a significantly adverse effect upon our capital expenditures, +earnings or competitive position. +Various proposals and proceedings that might affect the petroleum industry are pending before +Congress, the Federal Energy Regulatory Commission, or FERC, various state legislatures, and the +courts. The industry historically has been heavily regulated and we can offer you no assurance +that the less stringent regulatory approach recently pursued by the FERC and Congress will continue +nor can we predict what effect such proposals or proceedings may have on our operations. +Environmental Regulation. Various federal, state and local laws and regulations concerning the +discharge of contaminants into the environment, the generation, storage, transportation and +disposal of wastes, and the protection of public health, natural resources, wildlife and the +environment affect our exploration, development and production operations, including processing +facilities. We must take into account the cost of complying with environmental regulations in +planning, designing, drilling, constructing, operating and abandoning wells. In most instances, the +regulatory requirements relate to the handling and disposal of drilling and production waste +products, water and air pollution control procedures, and the remediation of petroleum-product +contamination. In addition, our operations may require us to obtain permits for, among other +things, +• +air emissions, +• +discharges into surface waters, and +• +the construction and operations of underground injection wells or surface pits to +dispose of produced saltwater and other nonhazardous oilfield wastes. +In the event of an unauthorized discharge, emission or activity, we may be liable for penalties, +costs and damages and we could be required to cleanup or mitigate the environmental impacts of +unauthorized discharges. Under state and federal laws, we could be required to remove or remediate +previously disposed wastes and remediate contamination, including contamination in surface water, +soil or groundwater, caused by disposal of that waste. We could be responsible for wastes disposed +of or released by us or prior owners or operators at properties owned or leased by us or at +locations where wastes have been taken for disposal. We could also be required to suspend or cease +operations in contaminated areas, or to perform remedial well plugging operations or cleanups to +prevent future contamination. The Environmental Protection Agency and various state agencies have +limited the disposal options for hazardous and nonhazardous wastes. The owner and operator of a +site, and persons that treated, disposed of or arranged for the disposal of hazardous substances +found at a site, may be liable, without regard to fault or the legality of the original conduct, +for the release of a hazardous substance into the environment. The Environmental Protection Agency, +state environmental agencies and, in some cases, third parties are authorized to take actions in +response to threats to human health or the environment and to seek to recover from responsible +classes of persons the costs of such action. Furthermore, certain wastes generated by our oil and +natural gas operations that are currently exempt from treatment as hazardous wastes may in the +future be designated as hazardous wastes and, therefore, be subject to considerably more rigorous +and costly operating and disposal requirements. +Federal and state occupational safety and health laws require us to organize information about +hazardous materials used, released or produced in our operations. Certain portions of this +information must be +13 +Table of Contents +provided to employees, state and local governmental authorities and local +citizens. We are also subject to the requirements and reporting set forth in federal workplace +standards. +We have made and will continue to make expenditures to comply with environmental regulations and +requirements. These are necessary business costs in the oil and gas industry. Although we are not +fully insured against all environmental risks, we maintain insurance coverage which we believe is +customary in the industry. Moreover, it is possible that other developments, such as stricter and +more comprehensive environmental laws and regulations, as well as claims for damages to property or +persons resulting from company operations, could result in substantial costs and liabilities, +including civil and criminal penalties, to Callon. We believe we are in compliance with existing +environmental regulations, and that, absent the occurrence of an extraordinary event the effect of +which cannot be predicted, any noncompliance will not have a material adverse effect on our +operations or earnings. +Commitments and Contingencies +The Company’s activities are subject to federal, state and local laws and regulations governing +environmental quality and pollution control. Although no assurances can be made, the Company +believes that, absent the occurrence of an extraordinary event, compliance with existing federal, +state and local laws, rules and regulations governing the release of materials into the environment +or otherwise relating to the protection of the environment will not have a material effect upon the +capital expenditures, earnings or the competitive position of the Company with respect to its +existing assets and operations. The Company cannot predict what effect additional regulation or +legislation, enforcement polices thereunder, and claims for damages to property, employees, other +persons, and the environment resulting from the Company’s operations could have on its activities. +Property Summary +We are engaged in the exploration, development, acquisition and production of oil and gas +properties. Our properties are concentrated offshore in the Gulf of Mexico and onshore, primarily, +in Louisiana and Alabama. We have historically increased our reserves and production by focusing +primarily on low to moderate risk exploration and acquisition opportunities in the Gulf of Mexico +shelf area. In 1998, we expanded our area of exploration to include the Gulf of Mexico deepwater +area. As of December 31, 2006, our estimated net proved reserves totaled 145.6 Bcfe and included +13.3 million barrels of oil (“MMBbl”) and 66.0 billion cubic feet of natural gas (“Bcf”), with a +pre-tax present value, discounted at 10%, of the estimated future net revenues based on constant +prices in effect at year-end of $534.7 million. Oil constitutes approximately 55% on an equivalent +basis of our total estimated proved reserves and approximately 46% of our total estimated proved +reserves are proved developed reserves. +Our Medusa (Mississippi Canyon Blocks 538/582) and Habanero (Garden Banks Block 341) discoveries +began production in the fourth quarter of 2003. A detailed discussion of each of these properties +is provided in the “Significant Properties” section of this report. These two deepwater discoveries +were responsible for 50% of our total production during 2006. +14 +Table of Contents +Significant Properties +The following table shows discounted cash flows and estimated net proved oil and gas reserves by +major field and for all other properties combined at December 31, 2006. +Pre-tax +Estimated Net Proved Reserves +Discounted +Oil +Gas +Total +Present +Value +Operator +(MBbls) +(MMcf) +(MMcfe) +($000) +(a)(b)(c) +Gulf of Mexico Deepwater: +Garden Banks Block +738/782/826/827 +“Entrada” +BP +3,824 +19,059 +42,003 +$ +134,977 +Mississippi Canyon 538/582 +“Medusa” +Murphy +6,030 +4,139 +40,319 +156,542 +Garden Banks Block 341 +“Habanero” +Shell +2,582 +6,252 +21,747 +121,909 +Gulf of Mexico Shelf and Onshore: +High Island Blocks 165/130 +Hydro GOM +48 +9,594 +9,880 +37,687 +West Cameron 3/LA +Callon +100 +3,393 +3,992 +17,919 +High Island Block A-540 +Walter Oil & Gas Corp. +104 +3,063 +3,686 +16,514 +West Cameron Block 295 +Hydro GOM/Cimarex +12 +4,679 +4,751 +15,990 +North Padre Island Block 913 +Callon +— +1,874 +1,878 +7,834 +East Cameron Block 109 +Energy Partners LTD +48 +1,592 +1,879 +7,515 +Other +Various +517 +12,392 +15,493 +17,856 +Total Net Proved Reserves +13,265 +66,037 +145,628 +$ +534,743 +(a) +Represents the present value of future net cash flows before deduction of federal income +taxes, discounted at 10%, attributable to estimated net proved reserves as of December 31, +2006, as set forth in the Company’s reserve reports prepared by its independent petroleum +reserve engineers, Huddleston & Co., Inc. of Houston, Texas. +(b) +Includes a reduction for estimated plugging and abandonment costs that is reflected as a +liability on our balance sheet at December 31, 2006, in accordance with Statement of Financial +Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”). See +the Oil and Gas Reserve table for the standardized measure of discounted future net cash flow. +(c) +We use the financial measure “present value of estimated +future net revenues from proved reserves, excluding income taxes.” +This is a non-GAAP financial measure. We believe that present value +of estimated future net revenues from proved reserves, excluding +income taxes, while not a financial measure in accordance with +generally accepted accounting principles, is an important financial +measure used by investors and independent oil and gas producers for +evaluating the relative value of oil and natural gas properties and +acquisitions because the tax characteristics of comparable companies +can differ materially. The total standardized measure for our proved +reserves as of December 31, 2006 was $470.8 million. The +standardized measure gives effect to income taxes, and is calculated in accordance with Statement of +Financial Accounting Standards No. 69, “Disclosures About +Oil and Gas Producing Activities.” The standardized measure of +our estimated net proved reserves of $470.8 million equals the +present value of our estimated future net revenue from proved +reserves, excluding income taxes, of $534.7 million, less +discounted estimated future income taxes relating to such future net +revenues of $63.9 million. +15 +Table of Contents +Gulf of Mexico Deepwater +Entrada, Garden Banks Blocks 738/782/826/827 +The Entrada discovery is located in approximately 4,500 feet of water in the Gulf of Mexico. Two +wells and seven sidetracks have been drilled to date. The Entrada Area is characterized by a +northwest plunging salt ridge with multiple stacked amplitudes trapped against the salt and various +faults. At year end 2006, we reclassified a portion of Entrada’s +estimated net proved +reserves to probable as of December 31, 2006 due to new performance data from analogous deepwater reservoirs. +Please refer to Note 15 of our Consolidated Financial Statements for further information regarding +reserves. On December 31, 2006, we owned a 20% working interest +in this discovery with BP Exploration and Production Company +(“BP”), the +operator, holding the remaining working interest. +Subsequent +to December 31, 2006, on March 8, 2007, we entered into an agreement with BP to purchase BP’s 80% working +interest in the Entrada Field for total cash consideration of $190 million. The purchase price +includes $150 million payable at closing and an additional $40 million payable after the +achievement of certain production milestones. The purchased interests include five federal +offshore blocks at Garden Banks Blocks 738, 782, 785, 826 and 827, subject to certain depth +limitations. Upon the completion of the acquisition, we will own a 100% working interest in the +Entrada Field and will become operator. The acquisition is expected to close within the next 45 +days and will add 150 Bcfe to our proved undeveloped reserves. +The Magnolia field is located on blocks adjacent to Entrada. The field and related production +facilities are owned by Conoco/Phillips, the operator, and Devon +Energy Corporation. Work has been +substantially completed on a front-end engineering design study to tie-back Entrada to the Magnolia production +facilities by an integrated project team consisting of a leading engineering firm and personnel +from BP and Callon, along with the Magnolia owners. Negotiations between the Magnolia facility +owners and Entrada owners for a production handling agreement have +been ongoing. We expect to complete +these negotiations in the near future once closing of our acquisition of BP’s interest in Entrada +is complete. Development expenditures are expected to commence in the second half of 2007 with the ordering +of long-lead items. The majority of development costs are anticipated to be incurred in 2008 and +early 2009. First production is projected to commence in the first quarter of 2009. +Medusa, Mississippi Canyon Blocks 538/582 +Our Medusa deepwater discovery was announced in September 1999, after we drilled the initial test +well in 2,235 feet of water to a total depth of 16,241 feet and encountered over 120 feet of pay in +two intervals. Subsequent sidetrack drilling from the wellbore was used to determine the extent of +the discovery and a second well was drilled in the first quarter of 2000 to further delineate the +extent of the pay intervals. We own a 15% +working interest, Murphy Exploration & Production Company (“Murphy”), the operator, owns a 60% +working interest and ENI Deepwater, LLC, owns the remaining 25% working interest. +In 2001 a drilling program began which included four development wells and one sidetrack. The +program included production casing being set on six wells to provide initial production take-points +and was completed in the first half of 2002. The construction of a floating production system, +spar, at Medusa was completed during the second quarter of 2003. The A-1 well was completed and +tied into the spar and commenced production in late November 2003. The remaining five wells were +completed and +16 +Table of Contents +commenced production in 2004. Mississippi Canyon 538 #4, North Medusa, was drilled +in 2003 and was temporarily abandoned after encountering 28 feet of net pay. The well bore was +re-entered in the fourth quarter of 2004, sidetracked and reached an objective depth of 9,600 feet +in January 2005. The sidetrack encountered 46 feet of net pay, was completed and commenced initial +production in April 2005. +During 2006 the field produced 8.2 Bcfe net to us which accounted for 40% of our total production. +Future plans include five recompletions to produce up-hole sands and two sidetracks to undrained +areas of the field up-dip or fault separated from existing productions. +In December 2003, we transferred our undivided 15% working interest in the spar production +facilities to Medusa Spar LLC in exchange for cash proceeds of approximately $25 million and a 10% +ownership interest in the LLC. A detailed discussion of this transaction is included in +“Management’s Discussion and Analysis of Financial Condition and Results of Operations-Off-Balance +Sheet Arrangements”. +Habanero, Garden Banks Block 341 +During February 1999, the initial test well on our Habanero deepwater discovery encountered over +200 feet of net pay in two zones. Located in 2,015 feet of water, the well was drilled to a +measured depth of 21,158 feet. We own an 11.25% working interest in the well. The well is operated +by Shell Deepwater Development Inc., which owns a 55% working interest, with the remaining working +interest being owned by Murphy. +A field delineation program began in mid-year 2001, which included three sidetracks of the +discovery well. Production casing was set on this well through the last of the sidetracks to the +Habanero 52 oil and gas sand and the Habanero 55 gas sand. Also, a development well was drilled in +the summer of 2003 which provides a take-point for production from the Habanero 52 oil sand. By +means of a sub-sea completion and tie back to an existing production facility in the area operated +by Shell, production from the Habanero 52 oil sand commenced in late November 2003 and from the +Habanero 55 gas sand in January 2004. In July 2004 the #2 well producing the Habanero 52 oil sand +developed mechanical difficulties with a subsurface control valve and was shut-in resulting in a +significant loss of production. Repairs were completed and production was restored in late +December 2004. In addition, the #1 well producing the Habanero 55 gas sand was recompleted to the +Habanero 55 oil sand in December 2004. +At the time the field was developed, there was no way to know what the drive mechanism would be, so +the wells were put at a mid-dip position. It is now known the field drive mechanism is water and +the wells need to be at the structural crest for maximum recovery. A sidetrack of the #1 well is +planned for this summer to move that well to an up-dip position. +During 2006 Habanero produced 2.1 Bcfe net to us which accounted for 10% of our total production. +Gulf of Mexico Shelf and Onshore Louisiana +High Island Blocks 165/130 +The High Island 165 #1 well was spud in the fourth quarter of 2005, reached total depth of 17,029 +feet in January 2006 and logged 140 feet of net pay. The well commenced production in October 2006 +and during February 2007 was producing at a gross rate of 44 million cubic feet of natural gas per +day. We have two development wells in progress, the High Island Block 130 #1 and #2 wells. The #1 +well is being +17 +Table of Contents +completed and should commence production at a similar rate late in the first quarter +of 2007. In addition to the productive sands discovered by the High Island 165 #1 well, the High +Island 130 #1 well encountered two deeper productive sands. The High Island 130 #2 well is drilling +and if successful should commence production in the second half of 2007. The High Island 165 #1 +well produced 0.4 Bcfe net to our interest in the fourth quarter of 2006. We have a 16.7% working +interest in the shallower productive zones and an 11.7% interest in the deeper discovered by the +High Island 130 #1 well and the operator of the field is Hydro Gulf of Mexico, LLC. +West Cameron 3/LA +We drilled our Prairie Beach prospect during the first half of 2006 which is located onshore in the +state waters of Cameron Parish, Louisiana. The well encountered 37 feet of net pay and began +production in October 2006. During 2006, the field produced 0.3 Bcfe net to us. We operate and own +a 75% working interest. +High Island Block A-540 +The #1 well was spud in November 2005 and reached a total depth of 9,450 feet the following month +after logging 32 feet of net pay in the objective section. First production commenced in late +September 2006 and during 2006 the field produced 0.3 Bcfe net to us. The company owns a 60% +working interest and Walter Oil and Gas is the operator. +West Cameron Block 295 +During the third quarter of 2005, the #2 well reached a total depth of 15,775 feet and logged 150 +feet of net pay in two zones. Each zone was encountered at the predicted depth and exceeded +anticipated thickness. The #2 well commenced production in the second quarter of 2006 and +encountered mechanical difficulties which were corrected. Sustained production was achieved by the +third quarter of 2006. In 2006, we drilled the #4 well, an offset to the #2 well. The #4 well +commenced production during December 2006 in a deeper, secondary zone. After this zone is depleted +we expect to recomplete the well in the main pay zone. Callon holds a 20.5% working interest in the +block and Hydro Gulf of Mexico, LLC is the operator. +A second prospect on this block was also drilled during 2005. The #3 well was drilled to a depth +of 16,286 feet in December 2005 and logged 110 feet of net (94 feet true vertical depth) pay in two +zones. The well was completed in a deeper secondary zone and will probably be recompleted to the +main pay zone in early 2008. The well commenced production in August 2006. Callon holds a 20.5% +working interest in the block and Cimarex Energy Company is the operator. +During 2006, the West Cameron 295 field produced 0.8 Bcfe net to us. +North Padre Island Block 913 +An exploratory well was drilled to a vertical depth of 8,082 feet in the fourth quarter of 2004 and +found natural gas pay in multiple intervals. The well is tied back to existing infrastructure on a +nearby block. We are the operator and own a 50% working interest. First production commenced in +March 2006 and during 2006 the field produced 1.5 Bcfe net to us. +18 +Table of Contents +East Cameron 109 +During +2006, an exploratory well was drilled to a vertical depth of 13,110 +feet and encountered 54 feet +of net pay. The well commenced production during the second half of 2006 and produced 0.1 Bcfe +before encountering mechanical problems. Production was restored in January 2007. Callon owns a +25% working interest and Energy Partners, LTD is the operator. +Oil and Gas Reserves +The following table sets forth certain information about our estimated proved reserves as reported +by Huddleston & Co., Inc. as of the dates set forth below. +Years Ended December 31, +2006 +2005 +2004 +(In thousands) +Proved developed: +Oil (Bbls) +5,159 +7,323 +10,292 +Gas (Mcf) +36,750 +30,982 +33,982 +Mcfe +67,704 +74,921 +95,735 +Proved undeveloped: +Oil (Bbls) +8,106 +11,105 +9,456 +Gas (Mcf) +29,287 +47,039 +38,637 +Mcfe +77,924 +113,667 +95,373 +Total proved: +Oil (Bbls) +13,265 +18,428 +19,748 +Gas (Mcf) +66,037 +78,021 +72,619 +Mcfe +145,628 +188,588 +191,108 +Estimated pre-tax future net cash flows (a) +$ +775,742 +$ +1,487,817 +$ +892,145 +Pre-tax +discounted present value (a)(b) +$ +534,743 +$ +1,088,714 +$ +612,595 +Standardized measure of discounted future +net cash flows(a)(b) +$ +470,791 +$ +837,552 +$ +515,893 +(a) +Includes a reduction for estimated plugging and abandonment costs that is reflected as +a liability on our balance sheet at December 31, 2006, in accordance with SFAS 143. +(b) +We use the financial measure “present value of estimated +future net revenues from proved reserves, excluding income taxes.” +This is a non-GAAP financial measure. We believe that present value +of estimated future net revenues from proved reserves, excluding +income taxes, while not a financial measure in accordance with +generally accepted accounting principles, is an important financial +measure used by investors and independent oil and gas producers for +evaluating the relative value of oil and natural gas properties and +acquisitions because the tax characteristics of comparable companies +can differ materially. The total standardized measure for our proved +reserves as of December 31, 2006 was $470.8 million. The standardized measure gives effect to +income taxes, and is calculated in accordance with Statement of +Financial Accounting Standards No. 69, “Disclosures About +Oil and Gas Producing Activities.” The standardized measure of +our estimated net proved reserves of $470.8 million equals the +present value of our estimated future net revenue from proved +reserves, excluding income taxes, of $534.7 million, less +discounted estimated future income taxes relating to such future net +revenues of $63.9 million. +19 +Table of Contents +Our independent reserve engineers, Huddleston & Co., Inc., prepared the estimates of the proved +reserves and the future net cash flows and present value thereof attributable to such proved +reserves. Reserves were estimated using oil and gas prices and production and development costs in +effect on December 31 of each such year, without escalation, and were otherwise prepared in +accordance with SEC regulations regarding disclosure of oil and gas reserve information. +There are numerous uncertainties inherent in estimating quantities of proved reserves, including +many factors beyond our control or the control of the reserve engineers. Reserve engineering is a +subjective process of estimating underground accumulations of oil and gas that cannot be measured +in an exact manner. The accuracy of any reserve or cash flow estimate is a function of the quality +of available data and of engineering and geological interpretation and judgment. Estimates by +different engineers often vary, sometimes significantly. In addition, physical factors, such as +the results of drilling, testing and production subsequent to the date of an estimate, as well as +economic factors, such as an increase or decrease in product prices that renders production of such +reserves more or less economic, may justify revision of such estimates. Accordingly, reserve +estimates could be different from the quantities of oil and gas that are ultimately recovered. +We have not filed any reports with other federal agencies which contain an estimate of total proved +net oil and gas reserves during our last fiscal year. +Present Activities and Productive Wells +The following table sets forth the wells we have drilled and completed during the periods +indicated. All such wells were drilled in the continental United States primarily in federal and +state waters in the Gulf of Mexico. +Years Ended December 31, +2006 +2005 +2004 +Gross +Net +Gross +Net +Gross +Net +Development: +Oil +— +— +1 +0.15 +— +— +Gas +2 +0.37 +— +— +2 +1.22 +Non-productive +— +— +— +— +— +— +Total +2 +0.37 +1 +0.15 +2 +1.22 +Exploration: +Oil +— +— +— +— +— +— +Gas +5 +2.05 +7 +2.42 +2 +0.72 +Non-productive +8 +2.98 +4 +1.25 +5 +1.24 +Total +13 +5.03 +11 +3.67 +7 +1.96 +20 +Table of Contents +The following table sets forth our productive wells as of December 31, 2006: +Wells +Gross +Net +Oil: +Working interest +40.00 +3.90 +Royalty interest +193.00 +3.15 +Total +233.00 +7.05 +Gas: +Working interest +35.00 +14.40 +Royalty interest +211.00 +1.49 +Total +246.00 +15.89 +A well is categorized as an oil well or a natural gas well based upon the ratio of oil to gas +reserves on a Mcfe basis. However, some of our wells produce both oil and gas. At December 31, +2006, we had no wells with multiple completions. At December 31, 2006, 1 gross (0.033 net) +exploration oil well, 1 gross (0.255 net) exploration gas well and 1 gross (0.117 net) development +gas well were in progress. +Leasehold Acreage +The following table shows our approximate developed and undeveloped (gross and net) leasehold +acreage as of December 31, 2006. +Leasehold Acreage +Developed +Undeveloped +Location +Gross +Net +Gross +Net +Louisiana +6,274 +4,019 +10,706 +4,454 +Texas +78 +— +15,150 +7,616 +Other states +— +— +681 +509 +Federal waters +107,029 +53,930 +357,270 +152,105 +Total +113,381 +57,949 +383,807 +164,684 +As of December 31, 2006, we owned various royalty and overriding royalty interests in 553 net +developed and 7,645 net undeveloped acres. In addition, we owned 4,071 developed and 121,929 +undeveloped mineral acres. +21 +Table of Contents +Major Customers +Our production is sold generally on month-to-month contracts at prevailing prices. The following +table identifies customers to whom we sold a significant percentage of our total oil and gas +production during each of the 12-month periods ended: +December 31 +2006 +2005 +2004 +Shell Trading Company +41 +% +34 +% +30 +% +Louis Dreyfus Energy Services +25 +% +16 +% +23 +% +Plains Marketing, L.P. +11 +% +16 +% +13 +% +Chevron Texaco Natural Gas +3 +% +10 +% +6 +% +Because alternative purchasers of oil and gas are readily available, we believe that the loss of +any of these purchasers would not result in a material adverse effect on our ability to market +future oil and gas production. +Title to Properties +We believe that the title to our oil and gas properties is good and defensible in accordance with +standards generally accepted in the oil and gas industry, subject to such exceptions which, in our +opinion, are not so material as to detract substantially from the use or value of such properties. +Our properties are typically subject, in one degree or another, to one or more of the following: +• +royalties and other burdens and obligations, express or implied, under oil and gas leases; +• +overriding royalties and other burdens created by us or our predecessors in title; +• +a variety of contractual obligations (including, in some cases, development obligations) +arising under operating agreements, farmout agreements, production sales contracts and +other agreements that may affect the properties or their titles; +• +back-ins and reversionary interests existing under purchase agreements and leasehold +assignments; +• +liens that arise in the normal course of operations, such as those for unpaid taxes, +statutory liens securing obligations to unpaid suppliers and contractors and contractual +liens under operating agreements; +• +pooling, unitization and communitization agreements, declarations and orders; and +• +easements, restrictions, rights-of-way and other matters that commonly affect property. +To the extent that such burdens and obligations affect our rights to production revenues, they have +been taken into account in calculating our net revenue interests and in estimating the size and +value of our reserves. We believe that the burdens and obligations affecting our properties are +conventional in the industry for properties of the kind owned by us. +22 +Table of Contents +ITEM 3. LEGAL PROCEEDINGS +We are a defendant in various legal proceedings and claims, which arise in the ordinary course of +our business. We do not believe the ultimate resolution of any such actions will have a material +affect on our financial position or results of operations. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +There were no matters submitted to a vote of security holders during the fourth quarter of 2006. +23 +Table of Contents +PART II. +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED +STOCKHOLDER MATTERS +Our common stock trades on the New York Stock Exchange under the symbol “CPE”. The following table +sets forth the high and low sale prices per share as reported for the periods indicated. +Quarter Ended +High +Low +2005: +First quarter +$ +18.00 +$ +13.22 +Second quarter +16.12 +12.42 +Third quarter +21.25 +14.81 +Fourth quarter +22.29 +16.65 +2006: +First quarter +$ +21.25 +$ +17.01 +Second quarter +21.99 +15.12 +Third quarter +19.96 +12.54 +Fourth quarter +17.44 +12.48 +As of March 5, 2007 there were approximately 4,057 common stockholders of record. +We have never paid dividends on our common stock and intend to retain our cash flow from +operations, net of preferred stock dividends, for the future operation and development of our +business. In addition, our primary credit facility and the terms of our outstanding subordinated +debt prohibit the payment of cash dividends on our common stock. +24 +Table of Contents +Performance Graph +The following graph compares the yearly percentage change for the five years ended December 31, +2006, in the cumulative total shareholder return on the Company’s Common Stock against the +cumulative total return for the (i) Hemscott Industry and Market Index of SIC Group 123 (the +“Hemscott Group Index”) consisting of independent oil and gas drilling and exploration companies +and (ii) the New York Stock Exchange Market Index. The comparison of total return on an investment +for each of the periods assumes that $100 was invested on December 31, 2001 in the Company, the +Hemscott Group Index and the New York Stock Exchange Market Index, and that all dividends were +reinvested. +COMPARE 5-YEAR CUMULATIVE TOTAL RETURN +AMONG CALLON PETROLEUM COMPANY +NYSE MARKET INDEX AND HEMSCOTT GROUP INDEX +ASSUMES $100 INVESTED ON DEC. 31, 2001 +ASSUMES DIVIDEND REINVESTED +FISCAL YEAR ENDING DEC. 31, 2006 +2001 +2002 +2003 +2004 +2005 +2006 +Callon Petroleum Company +$ +100 +$ +49 +$ +151 +$ +211 +$ +258 +$ +219 +Hemscott Group Index +$ +100 +$ +93 +$ +121 +$ +170 +$ +268 +$ +318 +NYSE Market Index +$ +100 +$ +82 +$ +106 +$ +119 +$ +129 +$ +152 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth, as of the dates and for the periods indicated, selected financial +information about us. The financial information for each of the five years in the period ended +December 31, 2006 has been derived from our audited Consolidated Financial Statements for such +periods. The information should be read in conjunction with “Management’s Discussion and Analysis +of Financial Condition and Results of Operations” and the Consolidated Financial Statements and +Notes thereto. The following information is not necessarily indicative of our future results. +25 +Table of Contents +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(In thousands, except per share amounts) +Years Ended December 31, +2006 +2005 +2004 +2003 +2002 +Statement of Operations Data: +Operating revenues: +Oil and gas sales +$ +182,268 +$ +141,290 +$ +119,802 +$ +73,697 +$ +61,171 +Operating expenses: +Lease operating expenses +28,881 +24,377 +22,308 +11,301 +11,030 +Depreciation, depletion and amortization +65,283 +44,946 +47,453 +28,253 +27,096 +General and administrative +8,591 +8,085 +8,758 +4,713 +4,705 +Accretion expense +4,960 +3,549 +3,400 +2,884 +— +Derivative expense +150 +6,028 +1,371 +535 +708 +Total operating expenses +107,865 +86,985 +83,290 +47,686 +43,539 +Income from operations +74,403 +54,305 +36,512 +26,011 +17,632 +Other (income) expenses: +Interest expense +16,480 +16,660 +20,137 +30,614 +26,140 +Other (income) +(1,869 +) +(998 +) +(357 +) +(444 +) +(1,004 +) +Loss on early extinguishment of debt +— +— +3,004 +5,573 +— +Gain on sale of pipeline +— +— +— +— +(2,454 +) +Gain on sale of Enron derivatives +— +— +— +— +(2,479 +) +Total other (income) expenses +14,611 +15,662 +22,784 +35,743 +20,203 +Income (loss) before income taxes +59,792 +38,643 +13,728 +(9,732 +) +(2,571 +) +Income tax expense (benefit) +20,707 +13,209 +(6,697 +) +8,432 +(900 +) +Income (loss) before equity in earnings of Medusa Spar LLC +and cumulative effect of change in accounting principle +39,085 +25,434 +20,425 +(18,164 +) +(1,671 +) +Equity in earnings of Medusa Spar LLC, net of tax +1,475 +1,342 +1,076 +(8 +) +— +Income (loss) before cumulative effect of change in +in accounting principle +40,560 +26,776 +21,501 +(18,172 +) +(1,671 +) +Cumulative effect of change in accounting principle, +net of tax +— +— +— +181 +— +Net income (loss) +40,560 +26,776 +21,501 +(17,991 +) +(1,671 +) +Preferred stock dividends +— +318 +1,272 +1,277 +1,277 +Net income (loss) available to common shares +$ +40,560 +$ +26,458 +$ +20,229 +$ +(19,268 +) +$ +(2,948 +) +26 +Table of Contents +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(In thousands, except per share amounts) +Years Ended December 31, +2006 +2005 +2004 +2003 +2002 +Net income (loss) per common share: +Basic: +Net income (loss) available to common before +cumulative effect of change in accounting principle +$ +2.00 +$ +1.43 +$ +1.28 +$ +(1.42 +) +$ +(.22 +) +Cumulative effect of change in accounting principle, +net of tax +— +— +— +.01 +— +Net income (loss) available to common +$ +2.00 +$ +1.43 +$ +1.28 +$ +(1.41 +) +$ +(.22 +) +Diluted: +Net income (loss) available to common before +cumulative effect of change in accounting principle +$ +1.90 +$ +1.28 +$ +1.22 +$ +(1.42 +) +$ +(.22 +) +Cumulative effect of change in accounting principle, +net of tax +— +— +— +.01 +— +Net income (loss) available to common +$ +1.90 +$ +1.28 +$ +1.22 +$ +(1.41 +) +$ +(.22 +) +Shares used in computing net income (loss) per common share: +Basic +20,270 +18,453 +15,796 +13,662 +13,387 +Diluted +21,363 +20,883 +17,678 +13,662 +13,387 +Balance Sheet Data (end of period): +Oil and gas properties, net +$ +547,027 +$ +447,364 +$ +406,690 +$ +390,163 +$ +377,661 +Total assets +$ +625,527 +$ +533,776 +$ +457,523 +$ +496,032 +$ +410,613 +Long-term debt, less current portion +$ +225,521 +$ +188,813 +$ +192,351 +$ +214,885 +$ +248,269 +Stockholders’ equity +$ +281,363 +$ +228,048 +$ +198,312 +$ +133,261 +$ +140,960 +We follow the full-cost method of accounting for oil and gas properties. Under this method of +accounting, our net capitalized costs to acquire, explore and develop oil and gas properties may +not exceed the sum of (1) the estimated future net revenues from proved reserves at current prices +discounted at 10% and (2) the lower of cost or market of unevaluated properties, net of tax (the +full-cost ceiling amount). If these capitalized costs exceed the full-cost ceiling amount, the +excess is charged to expense. +27 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +The following discussion is intended to assist in an understanding of our financial condition and +results of operations. Our Consolidated Financial Statements and Notes thereto contain detailed +information that should be referred to in conjunction with the following discussion. See Item 8 +“Financial Statements and Supplementary Data.” +General +We have been engaged in the exploration, development, acquisition and production of oil and gas +properties since 1950. Our revenues, profitability and future growth and the carrying value of our +oil and gas properties are substantially dependent on prevailing prices of oil and gas and our +ability to find, develop and acquire additional oil and gas reserves that are economically +recoverable. Our ability to maintain or increase our borrowing capacity and to obtain additional +capital on attractive terms is also influenced by oil and gas prices. +Significant events relating to our financial and operating results for the year ended December 31, +2006 included the closing of our four-year amended and restated senior secured credit facility +which was underwritten by Union Bank of California, N.A. The credit facility has an initial +borrowing base of $75 million, which will be reviewed and redetermined semi-annually and can be +increased to a maximum of $175 million. We expect planned 2007 capital expenditures of +approximately $125 million will be funded with cash flows from operations and supplemented, if +necessary, with our senior secured credit facility, which had $40 million available at December 31, +2006. For a more detailed discussion of outstanding debt see Note 7 to our Consolidated Financial +Statements. +Our estimated net proved oil and gas reserves decreased at December 31, 2006 to 145.6 Bcfe. This +represents a decrease of 23% from previous year-end 2005 estimated proved reserves of 188.6 Bcfe. +Prices for oil and gas are subject to large fluctuations in response to relatively minor changes in +the supply of and demand for oil and gas, market uncertainty and a variety of additional factors +beyond our control. These factors include weather conditions in the United States, the condition +of the United States economy, the actions of the Organization of Petroleum Exporting Countries, +governmental regulation, political stability in the Middle East and elsewhere, the foreign supply +of crude oil and natural gas, the price of foreign imports and the availability of alternate fuel +sources. Any substantial and extended decline in the price of crude oil or natural gas would have +an adverse effect on our carrying value of the proved reserves, borrowing capacity, revenues, +profitability and cash flows from operations. We use derivative financial instruments (see Note 8 +to our Consolidated Financial Statements and Item 7A. “Quantitative and Qualitative Disclosures +About Market Risks”) for price protection purposes on a limited amount of our future production and +do not use these instruments for trading purposes. On a Mcfe basis, natural gas represents +approximately 73% of budgeted 2007 production and 45% of proved reserves at year-end 2006. +Inflation has not had a material impact on us and is not expected to have a material impact on us +in the future. +Summary of Significant Accounting Policies +Property and Equipment. We follow the full-cost method of accounting for oil and gas properties +whereby all costs incurred in connection with the acquisition, exploration and development of oil +and gas reserves, including certain overhead costs, are capitalized into the “full-cost pool.” The +amounts we capitalize into the full-cost pool are depleted (charged against earnings) using the +unit-of-production method. The full-cost +28 +Table of Contents +method of accounting for our proved oil and gas +properties requires that we make estimates based on assumptions as to future events that could +change. These estimates are described below. +Depreciation, Depletion and Amortization (DD&A) of Oil and Gas Properties . We calculate depletion +by using the net capitalized costs in our full-cost pool plus future development costs (combined, +the depletable base) and our estimated net proved reserve quantities. Capitalized costs added to +the full-cost pool include the following: +• +the cost of drilling and equipping productive wells, dry hole costs, acquisition costs +of properties with proved reserves, delay rentals and other costs related to exploration +and development of our oil and gas properties; +• +our payroll and general and administrative costs and costs related to fringe benefits +paid to employees directly engaged in the acquisition, exploration and/or development of +oil and gas properties as well as other directly identifiable general and administrative +costs associated with such activities. Such capitalized costs do not include any costs +related to our production of oil and gas or our general corporate overhead; +• +costs associated with properties that do not have proved reserves classified as +unevaluated property costs and are excluded from the depletable base. These unevaluated +property costs are added to the depletable base at such time as wells are completed on the +properties, the properties are sold or we determine these costs have been impaired. Our +determination that a property has or has not been impaired (which is discussed below) +requires that we make assumptions about future events; +• +estimated costs to dismantle, abandon and restore properties that are capitalized to the +full-cost pool when the related liabilities are incurred under SFAS 143; and +• +our estimates of future costs to develop proved properties are added to the full-cost +pool for purposes of the DD&A computation. We use assumptions based on the latest +geologic, engineering, regulatory and cost data available to us to estimate these amounts. +However, the estimates we make are subjective and may change over time. Our estimates of +future development costs are periodically updated as additional information becomes +available. +Capitalized costs included in the full-cost pool are depleted and charged against earnings using +the unit-of-production method. Under this method, we estimate the proved reserves quantities at +the beginning of each accounting period. For each barrel of Mcfe produced during the period, we +record a depletion charge equal to the amount included in the depletable base (net of accumulated +depreciation, depletion and amortization) divided by our estimated net proved reserve quantities. +Because we use estimates and assumptions to calculate proved reserves (as discussed below) and the +amounts included in the full-cost pool, our depletion rates may change if the estimates and +assumptions are not realized. Such changes may be material. +Ceiling Test . Under the full-cost accounting rules of the SEC, we review the carrying value of our +proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and +gas properties, net of +accumulated depreciation, depletion and amortization and deferred income taxes, may not exceed the +present value of estimated future net cash flows from proved oil and gas reserves, discounted at +10%, plus the lower of cost or fair value of unevaluated properties, net of related tax effects +(the full-cost ceiling amount). These rules generally require pricing future oil and gas +production at the unescalated market price for oil and gas at the end of each fiscal quarter and +require a write-down if the “ceiling” is exceeded. However, if prices recover sufficiently +subsequent to the balance sheet date before the release of the financial statements then use of the +subsequent pricing is allowed and no write-down would be required if same pricing was used. Given +the volatility of oil and gas prices, it is reasonably possible that our estimate of discounted +future net cash flows from proved oil and gas reserves could change in the near term. If oil and +gas prices decline significantly, +29 +Table of Contents +even if only for a short period of time, it is possible that +write-downs of oil and gas properties could occur in the future. +Estimating Reserves and Present Values . The estimates of quantities of proved oil and gas reserves +and the discounted present value of estimated future net cash flows from such reserves at the end +of each quarter are based on numerous assumptions, which are likely to change over time. These +assumptions include: +• +the prices at which we can sell our oil and gas production in the future. Oil and gas +prices are volatile, but we are required to assume that they will not change from the +prices in effect at the end of the quarter. In general, higher oil and gas prices will +increase quantities of proved reserves and the present value of estimated future net cash +flows from such reserves, while lower prices will decrease these amounts. Because our +properties have relatively short productive lives, changes in prices will affect the +present value of estimated future net cash flows more than the estimated quantities of oil +and gas reserves; +• +the costs to develop and produce our reserves and the costs to dismantle our production +facilities when reserves are depleted. These costs are likely to change over time, but we +are required to assume that costs in effect at the end of the quarter will not change. +Increases in costs will reduce estimated oil and gas quantities and the present value of +estimated future net cash flows, while decreases in costs will increase such amounts. +Because our properties have relatively short productive lives, changes in costs will affect +the present value of estimated future net cash flows more than the estimated quantities of +oil and gas reserves; and +• +the potential royalties payable to the Mineral Management Service. See Note 9 of our +Consolidated Financial Statements for a more detailed discussion of this potential +liability. +In addition, the process of estimating proved oil and gas reserves requires that our independent +and internal reserve engineers exercise judgment based on available geological, geophysical and +technical information. We have described the risks associated with reserve estimation and the +volatility of oil and gas prices under “Risk Factors”. +Unproved Properties . Costs associated with properties that do not have proved reserves, including +capitalized interest, are excluded from the depletable base. These unproved properties are +included in the line item “Unevaluated properties excluded from amortization.” Unproved property +costs are transferred to the depletable base when wells are completed on the properties or the +properties are sold. In addition, we are required to determine whether our unproved properties are +impaired and, if so, include the costs of such properties in the depletable base. We determine +whether an unproved property should be impaired by periodically reviewing our exploration program +on a property by property basis. This determination may require the exercise of substantial +judgment by our management. +Asset Retirement Obligations. We account for asset retirement obligations in accordance with +Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” +(“SFAS 143”), which +essentially requires entities to record the fair value of a liability for obligations associated +with the retirement of tangible long-lived assets and the associated asset retirement costs. +Interest is accreted on the present value of the asset retirement obligation and reported as +accretion expense within operating expenses in the Consolidated Statements of Operations. See Note +10 to our Consolidated Financial Statements. +Derivatives. We periodically use derivative financial instruments to manage oil and gas price risk +on a limited amount of our future production and do not use these instruments for trading purposes. +Settlement of derivative contracts are generally based on the difference between the contract +price or prices specified in the derivative instrument and a NYMEX price or other cash or futures +index price. Such derivatives are +30 +Table of Contents +accounted for under Statement of Financial Accounting Standards +No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) as amended. +Our derivative contracts that are accounted for as cash flow hedges under SFAS 133 are recorded at +fair market value and the changes in fair value are recorded through other comprehensive income +(loss), net of tax, in stockholders’ equity. The cash settlements on these contracts are recorded +as an increase or decrease in oil and gas sales. The changes in fair value related to ineffective +derivative contracts are recognized as derivative expense (income). The cash settlement on these +contracts is also recorded within derivative expense (income). The changes in fair value of the +our derivative contracts that are not designated as effective cash flow hedges are recorded through +the statement of operations as derivative expense (income). See Note 8 to our Consolidated +Financial Statements. +Income Taxes. We follow the asset and liability method of accounting for deferred income taxes +prescribed by Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes” +(“SFAS 109”). SFAS 109 provides for the recognition of a deferred tax asset for deductible +temporary timing differences, capital and operating loss carryforwards, statutory depletion +carryforward and tax credit carryforwards, net of a “valuation allowance”. The valuation allowance +is provided for that portion of the asset, for which it is deemed more likely than not, that it +will not be realized. +Share-Based Compensation. Effective January 1, 2006, we adopted Statement of Financial Accounting +Standard No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”) utilizing the modified +prospective transition method. Prior to the adoption of SFAS 123R, we accounted for stock option +grants in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued +to Employees” (the intrinsic value method) and, accordingly, recognized no compensation expense for +stock option grants. +Under the modified prospective transition method, SFAS 123R applies to new awards, unvested awards +as of January 1, 2006 and awards that were outstanding on January 1, 2006 that are subsequently +modified, repurchased or cancelled. Under the modified prospective transition method, compensation +cost recognized in 2006 includes compensation cost for all share-based payments granted prior to, +but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in +accordance with the original provisions of Statement of Financial Accounting Standard No. 123 +“Accounting for Stock-Based Compensation,” (“SFAS 123”) and compensation cost for all share-based +payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in +accordance with the provisions of SFAS 123R. Prior periods were not restated to reflect the impact +of adopting the new standard. +SFAS 123R requires the cash flows from tax benefits resulting from tax deductions in excess of +compensation cost recognized for stock options exercised (excess tax benefits) to be classified as +financing cash flows. The $1.4 million of excess tax benefits classified as a financing cash +inflow for the year ended December 31, 2006 +would have been classified as an operating cash flow had we not adopted SFAS 123R. There were no +cash proceeds from the exercise of stock options for the year ended December 31, 2006 due to the +fact that all options were exercised through net-share settlements. As a result of most of our +stock-based compensation being in the form of restricted stock, the impact of the adoption of SFAS +123R on income before taxes, net income and basic and diluted earnings per share for the year ended +December 31, 2006 was immaterial. See Note 3 to our Consolidated Financial Statements. +New Accounting Standards +In June 2006, the Financial Accounting Standards Board (“FASB”) released interpretation No. 48, +Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 clarifies the accounting for income +taxes by prescribing the minimum recognition threshold a tax position must meet before being +recognized in the financial statements. FIN 48 also provides guidance on derecognition, +measurement, classification, interest +31 +Table of Contents +and penalties, accounting in interim periods, disclosure and +transition. The effective date for FIN 48 is fiscal years beginning after December 15, 2006. We +are currently reviewing the provisions of FIN 48 and have not yet determined the impact of +adoption. +In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, Fair Value +Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair +value and requires enhanced disclosures about fair value measurements. SFAS 157 is effective for +fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We +are still reviewing the provisions of SFAS 157 and have not yet determined the impact of adoption. +Liquidity and Capital Resources +Historically, our primary sources of capital have been cash flows from operations, borrowings from +financial institutions and the sale of debt and equity securities. Net cash and cash equivalents +decreased by $669,000 during 2006 to $1.9 million. Cash provided from operating activities during +2006 totaled $135.5 million, an increase of 83% from $74.0 million in 2005. +On August 30, 2006, we closed on a four-year amended and restated senior secured credit facility +underwritten by Union Bank of California, N.A. The credit facility includes an initial borrowing +base of $75 million, which will be reviewed and redetermined semi-annually and can be increased to +a maximum of $175 million. During 2006 we drew $35 million under our facility which was +outstanding as of December 31, 2006 and $40 million was +available for future borrowings. In connection with the anticipated +financing of the acquisition of BP’s interest in the Entrada +Field, the borrowing base under this facility would be reduced to +$50 million at closing until the next borrowing base +redetermination date. Please refer to “Subsequent Events” +below for more discussion on the Entrada acquisition. +In December 2003 and March 2004, we closed on our 9.75% senior notes due 2010 in the aggregate +principal amount of $200 million. The net proceeds from these notes and the public offering of +3,450,000 shares of common stock in the second quarter of 2004 were used to restructure our debt +that was maturing in 2004 and 2005. See Note 7 to the Consolidated Financial Statements for a more +detail discussion of long-term debt. +The indenture governing our 9.75% senior notes due 2010 and our senior secured credit facility +contain various covenants including restrictions on additional indebtedness and payment of cash +dividends. In addition, our senior secured credit facility contains covenants for maintenance of +certain financial ratios. We were in compliance with these covenants at December 31, 2006. +Our oil and gas reserves as estimated by Huddleston & Co., Inc. were 145.6 Bcfe of natural gas +equivalents on December 31, 2006. Our cash flow from operations during 2006 was generated by the +production of 20.8 Bcfe. +Production of our reserves during 2007, without weather-related downtime, is projected to be +higher than 2006 due to new discoveries that are projected to commence initial production during +the year, which is expected to offset anticipated declines from our current producing properties. +In +addition to the acquisition of BP’s interest in the Entrada +field, our planned capital expenditures for 2007 total $125 million and include capitalized interest and +general and administrative expenses. The current portion of our asset retirement obligation will +require an additional $10 million resulting in total capital expenditures of $135 million for 2007. +Capital expenditure plans for 2007 include: +• +the discretionary drilling of up to 17 exploratory and development wells; +• +lease and seismic acquisition; and +• +capitalized interest and overhead. +32 +Table of Contents +We believe that our operating cash flow and our credit facility will be adequate to meet our +capital, debt repayment, and operating requirements for 2007. We fund our day-to-day operating +expenses and capital expenditures from operating cash flows, supplemented as needed by borrowings +under our credit facility. In addition, we have sold debt and equity in both public and private +offerings in the past, and we expect that these sources of capital will continue to be available to +us in the future. Because of the liquidity and capital resources alternatives available to us, +including internally generated cash flows, our management believes that our short-term and +long-term liquidity is adequate to fund operations, including our capital spending program and +repayment of maturing debt. +Our cash flow, both in the short and long-term, is impacted by highly volatile oil and natural gas +prices, production levels, industry trends impacting operating expenses and our ability to continue +to acquire or find reserves at competitive prices. Cash flow forecasts for internal use by +management are revised monthly in response to changing market conditions and production +projections. We may adjust capital expenditure budgets within the planned total amount in response +to the adjusted cash flow forecasts and market trends in drilling and acquisitions costs. +The following table describes our outstanding contractual obligations as of December 31, 2006 (in +thousands): +Payments due by Period +More +Contractual +Less Than +One-Three +Three-Five +Than-Five +Obligations +Total +One Year +Years +Years +Years +Senior Secured Credit Facility +$ +35,000 +$ +— +$ +— +$ +35,000 +$ +— +9.75% Senior Notes +200,000 +— +— +200,000 +— +Capital lease (future minimum payments) +1,270 +348 +457 +446 +19 +Throughput Commitments: +Medusa Spar LLC +8,848 +3,152 +5,696 +— +— +Medusa Oil Pipeline +400 +105 +132 +101 +62 +$ +245,518 +$ +3,605 +$ +6,285 +$ +235,547 +$ +81 +Subsequent +Events +Subsequent +to December 31, 2006, on March 8, 2007, we entered into an agreement with BP to purchase BP’s 80% working interest in the Entrada Field for total cash +consideration of $190 million. The purchase price includes $150 million payable at closing and an +additional $40 million payable after the achievement of certain production milestones. The +purchased interests include five federal offshore blocks at Garden Banks Blocks 738, 782, 785, 826 +and 827, subject to certain depth limitations. Upon the completion of the acquisition, we will own a 100% working interest in the Entrada Field and will become operator. +The acquisition is expected to close within the next 45 days and will add 150 Bcfe to our proved +undeveloped reserves. +To finance +the initial $150 million payment of the purchase price, a commitment has been received from Merrill +Lynch Capital Corporation to make available to us a 7-year, $200 million revolving credit facility +secured by a lien on the Entrada properties. We plan to borrow the full commitment amount at closing +to cover the required $150 million payment to BP and, expenses +and fees, and the balance of the funds can be used for +Entrada development cost or general corporate purposes. +Off-Balance Sheet Arrangements +We have a 10% ownership interest in Medusa Spar LLC (“LLC”), which is a limited liability company +that owns a 75% undivided ownership interest in the deepwater spar production facilities on our +Medusa +33 +Table of Contents +Field in the Gulf of Mexico. We contributed a 15% undivided ownership interest in the +production facility to the LLC in return for approximately $25 million in cash and a 10% ownership +interest in the LLC. The LLC earns a tariff based upon production volume throughput from the Medusa +area. We are obligated to process our share of production from the Medusa Field and any future +discoveries in the area through the spar production facilities. This arrangement allows us to defer +the cost of the spar production facility over the life of the Medusa Field. Our cash proceeds were +used to reduce the balance outstanding under our senior secured credit facility. The LLC used the +cash proceeds from $83.7 million of non-recourse financing and a cash contribution by one of the +LLC owners to acquire its 75% interest in the spar. On December 31, 2006, $33.2 million of the +financing was outstanding. The balance of Medusa Spar LLC is owned by Oceaneering International, +Inc. and Murphy. We are accounting for its 10% ownership interest in the LLC under the equity +method. +Results of Operations +The following table sets forth certain operating information with respect to our oil and gas +operations for each of the three years in the period ended December 31, 2006. +December 31, +2006 +2005 +2004 +Production: +Oil (MBbls) +1,634 +1,837 +1,736 +Gas (MMcf) +10,977 +7,768 +11,387 +Total production (MMcfe) +20,780 +18,787 +21,801 +Average daily production (MMcfe) +56.9 +51.5 +59.6 +Average sales price: +Oil (per Bbl) (a) +$ +57.33 +$ +41.61 +$ +28.71 +Gas (per Mcf) +$ +8.07 +$ +8.35 +$ +6.15 +Total (per Mcfe) +$ +8.77 +$ +7.52 +$ +5.50 +Oil and gas revenues (in thousands): +Oil revenue +$ +93,665 +$ +76,425 +$ +49,826 +Gas revenue +88,603 +64,865 +69,976 +Total +$ +182,268 +$ +141,290 +$ +119,802 +Lease operating expenses (in thousands) +$ +28,881 +$ +24,377 +$ +22,308 +Additional per Mcfe data: +Sales price +$ +8.77 +$ +7.52 +$ +5.50 +Lease operating expenses +1.39 +1.30 +1.02 +Operating margin +$ +7.38 +$ +6.22 +$ +4.48 +Depletion +$ +3.14 +$ +2.39 +$ +2.18 +General and administrative (net of management fees) +$ +.41 +$ +.43 +$ +.40 +(a) Below is a reconciliation of the average NYMEX +price to the average realized sales price per +barrel of oil: +Average NYMEX oil price +$ +66.22 +$ +56.57 +$ +41.38 +Basis differential and quality adjustments +(7.03 +) +(8.45 +) +(4.60 +) +Transportation +(1.25 +) +(1.26 +) +(1.27 +) +Hedging +(0.61 +) +(5.25 +) +(6.80 +) +Average realized oil price +$ +57.33 +$ +41.61 +$ +28.71 +34 +Table of Contents +Comparison of Results of Operations for the Years Ended December 31, 2006 and 2005 +Oil and Gas Revenues +Total oil and gas revenues increased 29% from $141.3 million in 2005 to $182.3 million in 2006 +primarily due to higher gas production and oil pricing. Total production for 2006 increased by 11% +versus 2005, which was impacted by downtime for inclement weather. +Gas production during 2006 totaled 11.0 Bcf and generated $88.6 million in revenues compared to 7.8 +Bcf and $64.9 million in revenues during the same period in 2005. Average gas prices realized for +2006 were $8.07 per Mcf compared to $8.35 per Mcf during the same period in 2005. The increase in +production was primarily due to production from our new wells at East Cameron Block 90, North Padre +Island Block 913, High Island Block 73, Brazos Block 405, West Cameron Block 295, High Island 165 +and West Cameron 3/LA and 2005 production being negatively impacted by inclement weather. The +increase in production from new properties was partially offset by normal and expected declines in +production from our Habanero, High Island Block 119 and Mobile Bay area fields and older +properties. +Oil production during 2006 totaled 1,634,000 barrels and generated $93.7 million in revenues +compared to 1,837,000 barrels and $76.4 million in revenues for the same period in 2005. Average +oil prices realized in 2006 were $57.33 per barrel compared to $41.61 per barrel in 2005. Oil +production decreased during 2006 primarily due to a normal and expected decline at Habanero. See +the Results of Operations table for a reconciliation of the realized oil prices to average NYMEX. +Lease Operating Expenses +Lease operating expenses for 2006 increased by 18% to $28.9 million compared to $24.4 million for +the same period in 2005. The increase was primarily due to new wells coming on line, higher costs +for fuel and marine transportation and an increase in insurance rates for our policies which were +renewed on April 1, 2006. In addition, we incurred approximately $1.5 million for pipeline repairs +at our South Marsh Island Block 261 field and had downhole repairs at our Medusa field. +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization for 2006 and 2005 was $65.3 million and $44.9 million, +respectively. The 45% increase was due to higher production volumes and a higher average depletion +rate for 2006 compared to 2005. The higher rate is primarily attributable to an increase in +finding costs, estimated costs of future development and capitalized asset retirement costs. +Accretion Expense +Accretion expense for 2006 and 2005 of $5.0 million and $3.5 million, respectively, represents +accretion of our asset retirement obligations. The increase was due to the addition of plugging +and abandonment obligations associated with new discoveries and an increase in plugging and +abandonment cost estimates. See Note 10 to the Consolidated Financial Statements. +General and Administrative +General and administrative expenses for 2006, net of amounts capitalized, were $8.6 million +compared to $8.1 million in 2005. The $500,000 (6%) increase in +general and administrative expenses was due +to increased overall cost. We recognized non-cash charges of approximately $1.1 million in the +third quarter of 2006 for the vesting of 20% of restricted shares granted in August 2006. General +and administrative expenses for 2005 included non-cash charges of +$930,000 recognized in the +second quarter of 2005 for the accelerated vesting of performance shares pursuant to the terms of +the plan due to deaths or disability for an executive officer and two directors of the Company. See +Note 3 for more details. +Interest Expense +Interest expense was relatively consistent in 2006 in the amount of $16.5 million compared to $16.7 +million in 2005. +Income Taxes +For 2006, we had income tax expense of $20.7 million compared to $13.2 million in 2005. The 57% +increase was due to an increase in income before income taxes. +35 +Table of Contents +Comparison of Results of Operations for the Years Ended December 31, 2005 and 2004 +Oil and Gas Revenues +Total oil and gas revenues increased 18% from $119.8 million in 2004 to $141.3 million in 2005 +primarily due to increased pricing. Total production for 2005 decreased by 14% as compared to 2004 +as a result of downtime associated with the tropical storm and hurricane activity in 2005. +Gas production during 2005 totaled 7.8 Bcf and generated $64.9 million in revenues compared to 11.4 +Bcf and $70.0 million in revenues during the same period in 2004. Average gas prices realized for +2005 were $8.35 per Mcf compared to $6.15 per Mcf during the same period last year. The decrease +in production was primarily due to significant downtime related to tropical storm and hurricane +activity and the normal and expected decline in production from our Mobile area fields and older +properties. +Oil production during 2005 totaled 1,837,000 barrels and generated $76.4 million in revenues +compared to 1,736,000 barrels and $49.8 million in revenues for the same period in 2004. Average +oil prices realized in 2005 were $41.61 per barrel compared to $28.71 per barrel in 2004. Oil +production increased during 2005 despite significant downtime resulting from tropical storms and +hurricanes. The increase was primarily attributable to our deepwater property Medusa which began +production in 2003 from a single well with five others being brought online during 2004 and all six +producing during 2005. In addition, our North Medusa discovery was completed and initial +production commenced through the field facilities in April 2005. See the Results of Operations +table for a reconciliation of the realized oil prices to average NYMEX. +Lease Operating Expenses +Lease operating expenses for 2005 increased by 9% to $24.4 million compared to $22.3 million for +the same period in 2004. The increase was primarily due to lease operating expenses related to our +deepwater discovery Medusa, which had higher throughput charges as a result of higher production +rates and the addition of our High Island Block 119 field, which began producing late in the third +quarter of 2004. +In addition, lease operating expenses for 2005 included the cost of repairs to our properties for +damages caused by tropical storms and hurricanes in the net amount of $1.2 million. This amount +includes the deductibles and an estimate of repairs not expected to be reimbursed by our property +insurance carrier. +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization for 2005 and 2004 were $44.9 million and $47.5 million, +respectively. The 5% decrease was primarily due to lower production volumes for 2005 compared to +2004. The decrease was partially offset by a higher average depletion rate. +Accretion Expense +Accretion expense for 2005 and 2004 of $3.5 million and $3.4 million, respectively, represents +accretion of our asset retirement obligations. See Note 10 to the Consolidated Financial +Statements. +General and Administrative +General and administrative expenses for 2005, net of amounts capitalized, were $8.1 million +compared to $8.8 million in 2004. Expenses for 2004 included a $2.6 million charge that was +incurred in the first quarter of 2004 for the early retirement of two executive officers of the +Company. Expenses for 2005 included a $930,000 non-cash charge for the accelerated vesting of +performance shares pursuant to the terms of the plan due to death or disability for an executive +officer and two directors of the Company. Expenses for 2005 also increased due to a reduction in +the amount of overhead which was capitalized. +Interest Expense +Interest expense decreased by 17% in 2005 to $16.7 million compared to $20.1 million in 2004. This +decrease is primarily attributable to an equity offering completed in the second quarter of 2004 in +which a portion of the proceeds were used to redeem $33 million of 11% Senior Subordinated Notes. +Loss on Early Extinguishment of Debt +A loss on early extinguishment of debt of $3.0 million was recognized in 2004 for the write-off of +deferred financing costs and bond discounts as well as pre-payment premiums associated with the +early extinguishment of debt. +Income Taxes +For 2005, we had an income tax expense of $13.2 million compared to an income tax benefit of $6.7 +million in 2004. The income tax benefit for 2004 resulted primarily from the reversal of the +valuation allowance established in 2003 against our deferred tax asset. As a result of production +from the Company’s first two deepwater projects starting in November 2003, as well as refinancing +our highest cost debt in 2004, we achieved profitable +operations and had income on an aggregate basis for the three-year period ended December 31, 2004. +As a result, we reversed the valuation allowance as of December 31, 2004. See Note 5 to our +Consolidated Financial Statements for a more detailed discussion. +36 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS +The Company’s revenues are derived from the sale of its crude oil and natural gas production. The +prices for oil and gas remain extremely volatile and sometimes experience large fluctuations as a +result of relatively small changes in supply, weather conditions, economic conditions and +government actions. From time to time, the Company enters into derivative financial instruments to +manage oil and gas price risk. +The Company may utilize fixed price “swaps”, which reduce the Company’s exposure to decreases in +commodity prices and limit the benefit the Company might otherwise have received from any increases +in commodity prices. +The Company may utilize price “collars” to reduce the risk of changes in oil and gas prices. Under +these arrangements, no payments are due by either party as long as the market price is above the +floor price and below the ceiling price set in the collar. If the price falls below the floor, the +counter-party to the collar pays the difference to the Company, and if the price rises above the +ceiling, the counter-party receives the difference from the Company. +Callon may purchase “puts” which reduce the Company’s exposure to decreases in oil and gas prices +while allowing realization of the full benefit from any increases in oil and gas prices. If the +price falls below the floor, the counter-party pays the difference to the Company. +The Company enters into these various agreements from time to time to reduce the effects of +volatile oil and gas prices and does not enter into derivative transactions for speculative +purposes. However, certain of the Company’s derivative positions may not be designated as hedges +for accounting purposes. See Note 8 to the +Consolidated Financial Statements for a description of the Company’s hedged position at December +31, 2006. There have been no significant changes in market risks faced by the Company since the +end of 2005. +Based on projected annual sales volumes for 2007 (excluding incremental production from 2007 +exploratory drilling), a 10% decline in the prices Callon receives for its crude oil and natural +gas production would have an approximate $12 million impact on our revenues. +37 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +Report of Independent Registered Public Accounting Firm +39 +Consolidated +Balance Sheets as of December 31, 2006 and 2005 +40 +Consolidated Statements of Operations for Each of the Three Years +in the Period Ended December 31, 2006 +41 +Consolidated Statements of Stockholders’ Equity +for Each of the Three Years in the Period Ended December 31, 2006 +42 +Consolidated Statements of Cash Flows for Each of the Three Years +in the Period Ended December 31, 2006 +43 +Notes to Consolidated Financial Statements +44 +38 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Stockholders and Board of Directors +Callon Petroleum Company +We have audited the accompanying consolidated balance sheets of Callon Petroleum Company as of +December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ +equity and cash flows for each of the three years in the period ended December 31, 2006. These +financial statements are the responsibility of the Company’s management. Our responsibility is to +express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting +Oversight Board (United States). Those standards require that we plan and perform the audit to +obtain reasonable assurance about whether the financial statements are free of material +misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and +disclosures in the financial statements. An audit also includes assessing the accounting +principles used and significant estimates made by management, as well as evaluating the overall +financial statement presentation. We believe that our audits provide a reasonable basis for our +opinion. +In our opinion, the financial statements referred to above present fairly, in all material +respects, the consolidated financial position of Callon Petroleum Company as of December 31, 2006 +and 2005, and the results of its operations and its cash flows for each of the three years in the +period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. +As discussed in Note 2 to the financial statements, in 2006 the Company changed its method of +accounting for stock-based compensation. +We also have audited, in accordance with the standards of the Public Company Accounting +Oversight Board (United States), the effectiveness of Callon Petroleum Company’s internal control +over financial reporting as of December 31, 2006, based on criteria established in Internal +Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission and our report dated March 15, 2007, expressed an unqualified opinion thereon. +/s/ +Ernst & Young LLP +New Orleans, Louisiana +March 15, 2007 +39 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(In thousands, except share data) +December 31, +2006 +2005 +ASSETS +Current assets: +Cash and cash equivalents +$ +1,896 +$ +2,565 +Accounts receivable +32,166 +33,195 +Deferred tax asset +— +26,770 +Restricted investments +4,306 +4,110 +Fair market value of derivatives +13,311 +889 +Other current assets +5,973 +1,998 +Total current assets +57,652 +69,527 +Oil and gas properties, full-cost accounting method: +Evaluated properties +1,096,907 +937,698 +Less accumulated depreciation, depletion and amortization +(604,682 +) +(539,399 +) +492,225 +398,299 +Unevaluated properties excluded from amortization +54,802 +49,065 +Total oil and gas properties +547,027 +447,364 +Other property and equipment, net +1,996 +1,605 +Long-term gas balancing receivable +714 +403 +Restricted investments +1,935 +1,858 +Investment in Medusa Spar LLC +12,580 +11,389 +Other assets, net +3,623 +1,630 +Total assets +$ +625,527 +$ +533,776 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable and accrued liabilities +$ +43,086 +$ +39,323 +Fair market value of derivatives +— +1,247 +Undistributed oil and gas revenues +3,525 +721 +Asset retirement obligations +14,355 +21,660 +Current maturities of long-term debt +213 +263 +Total current liabilities +61,179 +63,214 +Long-term debt +225,521 +188,813 +Asset retirement obligations +26,824 +16,613 +Deferred tax liability +30,054 +31,633 +Accrued liabilities to be refinanced +— +5,000 +Other long-term liabilities +586 +455 +Total liabilities +344,164 +305,728 +Stockholders’ equity: +Preferred Stock, $.01 par value; 2,500,000 shares authorized; +— +— +Common Stock, $.01 par value; 30,000,000 shares +authorized; 20,747,773 shares and 19,357,138 shares issued and +outstanding at December 31, 2006 and 2005, respectively +207 +194 +Unearned compensation-restricted stock +— +(3,334 +) +Capital in excess of par value +220,785 +220,360 +Other comprehensive income (loss) +8,652 +(331 +) +Retained earnings +51,719 +11,159 +Total stockholders’ equity +281,363 +228,048 +Total liabilities and stockholders’ equity +$ +625,527 +$ +533,776 +The accompanying notes are an integral part of these financial statements. +40 +Table of Contents +Callon Petroleum Company +Consolidated Statements of Operations +For the Years Ended December 31, 2006, 2005 and 2004 +(In thousands, except per share amounts) +2006 +2005 +2004 +Operating revenues: +Oil sales +$ +93,665 +$ +76,425 +$ +49,826 +Gas sales +88,603 +64,865 +69,976 +Total operating revenues +182,268 +141,290 +119,802 +Operating expenses: +Lease operating expenses +28,881 +24,377 +22,308 +Depreciation, depletion and amortization +65,283 +44,946 +47,453 +General and administrative +8,591 +8,085 +8,758 +Accretion expense +4,960 +3,549 +3,400 +Derivative expense +150 +6,028 +1,371 +Total operating expenses +107,865 +86,985 +83,290 +Income from operations +74,403 +54,305 +36,512 +Other (income) expenses: +Interest expense +16,480 +16,660 +20,137 +Other (income) +(1,869 +) +(998 +) +(357 +) +Loss on early extinguishment of debt +— +— +3,004 +Total other (income) expenses +14,611 +15,662 +22,784 +Income before income taxes +59,792 +38,643 +13,728 +Income tax expense (benefit) +20,707 +13,209 +(6,697 +) +Income before equity in earnings of Medusa Spar LLC +39,085 +25,434 +20,425 +Equity in earnings of Medusa Spar LLC, net of tax +1,475 +1,342 +1,076 +Net income +40,560 +26,776 +21,501 +Preferred stock dividends +— +318 +1,272 +Net income available to common shares +$ +40,560 +$ +26,458 +$ +20,229 +Net income per common share: +Basic +$ +2.00 +$ +1.43 +$ +1.28 +Diluted +$ +1.90 +$ +1.28 +$ +1.22 +Shares used in computing net income per share amounts: +Basic +20,270 +18,453 +15,796 +Diluted +21,363 +20,883 +17,678 +The accompanying notes are an integral part of these financial statements. +41 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(In thousands) +Unearned +Accumulated +Total +Restricted +Capital in +Other +Retained +Stock- +Preferred +Common +Stock +Excess of +Comprehensive +Earnings +holders’ +Stock +Stock +Compensation +Par Value +Income (Loss) +(Deficit) +Equity +Balances, December 31, 2003 +$ +6 +$ +139 +$ +(372 +) +$ +169,036 +$ +(20 +) +$ +(35,528 +) +$ +133,261 +Comprehensive income (loss): +Net income +— +— +— +— +— +21,501 +Other comprehensive (loss) +— +— +— +— +(1,863 +) +— +Total comprehensive income +19,638 +Preferred stock dividend +— +— +— +— +— +(1,272 +) +(1,272 +) +Sale of common stock +— +35 +— +44,012 +— +— +44,047 +Shares issued pursuant to employee +benefit and option plan +— +1 +— +720 +— +— +721 +Employee stock purchase plan +— +1 +— +208 +— +— +209 +Tax benefits related to stock +compensation plans +— +— +— +1,214 +— +— +1,214 +Restricted stock +— +— +(4,980 +) +5,474 +— +— +494 +Balances, December 31, 2004 +6 +176 +(5,352 +) +220,664 +(1,883 +) +(15,299 +) +198,312 +Comprehensive income: +Net income +— +— +— +— +— +26,776 +Other comprehensive income +— +— +— +— +1,552 +— +Total comprehensive income +28,328 +Preferred stock dividend +— +— +— +— +— +(318 +) +(318 +) +Conversion of preferred shares +to common stock +(6 +) +13 +— +(643 +) +— +— +(636 +) +Shares issued pursuant to employee +benefit and option plan +— +1 +— +(325 +) +— +— +(324 +) +Employee stock purchase plan +— +— +— +(33 +) +— +— +(33 +) +Tax benefits related to stock +compensation plans +— +— +— +1,029 +— +— +1,029 +Restricted stock +— +2 +2,018 +(330 +) +— +— +1,690 +Warrants +— +2 +— +(2 +) +— +— +— +Balances, December 31, 2005 +— +194 +(3,334 +) +220,360 +(331 +) +11,159 +228,048 +Comprehensive income: +Net income +— +— +— +— +— +40,560 +Other comprehensive income +— +— +— +— +8,983 +— +Total comprehensive income +49,543 +Shares issued pursuant to employee +benefit and option plan +— +2 +— +(441 +) +— +— +(439 +) +Tax benefits related to stock +compensation plans +— +— +— +1,356 +— +— +1,356 +Adoption of 123R +3,334 +(3,334 +) +— +— +— +Restricted stock +— +1 +— +2,854 +— +— +2,855 +Warrants +— +10 +— +(10 +) +— +— +— +Balances, December 31, 2006 +$ +— +$ +207 +$ +— +$ +220,785 +$ +8,652 +$ +51,719 +$ +281,363 +The accompanying notes are an integral part of these financial statements. +42 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2006, 2005 and 2004 +(In thousands) +2006 +2005 +2004 +Cash flows from operating activities: +Net income +$ +40,560 +$ +26,776 +$ +21,501 +Adjustments to reconcile net income to +cash provided by operating activities: +Depreciation, depletion and amortization +65,929 +45,657 +48,164 +Accretion expense +4,960 +3,549 +3,400 +Amortization of deferred financing costs +2,221 +2,062 +1,929 +Non-cash loss on extinguishment of debt +— +— +2,910 +Equity in earnings of Medusa Spar, LLC +(1,475 +) +(1,342 +) +(1,076 +) +Non-cash derivative expense +150 +1,635 +(135 +) +Deferred income tax expense (benefit) +20,707 +13,209 +(6,697 +) +Non-cash charge related to compensation plans +1,420 +1,906 +1,225 +Excess tax benefits from share-based payment arrangements +(1,449 +) +— +— +Changes in current assets and liabilities: +Accounts receivable, trade +(2,107 +) +(11,169 +) +(4,495 +) +Other current assets +(3,975 +) +670 +971 +Current liabilities +11,311 +(8,666 +) +2,903 +Change in gas balancing receivable +(311 +) +322 +376 +Change in gas balancing payable +133 +(289 +) +400 +Change in other long-term liabilities +(2 +) +(18 +) +(20 +) +Change in other assets, net +(2,588 +) +(292 +) +(448 +) +Cash provided by operating activities +135,484 +74,010 +70,908 +Cash flows from investing activities: +Capital expenditures +(167,979 +) +(73,072 +) +(64,649 +) +Distribution from Medusa Spar, LLC +1,078 +463 +339 +Cash used by investing activities +(166,901 +) +(72,609 +) +(64,310 +) +Cash flows from financing activities: +Change in accrued liabilities to be refinanced +(5,000 +) +5,000 +— +Increases in debt +88,000 +7,000 +90,000 +Payments on debt +(53,000 +) +(12,000 +) +(205,915 +) +Restricted cash +— +— +63,345 +Debt issuance cost +— +— +(984 +) +Issuance of common stock +— +2 +44,047 +Buyout of preferred stock +— +(637 +) +— +Equity issued related to employee stock plans +(438 +) +(573 +) +199 +Excess tax benefits from share-based payment arrangements +1,449 +— +— +Capital leases +(263 +) +(576 +) +(1,452 +) +Cash dividends on preferred stock +— +(318 +) +(1,272 +) +Cash +provided (used) by financing activities +30,748 +(2,102 +) +(12,032 +) +Net decrease in cash and cash equivalents +(669 +) +(701 +) +(5,434 +) +Cash and cash equivalents: +Balance, beginning of period +2,565 +3,266 +8,700 +Balance, end of period +$ +1,896 +$ +2,565 +$ +3,266 +The accompanying notes are an integral part of these financial statements. +43 +Table of Contents +CALLON PETROLEUM COMPANY +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +General +Callon Petroleum Company (“the Company” or “Callon”) was organized under the laws of the state of +Delaware in March 1994 to serve as the surviving entity in the consolidation and combination of +several related entities (referred to herein collectively as the “Constituent Entities”). The +combination of the businesses and properties of the Constituent Entities with the Company was +completed on September 16, 1994 (“Consolidation”). +As a result of the Consolidation, all of the businesses and properties of the Constituent Entities +are owned (directly or indirectly) by the Company. Certain registration rights were granted to the +stockholders of certain of the Constituent Entities. See Note 9. +The Company and its predecessors have been engaged in the acquisition, development and exploration +of crude oil and natural gas since 1950. The Company’s properties are geographically concentrated +in Louisiana, Alabama and offshore Gulf of Mexico. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Principles of Consolidation and Reporting +The Consolidated Financial Statements include the accounts of the Company, and its subsidiary, +Callon Petroleum Operating Company (“CPOC”). CPOC also has subsidiaries, namely Callon Offshore +Production, Inc. and Mississippi Marketing, Inc. All intercompany accounts and transactions have +been eliminated. Certain prior year amounts have been reclassified to conform to presentation in +the current year. +Use of Estimates +The preparation of financial statements in conformity with U.S. generally accepted accounting +principles requires management to make estimates and assumptions that affect the reported amounts +of assets and liabilities and disclosure of contingent assets and liabilities at the date of the +financial statements and the reported amounts of revenues and expenses during the reporting period. +Actual results could differ from those estimates. +Asset Retirement Obligations +The Company accounts for asset retirement obligations in accordance with Statement of Financial +Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”), which +essentially requires entities to record the fair value of a liability for obligations associated +with the retirement of tangible long-lived assets and the associated asset retirement costs. +Interest is accreted on the present value of the asset retirement obligation and reported as +accretion expense within operating expenses in the Consolidated Statements of Operations. See Note +10. +44 +Table of Contents +Oil and Gas Properties +The Company follows the full-cost method of accounting for oil and gas properties whereby all costs +incurred in connection with the acquisition, exploration and development of oil and gas reserves, +including certain overhead costs, are capitalized. Such amounts include the cost of drilling and +equipping productive wells, dry hole costs, lease acquisition costs, delay rentals, interest +capitalized on unevaluated leases and other costs related to exploration and development +activities. General and administrative costs capitalized include salaries and related fringe +benefits paid to employees directly engaged in the acquisition, exploration and/or development of +oil and gas properties as well as other directly identifiable general and administrative costs +associated with such activities. Such capitalized costs ($9.6 million in 2006, $7.1 million in 2005 +and $7.2 million in 2004) do not include any costs related to production or general corporate +overhead. Costs associated with unevaluated properties, including capitalized interest on such +costs, are excluded from amortization. Unevaluated property costs are transferred to evaluated +property costs at such time as wells are completed on the properties, the properties are sold or +management determines that these costs have been impaired. +Costs of oil and gas properties, including future development and future site restoration, +dismantlement and abandonment costs, which have proved reserves and properties which have been +determined to be worthless, are depleted using the unit-of-production method based on proved +reserves. If the total capitalized costs of oil and gas properties, net of accumulated +amortization and deferred taxes relating to oil and gas properties, exceed the sum of (1) the +estimated future net revenues from proved reserves at current prices discounted at 10% and (2) the +lower of cost or market of unevaluated properties, net of tax effects (the full-cost ceiling +amount), then such excess is charged to expense during the period in which the excess occurs. See +Note 11. +Upon the acquisition or discovery of oil and gas properties, management estimates the future net +costs to be incurred to dismantle, abandon and restore the property using available geological, +engineering and regulatory data. Such cost estimates are periodically updated for changes in +conditions and requirements. In accordance with SFAS 143, such costs +are capitalized to the full-cost pool when the related liabilities are incurred. In accordance with Staff Accounting +Bulletin No. 106, assets recorded in connection with the recognition of an asset retirement +obligation pursuant to SFAS 143 are included as part of the costs subject to the full-cost ceiling +limitation. The future cash outflows associated with settling the recorded asset retirement +obligations are excluded from the computation of the present value of estimated future net revenues +used in applying the ceiling test. +Property and Equipment +Depreciation of other property and equipment is provided using the straight-line method over +estimated lives of three to 20 years. Depreciation of pipeline and other facilities is provided +using the straight-line method over estimated lives of 15 to 27 years. Depreciation expense of +$351,000, $355,000 and $346,000 relating to other property and equipment was included in general +and administrative expenses in the Company’s statements of operations for the years ended December +31, 2006, 2005 and 2004, respectively. The accumulated depreciation on other property and +equipment was $10.8 million and $10.6 million as of December 31, 2006 and 2005, respectively. +45 +Table of Contents +Investment in Medusa Spar LLC +The +Company has a 10% ownership interest in Medusa Spar, LLC +(“LLC”), which is a limited liability company +that owns a 75% undivided ownership interest in the deepwater spar production facilities on +Callon’s Medusa Field in the Gulf of Mexico. The Company contributed a 15% undivided ownership +interest in the production facility to the LLC in return for approximately $25 million in cash and +a 10% ownership interest in the LLC. The LLC earns a tariff based upon production volume throughput +from the Medusa area. Callon is obligated to process its share of production from the Medusa Field +and any future discoveries in the area through the spar production facilities. This arrangement +allows Callon to defer the cost of the spar production facility over the life of the Medusa Field. +The Company’s cash proceeds were used to reduce the balance outstanding under its senior secured +credit facility. The LLC used the cash proceeds from $83.7 million of non-recourse financing and a +cash contribution by one of the LLC owners to acquire its 75% interest in the spar. On December 31, +2006, $33.2 million of the financing was outstanding. The balance of Medusa Spar LLC is owned by +Oceaneering International, Inc. (NYSE:OII) and Murphy Oil Corporation (NYSE:MUR). The Company is +accounting for its 10% ownership interest in the LLC under the equity method. +Natural Gas Imbalances +The Company follows the entitlement method of accounting for its proportionate share of gas +production on a well-by-well basis, recording a receivable to the extent that a well is in an +“undertake” position and recording a liability to the extent that a well is in an “overtake” +position. Gas balancing receivables were $714,000 and $403,000 as of December 31, 2006 and 2005, +respectively. Gas balancing payables were $437,000 and $304,000 as of December 31, 2006 and 2005, +respectively. +Derivatives +The Company periodically uses derivative financial instruments to manage oil and gas price risk on +a limited amount of its future production and does not use these instruments for trading purposes. +Settlement of derivative contracts are generally based on the difference between the contract price +or prices specified in the derivative instrument and a NYMEX price or other cash or futures index +price. Such derivatives are accounted for under Statement of Financial Accounting Standards No. +133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) as amended. +The Company’s derivative contracts that are accounted for as cash flow hedges under SFAS 133 are +recorded at fair market value and the changes in fair value are recorded through other +comprehensive income (loss), net of tax, in stockholders’ equity. The cash settlements on these +contracts are recorded as an increase or decrease in oil and gas sales. The changes in fair value +related to ineffective derivative contracts are recognized as derivative expense (income). The +cash settlement on these contracts is also recorded within derivative expense (income). The +changes in fair value of the Company’s derivative contracts that are not designated as effective +cash flow hedges are recorded through the statement of operations as derivative expense (income). +See Note 8. +Income Tax +The Company follows the asset and liability method of accounting for deferred income taxes +prescribed by Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” +(“SFAS 109”). SFAS 109 provides for the recognition of a deferred tax asset for deductible +temporary timing differences, capital and operating loss carryforwards, statutory depletion +carryforward and tax credit carryforwards, net of a valuation allowance. The valuation allowance +is provided for that portion of the asset for which it is deemed more likely than not will not be +realized. See Note 5. +46 +Table of Contents +Stock-Based Compensation +Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standard No. 123 +(revised 2004), “Share-Based Payment,” (“SFAS 123R”) utilizing the modified prospective transition +method. Prior to the adoption of SFAS 123R, the Company accounted for stock option grants in +accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to +Employees” (the intrinsic value method) and, accordingly, recognized no compensation expense for +stock option grants. +Under the modified prospective transition method, SFAS 123R applies to new awards, unvested awards +as of January 1, 2006 and awards that were outstanding on January 1, 2006 that are subsequently +modified, repurchased or cancelled. Under the modified prospective transition method, compensation +cost recognized in 2006 includes compensation cost for all share-based payments granted prior to, +but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in +accordance with the original provisions of Statement of Financial Accounting Standard No. 123 +“Accounting for Stock-Based Compensation,” (“SFAS 123”) and compensation cost for all share-based +payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in +accordance with the provisions of SFAS 123R. Prior periods were not restated to reflect the impact +of adopting the new standard. +SFAS 123R requires the cash flows from tax benefits resulting from tax deductions in excess of +compensation cost recognized for stock options exercised (excess tax benefits) to be classified as +financing cash flows. The $1.4 million of excess tax benefits classified as a financing cash +inflow for the year ended December 31, 2006 would have been classified as an operating cash flow +had the Company not adopted SFAS 123R. There were no cash proceeds from the exercise of stock +options for the year ended December 31, 2006 due to the fact that all options were exercised +through net-share settlements. As a result of most of the Company’s stock-based compensation being +in the form of restricted stock, the impact of the adoption of SFAS 123R on income before taxes, +net income and basic and diluted earnings per share for the year ended December 31, 2006 was +not significant. See Note 3. +Accounts Receivable +Accounts receivable consists primarily of accrued oil and gas production receivables. The balance +in the reserve for doubtful accounts included in accounts receivable was $66,000 at both December +31, 2006 and 2005, respectively. There were no net charge offs recorded against the reserve for +doubtful accounts and no provisions to expense in the three-year period ended December 31, 2006. +Accrued Liabilities to be Refinanced +Amounts included in accrued liabilities to be refinanced at December 31, 2005 represent capital +expenditures that were refinanced with the availability under the Company’s senior secured credit +facility subsequent to December 31, 2005. +Major Customers +The Company’s production is generally sold on month-to-month contracts at prevailing prices. The +following table identifies customers to whom it sold a significant percentage of its total oil and +gas production during each of the years ended: +December 31, +2006 +2005 +2004 +Shell Trading Company +41 +% +34 +% +30 +% +Louis Dreyfus Energy Services +25 +% +16 +% +23 +% +Plains Marketing, L.P. +11 +% +16 +% +13 +% +Chevron Texaco Natural Gas +3 +% +10 +% +6 +% +47 +Table of Contents +Because alternative purchasers of oil and gas are readily available, the Company believes that the +loss of any of these purchasers would not result in a material adverse effect on its ability to +market future oil and gas production. +Statements of Cash Flows +For purposes of the Consolidated Financial Statements, the Company considers all highly liquid +investments with an original maturity of three months or less to be cash equivalents. +The Company paid no federal income taxes for the three years in the period ended December 31, 2006. +During the years ended December 31, 2006, 2005 and 2004, the Company made cash payments for +interest of $20,468,000, $19,854,000 and $23,197,000, respectively. +Fair Value of Financial Instruments +Fair value of cash and cash equivalents, accounts receivable, accounts payable, the capital lease +and the senior secured credit facility approximates book value at December 31, 2006 and 2005. The +Company’s 9.75% Senior Notes due 2010 had an estimated fair value of 101.5% and 103% of face value +at December 31, 2006 and 2005, respectively. +Accounting Pronouncements +In June 2006, the Financial Accounting Standards Board (“FASB”) released interpretation No. 48, +Accounting for Uncertainty in Income Taxes, (“FIN 48”). FIN 48 clarifies the accounting for income +taxes by prescribing the minimum recognition threshold a tax position must meet before being +recognized in the financial statements. FIN 48 also provides guidance on derecognition, +measurement, classification, interest and penalties, accounting in interim periods, disclosure and +transition. The effective date for FIN 48 is fiscal years beginning after December 15, 2006. The +Company is currently reviewing the provisions of FIN 48 and has not yet determined the impact of +adoption. +In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, Fair Value +Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair +value and requires enhanced disclosures about fair value measurements. SFAS 157 is effective for +fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The +Company is still reviewing the provisions of SFAS 157 and has not yet determined the impact of +adoption. +3. STOCK-BASED COMPENSATION +The Company has various stock plans (“Plans”) under which employees of the Company and its +subsidiaries and non-employee members of the Board of Directors of the Company have been or may be +granted certain stock-based compensation. For further discussion of the Plans, refer to Note 12. +For the +year ended December 31, 2006, the Company recorded stock-based compensation expense of $3.5 million, +of which $1.8 million was included in general and administrative expenses and $1.7 million was +capitalized to +48 +Table of Contents +oil and gas properties. Shares available for future stock option or restricted stock grants to +employees and directors under existing plans were 490,666 at December 31, 2006. +The following table illustrates the effect on operating results and net income per share had the +Company accounted for stock-based compensation in accordance with SFAS 123 for the years ended +December 31, 2005 and 2004: +2005 +2004 +(In thousands, except per share data) +Net income available to common shares, +as reported +$ +26,458 +$ +20,229 +Stock-based compensation expense included +in net income as reported, net of tax +1,313 +348 +Deduct: Total stock-based +compensation expense under fair +value based method, net of tax +(1,497 +) +(549 +) +Pro forma net income available to +common shares +$ +26,274 +$ +20,028 +Basic net income per share: As Reported +1.43 +1.28 +Pro Forma +1.42 +1.27 +Diluted net income per share: As Reported +1.28 +1.22 +Pro Forma +1.27 +1.20 +Stock Options +The +Company uses the Black-Scholes option pricing model to estimate the fair value of +stock option awards with the following weighted-average assumptions for the indicated periods. +For the Years Ended +December 31, +2006 +2005 +2004 +Dividend yield +— +— +— +Expected volatility +38.9 +% +37.5 +% +45.1 +% +Risk-free interest rate +4.6 +% +4.3 +% +3.7 +% +Expected life of option (in years) +5 +5 +5 +Weighted-average grant-date fair value +$ +7.72 +$ +5.93 +$ +5.48 +Forfeiture rate +7.5 +% +— +— +The assumptions above are based on multiple factors, including historical exercise patterns of +employees with respect to exercise and post-vesting employment termination behaviors, expected +future exercising patterns and the historical volatility of the +Company’s stock price. +49 +Table of Contents +The +following table represents stock option activity and weighted average +exercised prices for the three years ended December 31, 2006: +2006 +2005 +2004 +Wtd Avg +Wtd Avg +Wtd Avg +Shares +Ex Price +Shares +Ex Price +Shares +Ex Price +Outstanding, beginning of year +1,205,558 +$ +10.11 +1,512,599 +$ +9.93 +2,450,867 +$ +9.84 +Granted (at market) +15,000 +18.69 +65,000 +15.79 +25,000 +12.40 +Exercised +(480,333 +) +10.66 +(329,441 +) +10.34 +(437,918 +) +9.74 +Forfeited +— +— +— +— +(525,350 +) +9.80 +Expired +— +— +(42,600 +) +10.60 +— +— +Outstanding, end of year +740,225 +$ +9.93 +1,205,558 +$ +10.11 +1,512,599 +$ +9.93 +Exercisable, end of year +695,225 +$ +9.44 +1,166,558 +$ +9.88 +1,446,486 +$ +10.20 +Weighted-average remaining +Contract life: +Outstanding options at end of period +4.06 +yrs. +3.98 +yrs. +4.48 +yrs. +Outstanding exercisable at end of period +3.76 +yrs. +3.79 +yrs. +4.34 +yrs. +The aggregate intrinsic value of options outstanding was $3.9 million and the aggregate +intrinsic value of options exercisable was $3.9 million. Total intrinsic value of options +exercised was $4.1 million for the year ended December 31, +2006. At December 31, 2006, there was $231,000 of unrecognized compensation cost related to nonvested +stock options, which is expected to be recognized over a +weighted-average period of two years. +Restricted Stock +The Plans allow for the issuance of restricted stock awards. The unearned stock-based compensation +related to these awards is being amortized to compensation expense on +a straight-line basis over the requisite service period for the +entire award. The +compensation expense for these awards was determined based on the market price of our stock at the +date of grant applied to the total numbers of shares that were anticipated to fully vest. As of +December 31, 2006, there was $9.1 million of unrecognized compensation cost associated with these +awards, which is expected to be recognized over a weighted average +period of 3.3 years. +The following table represents unvested restricted stock activity for the year ended December 31, +2006: +Weighted-Average +Number of +Grant-Date +Shares +Fair Value +Outstanding shares at beginning of period +272,000 +$ +13.66 +Granted +582,500 +15.77 +Vested +(191,500 +) +15.02 +Forfeited +(4,200 +) +13.82 +Outstanding shares at end of period +658,800 +$ +15.13 +For the years ended December 31, 2006, 2005 and 2004 the Company recognized non-cash compensation +expense associated with the restricted stock awards of $3.4 million, $2.0 million and $906,000, +respectively. Included in 2005 was $1.0 million of accelerated vesting of performance shares +pursuant to the terms of the plan due to the deaths or disability for an executive officer and two +directors of the Company. There were no restricted stock grants +during the year ended December 31, 2005 and +the weighted average grant-date fair value +of restricted stock granted during the year ended December 31, 2004 was +$13.69. +50 +Table of Contents +4. NET INCOME PER SHARE +Basic net income per common share was computed by dividing net income by the weighted average +number of shares of common stock outstanding during the year. Diluted net income per common share +was determined on a weighted average basis using common shares issued and outstanding adjusted for +the effect of stock options considered common stock equivalents computed using the treasury stock +method and the effect of the convertible preferred stock (if dilutive). +A reconciliation of the basic and diluted net income per share computation is as follows (in +thousands, except per share amounts): +2006 +2005 +2004 +(a) Net income available to common shares +$ +40,560 +$ +26,458 +$ +20,229 +Preferred dividends assuming conversion of +preferred stock (if dilutive) +— +318 +1,272 +(b) Net income available to common shares assum- +ing conversion of preferred stock +(if dilutive) +$ +40,560 +$ +26,776 +$ +21,501 +(c) Weighted average shares outstanding +20,270 +18,453 +15,796 +Dilutive impact of stock options +238 +348 +233 +Dilutive impact of restricted stock +78 +69 +75 +Dilutive impact of warrants +777 +1,375 +894 +Convertible preferred stock (if dilutive) +— +638 +680 +(d) Weighted average shares outstanding for diluted +net income per share +21,363 +20,883 +17,678 +Stock options and warrants excluded due to the +exercise price being greater than the stock price +28 +1 +89 +Basic net income per share (a ¸ c) +$ +2.00 +$ +1.43 +$ +1.28 +Diluted net income per share (b ¸ d) +$ +1.90 +$ +1.28 +$ +1.22 +51 +Table of Contents +5. INCOME TAXES +Below is an analysis of the net deferred tax liability as of December 31, 2006 and 2005. +December 31, +2006 +2005 +(In thousands) +Deferred Tax Asset: +Federal net operating loss carryforwards +$ +58,051 +$ +58,240 +Statutory depletion carryforward +4,651 +4,443 +Alternative minimum tax credit carryforward +332 +547 +Asset retirement obligations +12,228 +11,307 +Other +2,443 +1,389 +Total deferred tax asset +77,705 +75,926 +Deferred Tax Liability: +Oil and gas properties +(101,921 +) +(80,565 +) +Other +(5,838 +) +(224 +) +Total deferred tax liability +(107,759 +) +(80,789 +) +Net deferred tax liability +$ +(30,054 +) +$ +(4,863 +) +If not utilized, the Company’s federal net operating loss carryforwards will expire in 2013 through +2021. The Company has significant state net operating loss carryforwards that are not included in +the deferred tax asset above, as the Company does not anticipate generating taxable state income in +the states in which these loss carryforwards apply. The Company has very limited state taxable +income as primarily all of its revenue is generated in federal waters not subject to state income +taxes. +The Company incurred losses in 2002 and 2003 and had losses on an aggregate basis for the +three-year period ended December 31, 2003. Because of these cumulative losses the Company +established a full valuation allowance of $11.5 million as of December 31, 2003. For the +three-year period ended December 31, 2004, the Company had income on an aggregate basis resulting +from the Company achieving profitable operations in 2004 due to the Company’s first two deepwater +projects starting in November 2003 and the refinancing of the Company’s highest cost debt. As a +result, the Company reversed the valuation allowance, which had a balance of $7.0 million, as of +December 31, 2004. +Below is a reconciliation of the reported amount of income tax expense attributable to continuing +operations for the year to the amount of income tax expense that would result from applying +domestic federal statutory tax rates to pretax income from continuing operations. +Years Ended December 31, +2006 +2005 +2004 +Income tax expense computed at the statutory +federal income tax rate +35 +% +35 +% +35 +% +Change in valuation allowance +— +— +(84 +)% +Other +— +(1 +)% +— +Effective income tax rate +35 +% +34 +% +(49 +)% +6. OTHER COMPREHENSIVE INCOME +The Company’s other comprehensive income (loss) of $9.0 million, $1.6 million and $(1.9) million +for the years ended December 31, 2006, 2005 and 2004 respectively, relates to the change in fair +value of its +52 +Table of Contents +derivatives. Other comprehensive income (loss) was net of income tax expense +(benefit) of $4.7 million, $835,000 and ($1.0) million for the years ended December 31, 2006, 2005 +and 2004, respectively. +7. LONG-TERM DEBT +Long-term debt consisted of the following at: +December 31, +2006 +2005 +(In thousands) +Senior secured credit facility +$ +35,000 +$ +— +9.75% Senior Notes (due 2010) net of +discount +189,862 +187,941 +Capital lease +872 +1,135 +Total long-term debt +225,734 +189,076 +Less current portion +213 +263 +Long-term portion +$ +225,521 +$ +188,813 +Senior +Secured Credit Facility. On August 30, 2006, the Company closed on a four-year amended and +restated senior secured credit facility underwritten by Union Bank of California, N.A. The initial +borrowing base is $75 million, which will be reviewed and redetermined semi-annually and can be +increased to a maximum of $175 million. Borrowings under the credit facility are secured by +mortgages covering the Company’s major producing fields. As of December 31, 2006 there was $35 +million outstanding under the facility with a weighted average interest rate of 6.73% and $40 +million was available for future borrowings. In connection with the +anticipated financing of the acquisition of BP’s interest in the +Entrada Field, the borrowing base under this facility would be +reduced to $50 million at closing until the next borrowing base +redetermination date. See Note 14 for more discussion on the Entrada +acquisition. +The credit facility bears interest at 0% to 0.50% above a defined base rate depending on +utilization of the borrowing base or, at the option of the Company, LIBOR plus 1.375% to 2.0% based +on utilization of the borrowing base. Under the senior secured credit facility, a commitment fee +of 0.25% or 0.375% per annum, depending on the amount of the unused portion of the borrowing base, +is payable quarterly. The range of interest rates on the senior secured credit facility during +2006 was 6.24% to 8.50%. +9.75% Senior Notes (due 2010). In December 2003, the Company borrowed $185 million pursuant to a +senior unsecured credit facility. The loans under the credit facility have a stated interest rate +of 9.75% and a seven-year maturity. In conjunction with the new senior unsecured notes, the Company +issued detachable warrants to purchase 2.775 million shares of its common stock at an exercise +price of $10 per share and an expiration date of December 2010. The warrants were valued at $10.6 +million and were treated as a discount on the debt. This senior unsecured debt matures December 8, +2010 and has an effective interest rate of 11.4%. The Company recorded the issuance of these new +securities at a fair value of $171 million. Deferred costs of $14 million associated with the +notes are being amortized over the life of the notes. +During March 2004, Callon borrowed an additional $15 million under its 9.75% senior unsecured +credit facility bringing the total outstanding under the facility to $200 million. The net proceeds +of approximately $14 million were primarily used to retire the remaining $10 million of 12% senior +loans due March 31, 2005 plus a 1% call premium of $100,000. The Company recorded the issuance of +these additional new securities at a fair value of $14 million. Deferred costs of $1 million +associated with the notes are being amortized over the life of the notes. +53 +Table of Contents +In March 2004, the $200 million in aggregate principal amount of loans outstanding under the 9.75% +senior unsecured credit facility were exchanged for 9.75% Senior Notes due 2010, Series A, (“Series +A notes”), issued pursuant to a senior indenture between Callon and American Stock Transfer & Trust +Company dated March 15, 2004. On August 12, 2004, the Company completed an offer to exchange its +9.75% Senior Notes due 2010, Series B, that have been registered under the Securities Act of 1933, +for all outstanding Series A notes. +As of December 31, 2006, 1.617 million of the 2.775 million detachable warrants issued with the +9.75% Senior Notes due 2010 were exercised. In addition, 265,210 of the $0.01 warrants associated +with the 12% senior loans, which were redeemed in 2004, were exercised in June 2006. +Certain of the Company’s subsidiaries guarantee the Company’s obligations under the $200 million +9.75% Senior Notes due 2010. The subsidiary guarantors are 100% owned, all of the guarantees are +full and unconditional and joint and several, the parent company has no independent assets or +operations and any subsidiaries of the parent company other than the subsidiary guarantors are +minor. +Loss on Early Extinguishment of Debt. In the first half of 2004, the Company completed several +transactions that restructured certain debt that was maturing through 2005 resulting in a loss on +early extinguishment of debt for the year ended December 31, 2004 of $3.0 million. +Capital +Lease. In December 2001, the Company entered into a 10-year gas processing agreement +associated with a production facility on Callon’s Mobile Block 952 Field with Hanover Compression +Limited Partnership, which is being accounted for as a capital lease. +Restrictive +Covenants. The Indenture governing our 9.75% senior notes due 2010 and our senior +secured credit facility contains various covenants including restrictions on additional +indebtedness and payment of cash dividends. In addition, our senior secured credit facility +contains covenants for maintenance of certain financial ratios. The Company was in compliance with +these covenants at December 31, 2006. +Future minimum lease payments and debt maturities are as follows (in thousands): +Capital Lease +Year +Payments +Debt +2007 +$ +348 +$ +— +2008 +228 +— +2009 +229 +— +2010 +220 +235,000 +Thereafter +245 +— +54 +Table of Contents +8. DERIVATIVES +The following table summarizes derivative expense for the periods presented (in thousands): +December 31, +2006 +2005 +2004 +Amortization of derivative contract premiums +$ +150 +$ +1,634 +$ +— +Change in fair value and settlements of ineffective +derivative contracts +— +4,394 +1,209 +Change in fair value and settlements of +non-designated +derivative contracts +— +— +162 +$ +150 +$ +6,028 +$ +1,371 +The change in fair value and settlements on ineffective derivative contracts in 2005 and 2004 +relate to contracts that were deemed ineffective as a result of a shortfall in production volumes +due to downtime resulting from damages caused by Hurricanes Katrina and Rita in 2005 and tropical +storms and Hurricane Ivan in 2004. Cash settlements on effective cash flow hedges for the year +ended December 31, 2006 resulted in an increase in oil and gas sales of $8.9 million. For the +years ended December 31, 2005 and 2004, cash settlements on effective cash flow hedges resulted in +a reduction in oil and gas sales of $10.3 million and $13.8 million, respectively. +Listed in the table below are the outstanding derivative contracts as of December 31, 2006: +Collars +Average +Average +Volumes per +Quantity +Floor +Ceiling +Product +Month +Type +Price +Price +Period +Oil +50,000 +Bbls +$ +65.00 +$ +88.75 +01/07-12/07 +Natural Gas +600,000 +MMBtu +$ +8.00 +$ +12.70 +01/07-12/07 +9. COMMITMENTS AND CONTINGENCIES +From time to time, the Company, as part of the Consolidation and other capital transactions, +entered into registration rights agreements whereby certain parties to the transactions are +entitled to require the Company to register common stock of the Company owned by them with the SEC +for sale to the public in firm commitment public offerings and generally to include shares owned by +them, at no cost, in registration statements filed by the Company. Costs of the offering will not +include broker’s discounts and commissions, which will be paid by the respective sellers of the +common stock. +55 +Table of Contents +The Company is involved in various claims and lawsuits incidental to its business. In the opinion +of management, the ultimate liability thereunder, if any, will not have a material adverse effect +on the financial position or results of operations of the Company. +The Company’s Medusa deepwater property is eligible for royalty suspensions pursuant to the Deep +Water Royalty Relief Act. In addition, the Company has several shallow water, deep natural gas +properties and prospects that are eligible for royalty suspensions. However, the federal offshore +leases covering these properties contain “price threshold” provisions for oil and gas prices. +Under these “price threshold” provisions, if the average monthly New York Mercantile Exchange +(NYMEX) sales price for oil or gas during a fiscal year exceeds the price threshold for oil or gas, +respectively, then royalties on the associated production must be paid to the Minerals Management +Service (MMS) at the rate stipulated in the lease. The price thresholds are adjusted annually by +the implicit price deflator for the GDP. The determination of whether or not royalties are due as +a result of the average NYMEX price exceeding the price threshold is made during the first quarter +of the succeeding year. Any royalty payments due must be made shortly after this determination is +made. If a royalty payment is due for all production during a year as a result of exceeding the +price threshold, the lessee is required to make monthly royalty payments during the succeeding +fiscal year for the succeeding year’s production. If at the end of any year the average NYMEX +price is below the price threshold, the lessee can apply for a refund for any associated royalties +paid during that year and the lessee will not be required to pay royalties monthly during the +succeeding year for the succeeding year’s production. +The Company was required to make monthly royalty payments for 2006 deepwater oil and gas production +and will be required to make monthly royalty payments for 2007. With regard to the shallow water, +deep natural gas royalty relief, the Company was not required to make royalty payments for 2006 and +will not be required to make royalty payments for 2007. +In the year succeeding the year in which any of the Company’s properties became subject to +royalties as the result of the average NYMEX price exceeding the price threshold, the portion of +reserves attributable to potential future royalties would not be included in a year-end reserve +report. However, if the average NYMEX prices were below the price thresholds in subsequent years, +our reserves would be increased to reflect reserves previously attributed to future royalties. As +a result, reported oil and gas reserves could materially increase or decrease, depending on the +relation of price thresholds versus the average NYMEX prices. The reduction in revenues resulting +from an obligation to pay these royalties and subsequent reduction of proved reserves could have a +material adverse effect on the Company’s results of operations and financial condition. The +Company’s reserve report as of December 31, 2006 excluded oil and gas reserves for Medusa that are +subject to MMS royalties as a result of the average 2006 NYMEX prices for oil and gas exceeding the +deepwater price thresholds. With regard to the shallow water, deep natural gas properties, there +was no reduction in reserves for potential future royalties as of December 31, 2006 as a result of +the average 2006 NYMEX price for gas being below the price threshold. +The Company’s Entrada Field is governed by leases from the MMS. These leases granted royalty +suspension without provisions for pricing thresholds for crude oil and natural gas which would +require us to pay royalties to the MMS if the thresholds were exceeded by the current year average +of NYMEX prices. The MMS has notified us the exclusion of the provisions occurred in error in the +lease issuance process and was not the MMS’s intention. Congress is considering various bills to +address this issue and if a bill were to pass to amend the leases to provide thresholds for crude +oil and natural gas prices the reserves for Entrada could be subject to such royalties. However, +the MMS stated in their correspondence to the Company that they will continue to honor the terms of +the leases as issued unless notified otherwise. This correspondence applies only to Callon’s 20% working interest +in the Entrada Field. +56 +Table of Contents +The Company’s activities are subject to federal, state and local laws and regulations governing +environmental quality and pollution control. Although no assurances can be made, the Company +believes that, absent the occurrence of an extraordinary event, compliance with existing federal, +state and local laws, rules and regulations governing the release of materials into the environment +or otherwise relating to the protection of the environment will not have a material effect upon the +capital expenditures, earnings or the competitive position of the Company with respect to its +existing assets and operations. The Company cannot predict what effect additional regulation or +legislation, enforcement polices thereunder, and claims for damages to property, employees, other +persons and the environment resulting from the Company’s operations could have on its activities. +10. ASSET RETIREMENT OBLIGATIONS +The following table summarizes the activity for the Company’s asset retirement obligations: +Twelve Months Ended +December 31, 2006 +December 31, 2005 +Asset retirement obligations at +beginning of period +$ +38,273 +$ +38,282 +Accretion expense +4,960 +3,549 +Net profits interest accretion +— +331 +Liabilities incurred +1,440 +2,365 +Liabilities settled +(16,970 +) +(5,184 +) +Revisions to estimate +13,476 +(1,070 +) +Asset retirement obligation at end of period +41,179 +38,273 +Less: current retirement obligations +(14,355 +) +(21,660 +) +Long-term retirement obligations +$ +26,824 +$ +16,613 +Assets, primarily short-term U.S. Government securities, of approximately $6.2 million at December +31, 2006, of which $4.3 million was current, were recorded as restricted investments. These assets +are held in abandonment trusts (“Trusts”) dedicated to pay future abandonment costs for several of +the Company’s oil and gas properties. +57 +Table of Contents +11. OIL AND GAS PROPERTIES +The following table discloses certain financial data relating to the Company’s oil and gas +activities, all of which are located in the United States. +Years Ended December 31, +2006 +2005 +2004 +(In thousands) +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance +$ +937,698 +$ +862,101 +$ +802,912 +Property acquisition costs +4,053 +6,627 +1,355 +Exploration costs +73,659 +46,379 +26,749 +Development costs +81,497 +22,591 +31,086 +Sale of mineral interests +— +— +(1 +) +End of period balance +$ +1,096,907 +$ +937,698 +$ +862,101 +Unevaluated Properties (excluded from +amortization) - +Beginning of period balance +$ +49,065 +$ +39,042 +$ +34,251 +Additions +19,103 +18,739 +16,367 +Capitalized interest +6,477 +5,655 +4,577 +Transfers to evaluated +(19,843 +) +(14,371 +) +(16,153 +) +End of period balance +$ +54,802 +$ +49,065 +$ +39,042 +Accumulated depreciation, depletion +and amortization- +Beginning of period balance +$ +539,399 +$ +494,453 +$ +447,000 +Provision charged to expense +65,283 +44,946 +47,453 +End of period balance +$ +604,682 +$ +539,399 +$ +494,453 +Unevaluated property costs, primarily lease acquisition costs incurred at federal and state lease +sales, unevaluated drilling costs, capitalized interest and general and administrative costs being +excluded from the amortizable evaluated property base, consisted of $24.7 million incurred in 2006, +$17.8 million incurred in 2005, $3.5 million incurred in +2004 and $8.8 million incurred in 2003 +and prior. These costs are directly related to the acquisition and evaluation of unproved +properties and major development projects. The excluded costs and related reserves are included in +the amortization base as the properties are evaluated and proved reserves are established or +impairment is determined. The Company expects that the majority of these costs will be evaluated +over the next three to five years. +Depletion per unit-of-production (thousand cubic feet of gas equivalent) amounted to $3.14, $2.39 +and $2.18 for the years ended December 31, 2006, 2005, and 2004, respectively. +Under the full-cost accounting rules of the SEC, the Company reviews the carrying value of its +proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and +gas properties, net of accumulated depreciation, depletion and amortization and deferred income +taxes, may not exceed the present value of estimated future net cash flows from proved oil and gas +reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of +related tax effects (the full-cost ceiling amount). These rules generally require pricing future +oil and gas production at the unescalated market price for oil and gas at the end of each fiscal +quarter and require a write-down if the “ceiling” is exceeded. However, if prices recover +sufficiently subsequent to the balance sheet date before the release of the financial statements +then use of the subsequent pricing is allowed and no write-down would be required if such pricing +was used. Given the volatility of oil and gas prices, it is reasonably possible that the Company’s +estimate of discounted future net cash flows from proved oil and gas reserves could change in the +near term. If oil and gas prices decline significantly, even if only for a short period of time, +it is possible that write-downs of oil and gas properties could occur in the future. +12. EMPLOYEE BENEFIT PLANS +The Company has adopted a series of incentive compensation plans designed to align the interest of +the executives and employees with those of its stockholders. The following is a brief description +of each plan: +58 +Table of Contents +Savings and Protection Plan +The Savings and Protection Plan (“401-K Plan”) provides employees with the +option to defer receipt of a portion of their compensation and the Company may, at +its discretion, match a portion of the employee’s deferral with cash and Company +Common Stock. The Company may also elect, at its discretion, to contribute a +non-matching amount in cash and Company Common Stock to employees. The amounts held +under the 401-K Plan are invested in various funds maintained by a third party in accordance with the directions of each +employee. An employee is fully vested, including Company discretionary +contributions, immediately upon participation in the 401-K Plan. The total amounts +contributed by the Company, including the value of the common stock contributed, +were $615,000, $557,000 and $528,000 in the years 2006, 2005 and 2004, respectively. +1996 Stock Incentive Plan +On August 23, 1996, the Board of Directors of the Company approved and adopted +the Callon Petroleum Company 1996 Stock Incentive Plan (the “1996 Plan”). The 1996 +Plan was approved by the shareholders in 1997 and limited to a maximum of 1,200,000 +shares (as amended from the original 900,000 shares) of common stock subject to +outstanding awards. The 1996 Plan was amended again and approved on May 9, 2000 at +the Annual Meeting of Shareholders, increasing the number of shares reserved for +issuance under the 1996 plan to 2,200,000 shares. Unvested options are subject to +forfeiture upon certain termination of employment events and expire 10 years from +the date of grant. +In August 2006, the Board of Directors approved the award of 520,000 shares of +restricted stock from the 1996 Plan. Of the 520,000 shares, 20,000 shares were +granted to non-employee members of the Board of Directors and vested immediately. +The remaining 500,000 shares were issued to employees of the Company with 20% vesting +immediately and the remaining 80% vesting ratably over the next four +years. The compensation cost with respect to the 20% that vested +immediately was recognized as an expense on the grant date and the +compensation cost with respect to the remaining 80% is being amortized to expense over the +vesting period. +2002 Stock Incentive Plan +On February 14, 2002, the Board of Directors of the Company approved and adopted +the 2002 Stock Incentive Plan (the “2002 Plan”). Pursuant to the 2002 Plan, 350,000 +shares of common stock shall be reserved for issuance upon the exercise of options or +for grants of stock options, stock appreciation rights or units, bonus stock, or +performance shares or units. This Plan qualified as a “broadly based” plan under the +provisions of the New York Stock Exchange’s rules and regulations and therefore did +not require shareholder approval. Because the 2002 Plan is a broadly based plan, the +aggregate number of shares underlying awards granted to officers and directors cannot +exceed 50% of the total number of shares underlying the awards granted to all +employees during any three-year period. +In 2006, 17,500 shares were awarded as restricted stock with 20% vesting immediately +and the remaining 80% vesting ratably over the next four years. The +compensation cost with respect to the 20% that vested immediately was +recognized as an expense on the grant date and the compensation cost +with respect to the remainging 80% is being amortized to expense over the vesting +period. +2006 Stock Incentive Plan +On March 9, 2006, the Board of Directors of the Company approved the 2006 Stock +Incentive Plan (“2006 Plan”). The 2006 Plan was approved by the shareholders at the +May 4, 2006 +59 +Table of Contents +annual meeting. Pursuant to the 2006 Plan, 500,000 shares of common +stock shall be reserved for issuance upon exercise of stock options, restricted +stock or other stock-based awards. In 2006, 45,000 shares were awarded as +restricted stock that will vest ratably over the next four years. The +compensation cost with respect to this grant is being amortized to expense over the +vesting period. +13. EQUITY TRANSACTIONS +On June 13, 2005, Callon called for redemption all of the Company’s outstanding shares of $2.125 +Convertible Exchange Preferred Stock, Series A. A notice of redemption and letter of transmittal +was mailed to all holders of record as of the close of business on June 10, 2005. Between June 13, +2005 and June 30, 2005, 180,173 shares of preferred stock were converted into 409,496 shares of the +Company’s common stock. Subsequent to June 30, 2005, 392,935 shares of preferred stock were +converted into 893,076 shares of the Company’s common stock. In addition, 23,563 shares of the +Company’s preferred stock were redeemed for $606,000 on July 14, 2005. As a result of the +redemption, we will benefit from an annual cash savings of $1.3 million in dividend payments. +On June 22, 2004, Callon closed the public offering of three million shares of common stock priced at +$13.25 per share raising net proceeds of approximately $38.2 million, after expenses. In addition, +the Company granted the underwriter, Johnson Rice & Company L.L.C., an over-allotment option to purchase an +additional 450,000 shares. On June 30, 2004, the underwriter exercised the over-allotment option +for an additional 450,000 shares priced at $13.25 per share, raising the net proceeds of the +offering by approximately $5.7 million, after expenses. The proceeds from the transactions were +used to redeem $33 million of the 11% Senior Subordinated Notes due December 15, 2005 and for +general corporate purposes. +The Company adopted a stockholder rights plan on March 30, 2000, designed to assure that the +Company’s stockholders receive fair and equal treatment in the event of any proposed takeover of +the Company and to guard against partial tender offers, squeeze-outs, open market accumulations, +and other abusive tactics to gain control without paying all stockholders a fair price. The rights +plan was not adopted in response to any specific takeover proposal. Under the rights plan, the +Company declared a dividend of one right (“Right”) on each share of the Company’s Common Stock. +Each Right will entitle the holder to purchase one one-thousandth of a share of a Series B +Preferred Stock, par value $0.01 per share, at an exercise price of $90 per one one-thousandth of a +share. +The Rights are not currently exercisable and will become exercisable only in the event a person or +group acquires, or engages in a tender or exchange offer to acquire, beneficial ownership of 15 +percent or more (one existing stockholder was granted an exception for up to 21 percent) of the +Company’s common stock. After the Rights become exercisable, each Right will also entitle its +holder to purchase a number of common shares of the Company having a market value of twice the +exercise price. The dividend distribution was made to stockholders of record at the close of +business on April 10, 2000. The Rights will expire on March 30, 2010. +14. SUBSEQUENT EVENTS +Subsequent to December 31, 2006, the Company entered into an agreement with BP Exploration and +Production Company (“BP”) to purchase BP’s 80% working interest in the Entrada Field for total cash +consideration of $190 million. The purchase price includes $150 million payable at closing and an +additional $40 million payable after the achievement of certain production milestones. The +purchased interests include five federal offshore blocks at Garden Banks Blocks 738, 782, 785, 826 +and 827, subject to certain depth +60 +Table of Contents +limitations. Upon the completion of the acquisition, Callon will +own a 100% working interest in the Entrada Field and will become operator. The acquisition is +expected to close within the next 45 days and will add 150 Bcfe to Callon’s proved undeveloped +reserves. +To finance +the initial $150 million payment of the purchase price, a commitment has been received from Merrill +Lynch Capital Corporation to make available to Callon a 7-year, $200 million revolving credit +facility secured by a lien on the Entrada properties. We plan to +borrow the full commitment amount at +closing to cover the required $150 +million payment to BP and, expenses and fees, and the balance of the funds can be used for Entrada development costs or +general corporate purposes. In connection with the closing of the +financing of the acquisition of BP’s interest in the Entrada +Field, the borrowing base of our senior secured credit facility will +be reduced to $50 million. +15. SUPPLEMENTAL OIL AND GAS RESERVE DATA (UNAUDITED) +The Company’s proved oil and gas reserves at December 31, 2006, 2005 and 2004 have been estimated +by Huddleston & Co., Inc who are the Company’s independent petroleum consultants. The reserves +were prepared in accordance with guidelines established by the SEC. Accordingly, the following +reserve estimates are based upon existing economic and operating conditions. +There are numerous uncertainties inherent in establishing quantities of proved reserves. The +following reserve data represents estimates only and should not be construed as being exact. In +addition, the standardized measure of discounted future net cash flows should not be construed as +the current market value of the Company’s oil and gas properties or the cost that would be incurred +to obtain equivalent reserves. See Note 9 regarding the provisions for royalty relief and the +effect on reserves. +Estimated Reserves +Changes in the estimated net quantities of crude oil and natural gas reserves, all of which are +located onshore and offshore in the continental United States, are as follows: +Reserve Quantities +Years Ended December 31, +2006 +2005 +2004 +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period +18,428 +19,748 +23,709 +Revisions to previous estimates +(3,733 +) +316 +(2,370 +)(a) +Purchase of reserves in place +— +71 +— +Extensions and discoveries +204 +129 +145 +Production +(1,634 +) +(1,836 +) +(1,736 +) +End of period +13,265 +18,428 +19,748 +Natural Gas (MMcf): +Beginning of period +78,021 +72,619 +74,691 +Revisions to previous estimates +(15,557 +) +(4,946 +) +2,138 +Purchase of reserves in place +— +1,308 +— +Extensions and discoveries +14,550 +16,808 +7,177 +Production +(10,977) +(7,768) +(11,387) +End of period +66,037 +78,021 +72,619 +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period +7,323 +10,292 +9,919 +End of period +5,159 +7,323 +10,292 +Natural Gas (MMcf): +Beginning of period +30,982 +33,982 +31,415 +End of period +36,750 +30,982 +33,982 +(a) +Includes Medusa royalty adjustment +61 +Table of Contents +Standardized Measure +The following tables present the Company’s standardized measure of discounted future net cash flows +and changes therein relating to proved oil and gas reserves and were computed using reserve +valuations based on regulations prescribed by the SEC. These regulations provide that the oil, +condensate and gas price structure utilized to project future net cash flows reflect period-end +prices (approximately $5.78 per Mcf for natural gas and $54.07 per Bbl for oil for the 2006 +disclosures, $10.13 per Mcf and $55.44 per Bbl for 2005 disclosures, and $6.51 per Mcf and $36.72 +per Bbl for 2004 disclosures) at each date presented with no escalation. Future production and +development costs are based on current costs without escalation. The resulting net future cash +flows have been discounted to their present values based on a 10% annual discount factor. +Standardized Measure +Years Ended December 31, +2006 +2005 +2004 +(In thousands) +Future cash inflows +$ +1,101,182 +$ +1,814,208 +$ +1,198,096 +Future costs - +Production +(243,740 +) +(238,321 +) +(231,616 +) +Development and net abandonment +(81,700 +) +(88,070 +) +(74,335 +) +Future net inflows before income taxes +775,742 +1,487,817 +892,145 +Future income taxes +(119,685 +) +(379,287 +) +(166,284 +) +Future net cash flows +656,057 +1,108,530 +725,861 +10% discount factor +(185,266 +) +(270,978 +) +(209,968 +) +Standardized measure of discounted +future net cash flows +$ +470,791 +$ +837,552 +$ +515,893 +Changes in Standardized Measure +Years Ended December 31, +2006 +2005 +2004 +(In thousands) +Standardized measure – beginning of period +$ +837,552 +$ +515,893 +$ +519,026 +Sales and transfers, net of production costs +(153,387 +) +(116,913 +) +(97,494 +) +Net change in sales and transfer prices, +net of production costs +(347,193 +) +391,570 +86,551 +Exchange and sale of in place reserves +— +— +— +Purchases, extensions, discoveries, and +improved +recovery, net of future production and +development costs incurred +122,862 +127,848 +77,576 +Revisions of quantity estimates +(155,342 +) +(17,241 +) +(41,314 +) +Accretion of discount +108,871 +61,259 +57,046 +Net change in income taxes +187,209 +(154,460 +) +(45,262 +) +Changes in production rates, timing and other +(129,781 +) +29,596 +(40,236 +) +Standardized measure — end of period +$ +470,791 +$ +837,552 +$ +515,893 +At year +end 2006, a downward revision was made by the Company’s +independent petroleum engineers to Entrada’s estimated net proved +reserves as of December 31, 2006 due to new performance data from analogous deepwater reservoirs. +16. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) +First +Second +Third +Fourth +Quarter +Quarter +Quarter +Quarter +(In thousands, except per share data) +2006 +Total revenues +$ +45,581 +$ +47,057 +$ +44,878 +$ +44,752 +Income from operations +22,605 +21,616 +17,815 +12,367 +Net income +12,767 +12,303 +9,630 +5,860 +Net income per common share-basic +$ +0.66 +$ +0.61 +$ +0.47 +$ +0.28 +Net income per common share-diluted +0.60 +0.57 +0.45 +0.27 +First +Second +Third +Fourth +Quarter +Quarter +Quarter(a) +Quarter(a) +(In thousands, except per share data) +2005 +Total revenues +$ +43,012 +$ +41,668 +$ +31,722 +$ +24,888 +Income from operations +18,134 +17,696 +8,692 +9,783 +Net income +9,475 +9,311 +3,683 +4,307 +Net income per common share-basic +$ +0.52 +$ +0.52 +$ +0.19 +$ +0.22 +Net income per common share-diluted +0.46 +0.46 +0.17 +0.20 +(a) +These quarters were impacted by tropical storm and hurricane activity. +62 +Table of Contents +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +There have been no disagreements with the independent auditors on any matters of accounting +principles or practices, financial statement disclosure, or auditing scope or procedures. +ITEM 9.A CONTROLS AND PROCEDURES +The term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the +Securities Exchange Act of 1934, or the Exchange Act. This term refers to the controls and +procedures of a company that are designed to ensure that information required to be disclosed by a +company in the reports that it files or submits under the Exchange Act is recorded, processed, +summarized and reported within the time periods specified by the Securities and Exchange +Commission. Our management, including our Chief Executive Officer and Chief Financial Officer, +have evaluated the effectiveness of our disclosure controls and procedures as of the end of the +period covered by this annual report. Based upon that evaluation, our Chief Executive Officer and +Chief Financial Officer have concluded that our disclosure controls and procedures were effective +as of the end of the period covered by this annual report. There were no changes to our internal +control over financial reporting during our last fiscal quarter that have materially affected, or +are reasonable likely to materially affect, our internal control over financial reporting. +Management’s Report On Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over +financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the +supervision and with the participation of our management, including our principal executive and +financial officers, we conducted an evaluation of the effectiveness of our internal control over +financial reporting as of December 31, 2006 based on the frame work in the Internal +Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our evaluation under the framework in Internal Control-Integrated Framework, +our management concluded that our internal control over financial reporting was effective as of +December 31, 2006. +Ernst & Young LLP, our independent registered public accounting firm, has issued an attestation +report on our management’s assessment of the effectiveness of our internal control over financial +reporting which is included herein. +63 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Stockholders and Board of Directors +Callon Petroleum Company +We have audited management’s assessment, included in the accompanying Management’s Report on +Internal Control over Financial Reporting, that Callon Petroleum Company maintained effective +internal control over financial reporting as of December 31, 2006, based on criteria established in +Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the +Treadway Commission (COSO). Callon Petroleum Company’s management is responsible for maintaining +effective internal control over financial reporting and for its assessment of the effectiveness of +internal control over financial reporting. Our responsibility is to express an opinion on +management’s assessment and an opinion on the effectiveness of the Company’s internal control over +financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight +Board (United States). Those standards require that we plan and perform the audit to obtain +reasonable assurance about whether effective internal control over financial reporting was +maintained in all material respects. Our audit included obtaining an understanding of internal +control over financial reporting, evaluating management’s assessment, testing and evaluating the +design and operating effectiveness of internal control, and performing such other procedures as we +considered necessary in the circumstances. We believe that our audit provides a reasonable basis +for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable +assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A +company’s internal control over financial reporting includes those policies and procedures that (1) +pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the +transactions and dispositions of the assets of the company; (2) provide reasonable assurance that +transactions are recorded as necessary to permit preparation of financial statements in accordance +with generally accepted accounting principles, and that receipts and expenditures of the company +are being made only in accordance with authorizations of management and directors of the company; +and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the +financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or +detect misstatements. Also, projections of any evaluation of effectiveness to future periods are +subject to the risk that controls may become inadequate because of changes in conditions, or that +the degree of compliance with the policies or procedures may deteriorate. +In our opinion, management’s assessment that Callon Petroleum Company maintained effective internal +control over financial reporting as of December 31, 2006, is fairly stated, in all material +respects, based on criteria established in Internal Control-Integrated Framework issued by the +Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, Callon +Petroleum Company maintained, in all material respects, effective internal control over financial +reporting as of December 31, 2006, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight +Board (United States), the consolidated balance sheets of Callon Petroleum Company as of December +31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and +cash flows for each of the three years in the period ended December 31, 2006 of Callon Petroleum +Company and our report dated March 15, 2007, expressed an unqualified opinion thereon. +/s/ +Ernst & Young LLP +New Orleans, Louisiana +March 15, 2007 +64 +Table of Contents +ITEM 9.B OTHER INFORMATION +We have disclosed all information required to be disclosed in a current report on Form 8-K during +the fourth quarter of the year ended December 31, 2006 in previously filed reports on Form 8-K. +65 +Table of Contents +PART III. +ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. +For information concerning Item 10, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 3, 2007 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +The Company has adopted a code of ethics that applies to the Company’s chief executive officer, +chief financial officer and chief accounting officer. The full text of such code of ethics has +been posted on the Company’s website at www.callon.com, and is available free of charge in print to +any shareholder who requests it. Request for copies should be addressed to the Secretary at 200 +North Canal Street, Natchez, Mississippi 39120. +66 +Table of Contents +ITEM 11. EXECUTIVE COMPENSATION. +For information concerning Item 11, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 3, 2007 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED +STOCKHOLDER MATTERS. +For information concerning the security ownership of certain beneficial owners and management, see +the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of +Stockholders to be held on May 3, 2007 which will be filed with the Securities and Exchange +Commission and is incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 3, 2007 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES. +For information concerning Item 14, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 3, 2007 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000928022/2006/0000950134-07-005981/item13.txt b/raw/filings/0000928022/2006/0000950134-07-005981/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..f7c1c7eb90b7c60e70c496c8c6d3594660b11882 --- /dev/null +++ b/raw/filings/0000928022/2006/0000950134-07-005981/item13.txt @@ -0,0 +1,4 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 3, 2007 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000928022/2006/0000950134-07-005981/item9a.txt b/raw/filings/0000928022/2006/0000950134-07-005981/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2006/0000950134-07-005981/rp_note.txt b/raw/filings/0000928022/2006/0000950134-07-005981/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2006/0000950134-07-005981/rpt_disclosure.txt b/raw/filings/0000928022/2006/0000950134-07-005981/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..900696ae5d1d87c4ad86e368d04fbb8f800faa36 --- /dev/null +++ b/raw/filings/0000928022/2006/0000950134-07-005981/rpt_disclosure.txt @@ -0,0 +1,143 @@ +Related Persons Transactions Oversight . The Company shall not enter into a related +person transaction unless such transaction is approved by the Committee after a review of +the transaction for potential conflicts of interest. The terms “related person” and +“transaction” shall have the meaning given such terms in Item 404 of Regulation S-K, as +amended from time to time. If such related person transaction occurs and is approved by +the Committee, the Committee shall review the disclosure(s) as required by Item 404. +9. +Risk Management Oversight . +9.1. +Risk Exposure . The Committee shall periodically meet with management and each +Independent Auditor to review and discuss (a) guidelines and policies with respect to risk +assessment and risk management to the extent necessary or appropriate to govern the process +by which the Company’s risk assessment and management is undertaken and handled (although +the Committee is not required to be the sole body responsible for risk assessment and +management) and (b) the Company’s major financial risk exposures and the steps management +has taken to monitor and control such exposures. If the Company manages and assesses its +risk through mechanisms other than the Committee, the mechanisms need not +38 +Table of Contents +be replaced by +the Committee, but the processes in place should be reviewed in a general manner by the +Committee. +9.2. +Insurance . The Committee shall periodically review and assess insurance coverage, +including Directors and Officers Liability, property and casualty loss, +errors and omissions and surety bonds, with management and, at the Committee’s discretion, +General Counsel. +9.3. +Special-Purpose Entities and Off-Balance Sheet Transactions . The Committee shall +periodically meet with management, the Internal Auditor, the General Counsel and the +External Auditor to review and assess all “special-purpose” entities of the Company and all +complex financing transactions involving the Company, including all related off-balance +sheet accounting matters. +9.4. +Consultation with Legal Counsel . The Committee shall periodically, at its discretion, +review with the General Counsel and, if the Committee deems it appropriate, outside legal +counsel legal matters (including material claims, pending legal proceedings, government +investigations and material reports, notices or inquires received from governmental +agencies) that may have a significant impact on the Company’s financial statements or risk +management. +10. +Reports and Assessments . +10.1. +Board Reports . The Chairperson of the Committee shall, periodically, at his or her +discretion, report to the Board on Committee actions and on the fulfillment of the +Committee’s responsibilities under this Charter. Such reports shall include any issues +that arise with respect to the quality or integrity of the Company’s financial statements, +the Company’s compliance with legal or regulatory requirements, the performance and +independence of the Company’s External Auditors and the performance of the Company’s +internal audit function. This report shall be presented and incorporated with and into the +next regularly scheduled Board meeting. +10.2. +Charter Assessment . The Committee shall annually assess the adequacy of this Charter +and advise the Board and the Nominating and Corporate Governance Committee of its +assessment and of its recommendation for any changes to the Charter. The Committee shall, +if requested by management, assist management with the preparation of a certification to be +presented annually to the NYSE affirming that the Committee reviewed and reassessed the +adequacy of this Charter. +10.3. +Committee Self-Assessment . The Committee shall annually make a self-assessment of its +performance and shall report the results of such self-assessment to the Board and the +Nominating and Corporate Governance Committee. +10.4. +Proxy Statement Report . The Committee shall prepare an annual report as required by +the rules and regulations of the SEC and submit it to the Board for inclusion in the +Company’s proxy statement prepared in connection with its annual meeting of stockholders. +39 +Table of Contents +10.5. +Recommend Action . The Committee shall annually make a determination as to whether to +recommend to the Board that the audited financials (certified by the External Auditor) be +included in the Company’s annual report on Form 10-K for filing with the SEC. +10.6. +Board Access to External Auditor . The Committee shall, whenever the Board of +Directors or the Committee deems it appropriate, have the External Auditor +attend a meeting of the Board to discuss specific issues and to answer questions from the +directors. +11. +General . +11.1. +Financial Statement Responsibility . The Company’s management is responsible for the +preparation, presentation and integrity of the Company’s financial statements and +disclosures, and the External Auditor is responsible for auditing year-end financial +statements and reviewing quarterly financial statements and conducting other procedures. +It is not the duty of the Committee to certify the Company’s financial statements, to +guarantee the External Auditor’s report or to plan or conduct audits. Since the primary +function of the Committee is oversight, the Committee shall be entitled to rely on the +expertise, skills and knowledge of management, the Internal Auditor and the External +Auditor and the accuracy of information provided to the Committee by such persons in +carrying out its oversight responsibilities. Nothing in this Charter is intended to change +the responsibilities of management and the External Auditor. +11.2. +Charter Guidelines . While the responsibilities of the Committee set forth in Section +5 through 10 above are contemplated to be the principal recurring activities of the +Committee in carrying out its oversight function, these responsibilities are to serve as a +guide with the understanding that the Committee may diverge from them as it deems +appropriate given the circumstances. +12. +Qualified Legal Compliance Committee Duties . +12.1. +Purpose . The Committee shall fulfill the requirements of a Qualified Legal Compliance +Committee, as defined in Part 205 of Title 17, Chapter II of the Code of Federal +Regulations ( “Part 205” ). +12.2. +Written Procedures . The Committee shall have the authority and responsibility to +establish written procedures to confidentially receive, consider and retain reports of +evidence of a material violation by the Company, its officers, directors, employees or +agents of federal or state securities laws, material breach of fiduciary duty, or a similar +material violation of any federal or state law. +12.3. +Report Submission . The Committee shall have the authority and responsibility to +inform the Company’s chief legal officer, as such term is used in Part 205 ( “CLO” ), and CEO +(or the equivalents thereof) of any report of evidence of a material violation (except in +case of futility). +12.4. +Investigation Determination . The Committee shall determine whether an investigation +is necessary regarding any report of evidence of a material violation by the Company, its +officers, directors, employees or agents. If the Committee determines an investigation is +necessary or appropriate, the +40 +Table of Contents +Committee shall (i) notify the Board of its determination to +investigate, (ii) initiate an investigation, which may be conducted either by the CLO (or +the equivalent thereof) or by outside counsel, and (iii) retain such additional Advisors to +assist in such investigation as the Committee deems necessary or appropriate. +12.5. +Conclusion of Investigation . At the conclusion of any investigation the Committee +shall (i) have the authority and responsibility to recommend, by majority vote, that the +Company implement an appropriate response to evidence +of a material violation, and (ii) inform the Company’s CLO and CEO (or the equivalents +thereof) and the Board of the results of any such investigation and the appropriate +remedial measures to be adopted, if any. +12.6. +Notification of SEC . The Committee shall have the authority to take all other +appropriate action, including the authority to notify the SEC in the event that the Company +fails in any material respect to implement an appropriate response that the Committee has +recommended the Company to take; provided, that the Committee determines, by +majority vote and after consultation with counsel, that such notification would be required +by law or in the best interest of the Company. +General Authority . The Committee shall have the authority to take any other action necessary to +meet the requirements of a Qualified Legal Compliance Committee under Part 205. +41 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0000928022/2008/0000950134-09-005716/filing.txt b/raw/filings/0000928022/2008/0000950134-09-005716/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..00ac1d48a0509dab5a95b0a19412b0910568216a --- /dev/null +++ b/raw/filings/0000928022/2008/0000950134-09-005716/filing.txt @@ -0,0 +1,5620 @@ +10-K +1 +d66826e10vk.htm +FORM 10-K +e10vk +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF +THE SECURITIES EXCHANGE ACT OF 1934 +FOR THE FISCAL YEAR ENDED DECEMBER 31, 2008 +Commission File Number 001-14039 +CALLON PETROLEUM COMPANY +(Exact name of Registrant as specified in its charter) +Delaware +64-0844345 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer +Identification No.) +200 North Canal Street +Natchez, Mississippi 39120 +(601) 442-1601 +(Address of Principal Executive +Offices)(Zip Code) +(Registrant’s telephone number +including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of exchange on which registered +Common Stock, Par Value $.01 Per Share +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of +the Securities Act. Yes o No þ . +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or +Section 15(d) of the Act. Yes o No þ . +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 þ No o . +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is +not contained herein, and will not be contained, to the best of Registrant’s knowledge, in +definitive proxy or information statements incorporated by reference in Part III of this Form 10-K +or any amendment to this Form 10-K. o +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. (Check one): +Large accelerated filer o +Accelerated filer þ +Non-accelerated filer o +Smaller reporting company o +(Do not check if a smaller reporting company) +Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule +12b-2). Yes o No þ . +The aggregate market value of the voting and non-voting common equity held by nonaffiliates of the +registrant was approximately $557 million as of June 30, 2008 (based on the last reported sale +price of such stock on the New York Stock Exchange on such date of $27.36). +As of March 10, 2009, there were 21,637,470 shares of the Registrant’s Common Stock, par value $.01 +per share, outstanding. +Document incorporated by reference: Portions of the definitive Proxy Statement of Callon Petroleum +Company (to be filed no later than 120 days after December 31, 2008) relating to the Annual Meeting +of Stockholders to be held on April 30, 2009, which are incorporated into Part III of this Form +10-K. +Table of Contents +Page +Item 1 and 2. Business and Properties +3 +Item 1A. Risk Factors +16 +Item 1B. Unresolved Staff Comments +25 +Item 3. Legal Proceedings +26 +Item 4. Submission of Matters to a Vote of Security Holders +26 +Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters +27 +Item 6. Selected Financial Data +28 +Item 7. Management’s Discussion and Analysis of Financial Condition and +Results of Operations +31 +Item 7A. Quantitative and Qualitative Disclosures about Market Risks +44 +Item 8. Financial Statements and Supplementary Data +45 +Item 9. Changes in and Disagreements with Accountants on Accounting +and Financial Disclosure +75 +Item 9.A Controls and Procedures +75 +Item 9.B Other Information +78 +Item 10. Directors and Executive Officers of the Registrant +79 +Item 11. Executive Compensation +79 +Item 12. Security Ownership of Certain Beneficial Owners and Management +and Related Stockholder Matters +79 +Item 13. Certain Relationships and Related Transactions +80 +Item 14. Principal Accountant Fees and Services +80 +Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K +80 +EX-10.25 +EX-23.1 +EX-23.3 +EX-31.1 +EX-31.2 +EX-32.1 +EX-32.2 +2 +Table of Contents +PART I. +ITEM 1 and 2. BUSINESS and PROPERTIES +Overview +Callon Petroleum Company has been engaged in the exploration, development, acquisition and +production of oil and gas properties since 1950. Our properties are geographically concentrated +primarily in the Gulf Coast Region both onshore and offshore. We were incorporated under the laws +of the state of Delaware in 1994 and succeeded to the business of a publicly traded limited +partnership, a joint venture with a consortium of European investors and an independent energy +company owned by a member of current management. As used herein, the “Company,” “Callon,” “we,” +“us,” and “our” refer to Callon Petroleum Company and its predecessors and subsidiaries unless the +context requires otherwise. +In 1989, we began increasing our reserves through the acquisition of producing properties that were +geologically complex, had (or were analogous to fields with) an established production history from +stacked pay zones and were candidates for exploitation. We focused on reducing operating costs and +implementing production enhancements through the application of technologically advanced production +and recompletion techniques. +Over the past 13 years, we have placed emphasis on the acquisition of acreage with exploration and +development drilling opportunities in the Gulf of Mexico shelf and deepwater areas. At December +31, 2008, we owned working interests in a total of 86 blocks/leases covering 193,000 net acres. To +minimize risk we join with industry partners to explore federal offshore blocks acquired in the +Gulf of Mexico. We perform extensive geological and geophysical studies using computer-aided +exploration techniques (CAEX), including, where appropriate, the acquisition of 3-D seismic or +high-resolution 2-D data to facilitate these efforts. We continue to develop prospects on the +shelf through our 3-D seismic partnership using Amplitude versus Offset (“AVO”) technology. We +have approximately 20,000 square miles of 3-D seismic data and have invested in pre-stack time +migration in order to apply AVO de-risking to our prospects. In 1998, we began exploration in the +Gulf of Mexico deepwater area (generally 900 to 5,500 feet of water) and during the fourth quarter +of 2003, our first two deepwater projects, the Medusa and Habanero fields, began production. +Please see “Significant Properties” for a more detailed discussion. +Business Plans for 2009 +The economies of the United States and rest of the world are currently in a recession which is +expected to last through 2009, perhaps longer. This recession has caused prices for oil and gas to +be significantly lower than prevailing prices in the first three quarters of 2008. In addition, +the capital markets are experiencing significant disruptions, and many financial institutions have +liquidity concerns, prompting government intervention to mitigate pressure on the credit markets. +These disruptions are expected to make it increasingly difficult for us to access the capital +markets to finance growth opportunities. +In response to these developments, and the change in forecasted cash flows as a result of the +abandonment of the Entrada project, we plan to modify our focus in 2009. In particular, we plan to +• +reduce our focus on exploration drilling in the Gulf of Mexico; +• +focus on acquisition of domestic, producing properties with development upside and +longer reserve lives; and +• +partner with financial and industry participants to finance our acquisition activities. +3 +Table of Contents +Our leases that are in unevaluated oil and gas properties do not expire for a couple of years which +allows us some flexibility. We are constantly monitoring market conditions and when we see project +economics improve as a result of some combination of increasing commodity prices and/or reductions in service +costs in the Gulf, we will revisit our drilling plans. +The Entrada Project +Entrada is an oil and gas field located in approximately 4,500 feet of water in the Gulf of Mexico. +In 2000, we acquired a 20% interest in the field and drilled two successful exploration wells. In +April 2007, we acquired the 80% working interest in the field that we did not then own. On April +8, 2008, we sold a 50% working interest in the Entrada field to CIECO Energy (US) Limited +(“CIECO”), for a cash payment of $155 million and an agreement to pay an additional $20 million +after the achievement of certain production milestones. We also contributed our 50% share of the +Entrada project to our wholly-owned subsidiary, Callon Entrada Company (“Callon Entrada”). As part +of the purchase, CIECO agreed to loan Callon Entrada the first $150 million of Callon Entrada’s +costs to develop the Entrada project plus up to $12 million of additional loans to pay accrued +interest thereon, which loans were non-recourse to any entity other than Callon Entrada, were not +guaranteed by Callon or any of its other subsidiaries, and were to be repaid solely out of the +proceeds of the sale of production from the Entrada project. +Our order +of magnitude estimate of the total costs to develop the Entrada +project were to be +approximately $300 million, or $150 million net to Callon Entrada’s 50% interest in the project. +Development of the Entrada project included the drilling of two wells, the #3 and #4 wells, and the +construction of sub-sea tie backs to a production platform owned by another oil and gas company on +an adjacent field in the Gulf of Mexico. Estimated costs to complete the project increased by over +50% primarily due to damage and down time caused by two hurricanes in the Gulf of Mexico, +unanticipated additional costs imposed by the Minerals Management +Service (MMS) requiring that we use a mooring system (vertical +load anchors) different from that we intended to use (conventional drag anchors), which mooring +system was ultimately unsuccessful, subsurface mechanical problems and higher fuel costs. In late +November 2008, the #3 well reached its total depth of 21,100 feet. After discussions with CIECO +and a review of the project economics, the decision was made to abandon the project. +Under the terms of its agreements with CIECO, Callon Entrada is responsible for its 50% working +interest share of the costs to plug and abandon the Entrada project, and CIECO is responsible for +its 50% working interest share of plugging and abandonment costs. Total wind down costs to abandon +the project are estimated to be approximately $46 million, or +$23 million net to Callon Entrada. The Entrada leases are scheduled to expire in June 2009 and plugging and +abandonment of the original two wells will be done within 18 months of the lease expiration. +We are in discussions with CIECO with regard to its failure to fund $40 million in loan requests +made in October and November and its share of a settlement payment to terminate a drilling +contract. Because these discussions are in early stages, no assurances can be made regarding the +outcome of these discussions. We do not believe that we have waived any of our rights under our +agreements with CIECO regarding the loan requests or the drilling contract settlement. +Business Strategy +Our goal is to increase shareholder value by increasing our reserves, production, cash flow and +earnings. We seek to achieve these goals through the following strategies: +• +in the current environment, focus on the acquisition of proved developed properties +along with underlying undeveloped properties both onshore and offshore in the Gulf Coast +Region; +• +as commodity prices improve and service costs decline, explore and develop oil and gas +properties; and +• +maintain efficient low operating costs. +4 +Table of Contents +Funding to achieve these goals will come from cash flows from operations, cash on hand and if needed, borrowings +from our senior secured revolving credit facility. +Exploration and Development Activities +In 2008, capital expenditures on an accrual basis for exploration and development costs related to +oil and gas properties totaled approximately $192 million. These expenditures included: +• +$144 million for our Entrada project; +• +$15 million in our deepwater area, which included one development well at our Medusa +Field; +• +$6 million in the Gulf of Mexico shelf and onshore south Louisiana: +• +$4 million for leasehold and seismic costs; +• +$4 million for plugging and abandonment costs; and +• +$7 million for capitalized interest and $12 million for capitalized general and +administration costs allocable directly to exploration and development projects. +Acquisitions and Divestitures +In April 2007, we acquired BP Exploration and Production Company’s (“BP”) 80% working interest in +Entrada Field for a purchase price of $190 million, which included $150 million payable at closing +and an additional $40 million payable after the achievement of certain production milestones. To +strengthen our balance sheet and provide additional liquidity for the development of our Gulf of +Mexico deepwater field Entrada, we completed the sale of certain non-core, non-operated royalty and +mineral interests for $61.5 million in December 2007. +On April 8, 2008, we completed the sale of a 50% working interest in the Entrada Field to CIECO for +a purchase price of $175 million with a cash payment of $155 million at closing and the additional +$20 million payable after the achievement of certain production milestones. See Note 15 - +“Entrada” for more details. +Property Summary +We are engaged in the exploration, development, acquisition and production of oil and gas +properties. Our properties are concentrated both onshore and offshore in the Gulf Coast Region. We +have historically increased our reserves and production by focusing primarily on low to moderate +risk exploration and acquisition opportunities in the Gulf Coast Region. In 1998, we expanded our +area of exploration to include the Gulf of Mexico deepwater area. As of December 31, 2008, our +estimated net proved reserves totaled 54.8 billion cubic feet of natural gas equivalent (“Bcfe”) +and included 6.0 million barrels of oil (“MMBbls”) and 18.7 billion cubic feet of natural gas +(“Bcf”), with a pre-tax present value, discounted at 10%, of the estimated future net revenues +based on constant prices in effect at year-end of $86.6 million. Oil constitutes approximately 66% +on an equivalent basis of our total estimated proved reserves and approximately 76% of our total +estimated proved reserves are proved developed reserves. +The reduction in 2008 reserves as compared to 2007 year-end proved reserves of 263.6 Bcfe was +primarily associated with the sale of a 50% working interest in the Entrada Field as discussed +above and the abandonment of the Entrada project. +5 +Table of Contents +Significant Properties +The following table shows discounted cash flows and net proved oil and gas reserves estimated by +our independent petroleum reserve engineers by major field and for all other properties combined at +December 31, 2008. +Pre-tax +Discounted +Estimated Net Proved Reserves +Present +Oil +Gas +Total +Value +Operator +(MBbls) +(MMcf) +(MMcfe) +($000) +(a)(b)(c) +Gulf of Mexico Deepwater: +Mississippi Canyon 538/582 +“Medusa” +Murphy +4,929 +3,506 +33,078 +$ +52,872 +Garden Banks Block 341 +“Habanero” +Shell +953 +5,041 +10,758 +28,687 +Gulf of Mexico Shelf and Onshore: +West Cameron Block 295 +Mariner Energy +9 +2,195 +2,249 +8,015 +East Cameron 257 +SPN Resources +— +1,401 +1,401 +5,492 +East Cameron Block 109 +Energy Partners LTD +37 +1,286 +1,508 +5,491 +East Cameron 2/LA +Apache +19 +977 +1,095 +4,189 +Other +Various +80 +4,246 +4,727 +(18,155 +) +Total Net Proved Reserves +6,027 +18,652 +54,816 +$ +86,591 +(a) +Represents the present value of future net cash flows before deduction of federal income +taxes, discounted at 10%, attributable to estimated net proved reserves as of December 31, +2008, as set forth in the Company’s reserve reports prepared by its independent petroleum +reserve engineers, Huddleston & Co., Inc. of Houston, Texas. Year-end average pricing was +$6.36 per Mcf for natural gas and $36.80 per Bbl for oil. +(b) +Includes a reduction for estimated plugging and abandonment costs that is reflected as a +liability on our balance sheet at December 31, 2008, in accordance with Statement of Financial +Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”). See +the Oil and Gas Reserve table for the standardized measure of discounted future net cash flow. +The negative Pre-Tax Present Value of the Gulf of Mexico Shelf and Onshore Other reflects +plugging and abandonment obligations, of which most are estimated to occur within the next five years, exceeding the future net cash flows. +(c) +We use the financial measure “Pre Tax Present Value.” This is a non-GAAP financial measure. +We believe that Pre Tax Present Value, while not a financial measure in accordance with +generally accepted accounting principles, is an important financial measure used by investors +and independent oil and gas producers for evaluating the relative value of oil and natural gas +properties and acquisitions because the tax characteristics of comparable companies can differ +materially. The total standardized measure for our proved reserves as of December 31, 2008 was +$86.3 million. The standardized measure gives effect to income taxes, and is calculated in +accordance with Statement of Financial Accounting Standards No. 69, “Disclosures About Oil and +Gas Producing Activities.” The standardized measure of our estimated net proved reserves of +$86.3 million equals the present value of our estimated future net revenue from proved +reserves, excluding income taxes, of $86.6 million, less discounted estimated future income +taxes relating to such future net revenues of $0.3 million. +6 +Table of Contents +Gulf of Mexico Deepwater +Medusa, Mississippi Canyon Blocks 538/582 +Our Medusa deepwater discovery was announced in September 1999, after we drilled the initial test +well in 2,235 feet of water to a total depth of 16,241 feet and encountered over 120 feet of pay in +two intervals. Subsequent sidetrack drilling from the wellbore was used to determine the extent of +the discovery, and a second well was drilled in the first quarter of 2000 to further delineate the +extent of the pay intervals. We own a 15% working interest, Murphy Exploration & Production Company (“Murphy”), the operator, owns +a 60% working interest and ENI Deepwater, LLC, owns the remaining 25% working interest. +In 2001, a drilling program began which included four development wells and one sidetrack. The +program included production casing being set on six wells to provide initial production take-points +and was completed in the first half of 2002. The construction of a floating production system, +spar, at Medusa was completed during the second quarter of 2003. The A-1 well was completed and +tied into the spar and commenced production in late November 2003. The remaining five wells were +completed and commenced production in 2004. Mississippi Canyon 538 #4, North Medusa, was drilled in +2003 and was temporarily abandoned after encountering 28 feet of net pay. The well bore was +re-entered in the fourth quarter of 2004, sidetracked and reached an objective depth of 9,600 feet +in January 2005. The sidetrack encountered 46 feet of net pay, was completed and commenced initial +production in April 2005. In 2007, the Mississippi Canyon 538 #5 was drilled into a previously +untapped fault- separated reservoir and commenced initial production in June 2008. +During 2008 the field produced 3.6 Bcfe net to us which accounted for 31% of our total production. +Future plans include five recompletions to produce up-hole sands and a new well to an undrained +area of the field up-dip or fault separated from existing production. +In December 2003, we transferred our undivided 15% working interest in the spar production +facilities to Medusa Spar LLC (“LLC”) in exchange for cash proceeds of approximately $25 million and a 10% +ownership interest in the LLC. A detailed discussion of this transaction is included in +“Management’s Discussion and Analysis of Financial Condition and Results of Operations-Off-Balance +Sheet Arrangements.” +Habanero, Garden Banks Block 341 +During February 1999, the initial test well on our Habanero deepwater discovery encountered over +200 feet of net pay in two zones. Located in 2,015 feet of water, the well was drilled to a +measured depth of 21,158 feet. We own an 11.25% working interest in the well. The well is operated +by Shell Deepwater Development Inc., which owns a 55% working interest, with the remaining working +interest being owned by Murphy. +A field delineation program began in mid-year 2001, which included three sidetracks of the +discovery well. Production casing was set on this well through the last of the sidetracks to the +Habanero 52 oil and gas sand and the Habanero 55 gas sand. Also, a development well was drilled in +the summer of 2003 which provides a take-point for production from the Habanero 52 oil sand. By +means of a sub-sea completion and tie-back to an existing production facility in the area operated +by Shell, production from the Habanero 52 oil sand commenced in late November 2003 and from the +Habanero 55 gas sand in January 2004. In July 2004, the #2 well producing the Habanero 52 oil sand +developed mechanical difficulties with a subsurface control valve and was shut-in resulting in a +significant loss of production. Repairs were completed and production was restored in late +December 2004. In addition, the #1 well producing the Habanero 55 gas sand was recompleted to the +Habanero 52 oil sand in December 2004. +7 +Table of Contents +At the time the field was developed, there was no way to know what the drive mechanism would be in +the Habanero 52 oil sand, so the wells were drilled in a mid-dip position. It is now known that +the Habanero 52 oil sand has strong water support requiring a well at structural crest for maximum +recovery. A sidetrack of the #1 well was completed in the third quarter of 2007 at a structurally +high position. +Future plans include sidetracks of both the wells to drain updip and partially fault-separated gas +in the Habanero 52 sand. +During 2008, Habanero produced 2.6 Bcfe net to us which accounted for 22% of our total production. +Gulf of Mexico Shelf and Onshore Louisiana +West Cameron Block 295 +During the third quarter of 2005, the #2 well reached a total depth of 15,775 feet and logged 150 +feet of net pay in two zones. Each zone was encountered at the predicted depth and exceeded +anticipated thickness. The #2 well commenced production in the second quarter of 2006 and +encountered mechanical difficulties which were corrected. Sustained production was achieved by the +third quarter of 2006. In 2006, we drilled the #4 well, an offset to the #2 well. The #4 well +commenced production during December 2006 in a deeper, secondary zone. After depletion the well +was recompleted to the primary pay zone and commenced production in December 2007. Callon holds a +20.5% working interest in the block and Mariner is the operator. +A second prospect on this block was also drilled during 2005. The #3 well was drilled to a depth +of 16,286 feet in December 2005 and logged 110 feet of net (94 feet true vertical depth) pay in two +zones. The well was completed in a deeper secondary zone and commenced production in August 2006. +The well ceased production in May 2008. Subsequent diagnostic work determined that both the deeper +secondary zone and the shallower primary zone were drained by the initial completion. There are no +additional plans for the well at this time. Callon holds a 20.5% working interest in the block and +Cimarex Energy Company is the operator. +During 2008, the West Cameron 295 field produced 1.0 Bcfe net to us. +East Cameron 257 +During 2001, an exploratory well was drilled to a vertical depth of 8,300 feet and was temporarily +abandoned. In 2006, the operator made the decision to complete and produce this well. During +2008, the East Cameron 257 field produced 0.5 Bcfe net to us. +East Cameron 109 +During 2006, an exploratory well was drilled to a vertical depth of 13,110 feet and encountered 54 +feet of net pay. The well produced 0.2 Bcfe net to us in 2008. Callon owns a 25% working interest +and Energy Partners, LTD is the operator. +8 +Table of Contents +East Cameron 2/LA +The State Lease 18121 #1 well was drilled to a vertical depth of 14,851 feet and encountered 20 +feet of net pay in August, 2007. First production was in the fourth quarter of 2008 and the well +produced 0.2 Bcfe net to us. Callon owns a 42.5% working interest and Apache is the operator. +Oil and Gas Reserves +The following table sets forth certain information about our estimated proved reserves as reported +by Huddleston & Co., Inc. as of the dates set forth below. +Years Ended December 31, +2008 +2007 +2006 +(In thousands) +Proved developed: +Oil (Bbls) +4,663 +4,723 +5,159 +Gas (Mcf) +13,463 +22,340 +36,750 +Mcfe +41,441 +50,676 +67,704 +Proved undeveloped: +Oil (Bbls) (c) +1,364 +19,808 +8,106 +Gas (Mcf) (c) +5,189 +94,114 +29,287 +Mcfe (c) +13,375 +212,964 +77,924 +Total proved: +Oil (Bbls) (c) +6,027 +24,531 +13,265 +Gas (Mcf) (c) +18,652 +116,454 +66,037 +Mcfe (c) +54,816 +263,640 +145,628 +Estimated pre-tax future net cash flows (a) +$ +113,555 +$ +2,317,905 +$ +775,742 +Pre-tax discounted present value (a) (b) +$ +86,591 +$ +1,591,472 +$ +534,743 +Standardized measure of discounted future +net cash flows (a) (b) +$ +86,305 +$ +1,133,989 +$ +470,791 +(a) +Includes a reduction for estimated plugging and abandonment costs that is reflected as +a liability on our balance sheet at December 31, 2008, in accordance with SFAS 143. +(b) +We use the financial measure “Pre Tax Present Value.” This is a non-GAAP financial +measure. We believe that Pre Tax Present Value, while not a financial measure in accordance +with generally accepted accounting principles, is an important financial measure used by +investors and independent oil and gas producers for evaluating the relative value of oil +and natural gas properties and acquisitions because the tax characteristics of comparable +companies can differ materially. The total standardized measure for our proved reserves as +of December 31, 2008 was $86.3 million. The standardized measure gives effect to income +taxes, and is calculated in accordance with Statement of Financial Accounting Standards No. +69, “Disclosures About Oil and Gas Producing Activities.” The standardized measure of our +estimated net proved reserves of $86.3 million equals the present value of our estimated +future net revenue from proved reserves, excluding income taxes, of $86.6 million, less +discounted estimated future income taxes relating to such future net revenues of $0.3 +million. Year-end average pricing was $6.36 per Mcf for natural gas and $36.80 per Bbl for +oil. +9 +Table of Contents +(c) +The reduction in 2008 reserves as compared to 2007 year-end proved reserves of 263.6 +Bcfe was primarily associated with the sale of a 50% working interest in the Entrada Field +and the abandonment of the Entrada project. +Our independent reserve engineers, Huddleston & Co., Inc., prepared the estimates of the proved +reserves and the future net cash flows and present value thereof attributable to such proved +reserves. Reserves were estimated using oil and gas prices and production and development costs in +effect on December 31 of each such year, without escalation, and were otherwise prepared in +accordance with SEC regulations regarding disclosure of oil and gas reserve information. +There are numerous uncertainties inherent in estimating quantities of proved reserves, including +many factors beyond our control or the control of the reserve engineers. Reserve engineering is a +subjective process of estimating underground accumulations of oil and gas that cannot be measured +in an exact manner. The accuracy of any reserve or cash flow estimate is a function of the quality +of available data and of engineering and geological interpretation and judgment. Estimates by +different engineers often vary, sometimes significantly. In addition, physical factors, such as +the results of drilling, testing and production subsequent to the date of an estimate, as well as +economic factors, such as an increase or decrease in product prices that renders production of such +reserves more or less economic, may justify revision of such estimates. Accordingly, reserve +estimates could be different from the quantities of oil and gas that are ultimately recovered. +We have not filed any reports with other federal agencies which contain an estimate of total proved +net oil and gas reserves during our last fiscal year. +Present Activities and Productive Wells +The following table sets forth the wells we have drilled and completed during the periods +indicated. All such wells were drilled in the continental United States primarily in federal and +state waters in the Gulf of Mexico. +Years Ended December 31, +2008 +2007 +2006 +Gross +Net +Gross +Net +Gross +Net +Development: +Oil +1 +0.15 +1 +0.25 +— +— +Gas +— +— +1 +0.12 +2 +0.37 +Non-productive +1 +0.50 +— +— +— +— +Total +2 +0.65 +2 +0.37 +2 +0.37 +Exploration: +Oil +— +— +— +— +— +— +Gas +— +— +2 +0.63 +5 +2.05 +Non-productive +2 +0.22 +3 +0.47 +8 +2.98 +Total +2 +0.22 +5 +1.10 +13 +5.03 +10 +Table of Contents +The following table sets forth our productive wells as of December 31, 2008: +Wells +Gross +Net +Oil: +Working interest +10.00 +1.56 +Royalty interest +— +— +Total +10.00 +1.56 +Gas: +Working interest +18.00 +7.22 +Royalty interest +6.00 +0.18 +Total +24.00 +7.40 +A well is categorized as an oil well or a natural gas well based upon the ratio of oil to gas +reserves on a thousand cubic feet of natural gas equivalent +(“Mcfe”) basis. However, some of our wells produce both oil and gas. At December 31, +2008, we had no wells with multiple completions. +Leasehold Acreage +The following table shows our approximate developed and undeveloped (gross and net) leasehold +acreage as of December 31, 2008. +Leasehold Acreage +Developed +Undeveloped +Location +Gross +Net +Gross +Net +Louisiana +5,666 +2,107 +4,718 +1,054 +Texas +3,520 +1,760 +4,800 +3,240 +Federal waters +87,990 +36,500 +313,354 +147,870 +Total +97,176 +40,367 +322,872 +152,164 +Major Customers +Our production is sold generally on month-to-month contracts at prevailing prices. The following +table identifies customers to whom we sold a significant percentage of our total oil and gas +production during each of the 12-month periods ended: +December 31, +2008 +2007 +2006 +Shell Trading Company +33 +% +25 +% +41 +% +Louis Dreyfus Energy Services +16 +% +20 +% +25 +% +StatoilHydro +— +13 +% +— +Plains Marketing, L.P. +23 +% +10 +% +11 +% +Because alternative purchasers of oil and gas are readily available, we believe that the loss of +any of these purchasers would not result in a material adverse effect on our ability to market +future oil and gas production. +11 +Table of Contents +Title to Properties +We believe that the title to our oil and gas properties is good and defensible in accordance with +standards generally accepted in the oil and gas industry, subject to such exceptions which, in our +opinion, are not so material as to detract substantially from the use or value of such properties. +Our properties are typically subject, in one degree or another, to one or more of the following: +• +royalties and other burdens and obligations, express or implied, under oil and gas +leases; +• +overriding royalties and other burdens created by us or our predecessors in title; +• +a variety of contractual obligations (including, in some cases, development obligations) +arising under operating agreements, farmout agreements, production sales contracts and +other agreements that may affect the properties or their titles; +• +back-ins and reversionary interests existing under purchase agreements and leasehold +assignments; +• +liens that arise in the normal course of operations, such as those for unpaid taxes, +statutory liens securing obligations to unpaid suppliers and contractors and contractual +liens under operating agreements; +• +pooling, unitization and communitization agreements, declarations and orders; and +• +easements, restrictions, rights-of-way and other matters that commonly affect property. +To the extent that such burdens and obligations affect our rights to production revenues, they have +been taken into account in calculating our net revenue interests and in estimating the size and +value of our reserves. We believe that the burdens and obligations affecting our properties are +conventional in the industry for properties of the kind owned by us. +Corporate Offices +Our headquarters are located in Natchez, Mississippi, in approximately 51,500 square feet of owned +space. We also maintain a leased business office in Houston, Texas, and own or lease field offices +in the area of the major fields in which we operate properties or have a significant interest. +Replacement of any of our leased offices would not result in material expenditures by us as +alternative locations to our leased space are anticipated to be readily available . +Employees +We had 87 employees as of December 31, 2008, none of whom are currently represented by a union. We +believe that we have good relations with our employees. We employ eight petroleum engineers and +eight petroleum geoscientists. +Regulations +General . The oil and gas industry is subject to regulation at the federal, state and local level, +and some of the laws, rules and regulations that govern our operations carry substantial penalties +for non-compliance. This regulatory burden increases our cost of doing business and, consequently, +affects our profitability. +Exploration and Production. Our operations are subject to federal, state and local regulations +that include requirements for permits to drill and to conduct other operations and for provision of +financial assurances (such as bonds) covering drilling and well operations. Other activities +subject to regulation are: +12 +Table of Contents +• +the location of wells, +• +the method of drilling and completing wells, +• +the rate of production, +• +the surface use and restoration of properties upon which wells are drilled, +• +the plugging and abandoning of wells, +• +the discharge of contaminants into water and the emission of contaminants into air, +• +the disposal of fluids used or other wastes obtained in connection with operations, +• +the marketing, transportation and reporting of production, and +• +the valuation and payment of royalties. +For instance, our OCS leases in federal waters are administered by MMS, and require compliance with +detailed MMS regulations and orders. Lessees must obtain MMS approval for exploration plans and +exploitation and production plans prior to the commencement of such operations. The MMS has +promulgated regulations requiring offshore production facilities located on the OCS to meet +stringent engineering and construction specifications. The MMS also has regulations restricting +the flaring or venting of natural gas, and prohibiting the flaring of liquid hydrocarbons and oil +without prior authorization. MMS policies concerning the volume of production that a lessee must +have to maintain an offshore lease beyond its primary term also are applicable to Callon. +Similarly, the MMS has promulgated other regulations governing the plugging and abandonment of +wells located offshore and the installation and removal of all production facilities. To cover the +various obligations of lessees on the OCS, the MMS generally requires that lessees have substantial +net worth or post bonds or other acceptable assurances that such obligations will be met. The cost +of these bonds or other surety can be substantial, and there is no assurance that bonds or other +surety can be obtained in all cases. Under some circumstances, the MMS may require any of our +operations on federal leases to be suspended or terminated. Any such suspension or termination +could materially adversely affect our financial conditions and results of operations. +Our sales of oil and natural gas are affected by the availability, terms and cost of pipeline +transportation. The price and terms for access to pipeline transportation remain subject to +extensive federal regulation. If these regulations change, we could face higher transmission costs +for our production and, possibly, reduced access to transmission capacity. +We do not currently anticipate that compliance with existing laws and regulations governing +exploration and production will have a significantly adverse effect upon our capital expenditures, +earnings or competitive position. +Various proposals and proceedings that might affect the petroleum industry are pending before +Congress, the Federal Energy Regulatory Commission, or FERC, various state legislatures, and the +courts. The industry historically has been heavily regulated and we can offer you no assurance +that the less stringent regulatory approach recently pursued by the FERC and Congress will continue +nor can we predict what effect such proposals or proceedings may have on our operations. +Environmental Regulation. Various federal, state and local laws and regulations concerning the +release of contaminants into the environment, including the discharge of contaminants into water +and the emission of contaminants into the air, the generation, storage, treatment, transportation +and disposal of wastes, and the protection of public health, welfare, and safety, and the +environment, including natural resources, affect our exploration, development and production +operations, including operations of our processing facilities. We must take into account the cost +of complying with environmental regulations in planning, designing, drilling, constructing, +operating and abandoning wells. Regulatory requirements relate to, among other things, the handling +and disposal of drilling and production waste products, the control of water and air +pollution and the removal, investigation, and remediation of petroleum-product contamination. In +addition, our operations may require us to obtain permits for, among other things, +13 +Table of Contents +• +air emissions, +• +discharges into surface waters, and +• +the construction and operations of underground injection wells or surface pits to +dispose of produced saltwater and other nonhazardous oilfield wastes. +In the event of an unauthorized discharge (e.g., to land or water), emission (e.g., to air) or +other activity, we may be liable for, among other things, penalties, costs and damages, and subject +to injunctive relief, and we could be required to cleanup or mitigate the environmental impacts of +those discharges, emissions or activities. Also, under federal, and certain state, laws, the +present and certain past owners and operators of a site, and persons that treated, disposed of or +arranged for the disposal of hazardous substances found at a site, may be liable, without regard to +fault or the legality of the original conduct, for the release of hazardous substances into the +environment. The Environmental Protection Agency, state environmental agencies and, in some cases +third parties are authorized to take actions in response to threats to human health or the +environment and to seek to recover from responsible classes of persons the costs of such actions. +We therefore could be required to remove or remediate previously disposed wastes and remediate +contamination, including contamination in surface water, soil or groundwater, caused by disposal of +that waste, irrespective of whether disposal or release were authorized. We could be responsible +for wastes disposed of or released by us or prior owners or operators at properties owned or leased +by us or at locations where wastes have been taken for disposal also irrespective of whether +disposal or release were authorized. We could also be required to suspend or cease operations in +contaminated areas, or to perform remedial well plugging operations or cleanups to prevent future +contamination. +Federal, and certain state, laws also impose duties and liabilities on certain “responsible +parties” related specifically to the prevention of oil spills and damages resulting from such +spills in or threatening United States waters or adjoining shorelines. A liable “responsible +party” includes the owner or operator of a facility, vessel or pipeline that is a source of an oil +discharge or that poses the substantial threat of discharge or, in the case of offshore facilities, +the lessee or permittee of the area in which a discharging facility is located. These laws assign +liability, which generally is joint and several, without regard to fault, to each liable party for +oil removal costs and a variety of public and private damages. Although defenses and limitations +exist to the liability imposed under these laws, they are limited. In the event of an oil +discharge or substantial threat of discharge, we could be liable for costs and damages. +The Environmental Protection Agency and various state agencies have limited the disposal options +for hazardous and nonhazardous wastes increasing costs of disposal. Furthermore, certain wastes +generated by our oil and natural gas operations that are currently exempt from treatment as +hazardous wastes may in the future be designated as hazardous wastes and, therefore, be subject to +considerably more rigorous and costly operating and disposal requirements. +Federal and state occupational safety and health laws require us to organize information about +hazardous materials used, released or produced in our operations. Certain portions of this +information must be provided to employees, state and local governmental authorities and local +citizens. We are also subject to the requirements and reporting set forth in federal workplace +standards. +More stringent laws and regulations relating to climate change and greenhouse gases (GHGs) may be +adopted in the future and could cause us to incur material expenses in complying with them. The +U.S. Congress last session considered climate change-related legislation to regulate GHG emissions +that could affect our operations and our regulatory costs, as well as the value of oil and natural +gas generally. Although that legislation did not pass, expectations are that Congress will +continue to consider some type +14 +Table of Contents +of climate change legislation and that EPA may consider climate change-related regulatory +initiatives. As a result, there is a great deal of uncertainty as to how and when federal +regulation of GHGs might take place. In addition to possible federal regulation, a number of +states, individually and regionally, also are considering or have implemented GHG regulatory +programs. These potential federal and state initiatives may result in so-called cap-and-trade +programs, under which overall GHG emissions are limited and GHG emissions are then allocated and +sold, and possibly other regulatory requirements, that could result in our incurring material +expenses to comply, e.g., by being required to purchase or to surrender allowances for GHGs +resulting from our operations. These regulatory initiatives also could adversely affect the +marketability of the oil and natural gas we produce. +There are federal and certain state laws that impose restrictions on activities adversely affecting +the habitat of certain plant and animal species. In the event of an unauthorized impact or taking +of a protected species or its habitat, we could be liable for penalties, costs and damages, and +subject to injunctive relief, and we could be required to mitigate those impacts. A critical +habitat or suitable habitat designation also could result in further material restrictions to land +use and may materially delay or prohibit land access for oil and natural gas development. +We have made and will continue to make expenditures to comply with environmental regulations and +requirements. These are necessary business costs in the oil and gas industry. Although we are not +fully insured against all environmental risks, we maintain insurance coverage which we believe is +customary in the industry. Moreover, it is possible that other developments, such as stricter and +more comprehensive environmental laws and regulations, as well as claims for damages to property or +persons resulting from company operations, could result in substantial costs and liabilities, to +Callon. We believe we are in compliance with existing environmental regulations, and that, absent +the occurrence of an extraordinary event the effect of which cannot be predicted, any noncompliance +will not have a material adverse effect on our operations or earnings. +Commitments and Contingencies +The Company’s activities are subject to federal, state and local laws and regulations governing +environmental quality and pollution control. Although no assurances can be made, the Company +believes that, absent the occurrence of an extraordinary event, compliance with existing federal, +state and local laws, rules and regulations governing the release of materials into the environment +or otherwise relating to the protection of the environment will not have a material effect upon the +capital expenditures, earnings or the competitive position of the Company with respect to its +existing assets and operations. The Company cannot predict what effect additional regulation or +legislation, enforcement polices thereunder, and claims for damages to property, employees, other +persons, and the environment resulting from the Company’s operations could have on its activities. +Availability of Reports +All of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form +8-K, and amendments to such reports as well as other filings we make pursuant to Section 13(a) and +15(d) of the Securities Exchange Act of 1934 are available free of charge on our Internet website. +The address of our Internet website is www.callon.com. Our Securities and Exchange Commission +(“SEC”) filings are available on our website as soon as they are posted to the EDGAR database on +the SEC’s website. +15 +Table of Contents +Item 1A. Risk Factors +Risk Factors +If the United States experiences a sustained economic downturn or recession, oil and natural gas +prices may fall or remain at their current depressed price for an extended period of time, which +may adversely affect our results of operations. The unprecedented disruption in the U.S. and +international credit markets has resulted in a rapid deterioration in the worldwide economy and +tightening of the financial markets in the second half of 2008, and the outlook for the economy in +2009 is uncertain. The current global credit and economic environment has reduced worldwide demand +for energy and resulted in significantly lower oil and natural gas prices. A sustained reduction in +the prices we receive for our oil and natural gas production could have a material adverse effect +on our results of operations. For example, for the quarter ending December 31, 2008, a 10% +reduction in the price we received for oil and natural gas would have reduced our revenues by +approximately $1.6 million. The continuation, or worsening, of domestic and global economic +conditions could continue to adversely affect our business and results of operations. +We may not be able to obtain funding on acceptable terms or at all because of the deterioration of +the credit and capital markets. This may hinder or prevent us from meeting our future capital needs +including the need to refinance $200 million in senior notes in 2010. Global financial markets and +economic conditions have been, and continue to be, disrupted and volatile due to a variety of +factors. As a result, the cost of raising money in the debt and equity capital markets has +increased substantially while the availability of funds from those markets has diminished +significantly. As a result of concerns about the stability of financial markets generally and the +solvency of lending counterparties specifically, the cost of obtaining money from the credit +markets generally has increased as many lenders and institutional investors have increased interest +rates, enacted tighter lending standards, refused to refinance existing debt on similar terms or at +all and reduced, or in some cases ceased, to provide funding to borrowers. In addition, lending +counterparties under our existing senior secured revolving credit facility and $200 million in +senior notes may be unwilling or unable to meet their funding obligations. +Due to these factors, we cannot be certain that new debt or equity financing will be available on +acceptable terms. Over the next 18 months, we will be required to refinance our $200 million of +senior notes. If funding is not available when needed, or is available only on unfavorable terms, +we may be unable to meet our obligations as they come due. Moreover, without adequate funding, we +may be unable to execute our growth strategy, take advantage of other business opportunities or +respond to competitive pressures, any of which could have a negative effect on our revenues and +results of operations. +We may be unable to integrate successfully the operations of future acquisitions with our +operations and we may not realize all the anticipated benefits of any future acquisition. We +intend to focus on producing property acquisitions. Integration of corporate acquisitions with our +existing business and operations will be a complex, time consuming and costly process. We cannot +assure you that we will achieve the desired profitability from any acquisitions we may complete in +the future. In addition, failure to assimilate future acquisitions successfully could adversely +affect our financial condition and results of operations. +16 +Table of Contents +Our acquisitions may involve numerous risks, including: +• +operating a larger combined organization and adding operations; +• +difficulties in the assimilation of the assets and operations of the acquired business, +especially if the assets acquired are in a new business segment or geographic area; +• +the risk that oil and natural gas reserves acquired may not be of the anticipated +magnitude or may not be developed as anticipated; +• +the loss of significant key employees from the acquired business: +• +the diversion of management’s attention from other business concerns; +• +the failure to realize expected profitability or growth; +• +the failure to realize expected synergies and cost savings; +• +coordinating geographically disparate organizations, systems and facilities; and +• +coordinating or consolidating corporate and administrative functions. +Further, unexpected costs and challenges may arise whenever businesses with different +operations or management are combined, and we may experience unanticipated delays in realizing the +benefits of an acquisition. If we consummate any future acquisition, our capitalization and +results of operation may change significantly, and you may not have the opportunity to evaluate the +economic, financial and other relevant information that we will consider in evaluating future +acquisitions. +Hedging transactions and receivables expose us to counterparty credit risk. Our hedging +transactions expose us to risk of financial loss if a counterparty fails to perform under a +contract. We use master agreements which allow us, in the event of +default, to elect early termination of all contracts with the defaulting counterparty. If we choose +to elect early termination, all asset and liability positions with the defaulting counterparty +would be net settled at the time of election. We also monitor the creditworthiness of our +counterparty on an ongoing basis. However, the current disruptions occurring in the financial +markets could lead to sudden changes in a counterparty’s liquidity, which could impair their +ability to perform under the terms of the hedging contract. We are unable to predict sudden changes +in a counterparty’s creditworthiness or ability to perform. Even if we do accurately predict sudden +changes, our ability to negate the risk may be limited depending upon market conditions. +During periods of falling commodity prices, such as in late 2008, our hedge receivable positions +increase, which increases our exposure. If the creditworthiness of +our counterparty, which is a +major financial institution, deteriorates and results in its nonperformance, we could incur a +significant loss. +Some of our customers are experiencing, or may experience in the future, severe financial problems +that have had or may have a significant impact on their creditworthiness. We cannot provide +assurance that one or more of our financially distressed customers will not default on their +obligations to us or that such a default or defaults will not have a material adverse effect on our +business, financial position, future results of operations, or future cash flows. Furthermore, the +bankruptcy of one or more of our customers, or some +other similar proceeding or liquidity constraint, might make it unlikely that we would be able to +collect all or a significant portion of amounts owed by the distressed entity or entities. In +addition, such events might force such customers to reduce or curtail their future use of our +products and services, which could have a material adverse effect on our results of operations and +financial condition. +17 +Table of Contents +Continued depressed oil and gas prices may adversely affect our results of operations and financial +condition . Our success is highly dependent on prices for oil and gas, which are extremely volatile. +Oil and gas prices are currently lower than in early 2008. Extended low prices for oil or gas will +have a material adverse effect on us. Oil and gas markets are both seasonal and cyclical. The +prices of oil and gas depend on factors we cannot control such as weather, economic conditions, and +levels of production, actions by OPEC and other countries and government actions. Prices of oil and +gas will affect the following aspects of our business: +• +our revenues, cash flows and earnings; +• +the amount of oil and gas that we are economically able to produce; +• +our ability to attract capital to finance our operations and the cost of the capital; +• +the amount we are allowed to borrow under our senior secured credit facility; +• +the value of our oil and gas properties; and +• +the profit or loss we incur in exploring for and developing our reserves. +Our reserve information represents estimates that may turn out to be incorrect if the assumptions +upon which these estimates are based are inaccurate. Any material inaccuracies in these reserve +estimates or underlying assumptions will materially affect the quantities and present value of our +reserves. The process of estimating oil and gas reserves is complex. It requires interpretations +of available technical data and various assumptions, including assumptions relating to economic +factors. Any significant inaccuracies in these interpretations or assumptions could materially +affect the estimated quantities and present value of reserves shown in this annual report. +In order to prepare these estimates, we must project production rates and the timing of development +expenditures. The assumptions regarding the timing and costs to commence production from our +deepwater wells used in preparing our reserves are often subject to revisions over time as +described under “Our deepwater operations have special operational risks that may negatively affect +the value of those assets.” We must also analyze available geological, geophysical, production and +engineering data, the extent, quality and reliability of which can vary. The process also requires +us to make economic assumptions, such as oil and gas prices, drilling and operating expenses, +capital expenditures, taxes and availability of funds. Therefore, estimates of oil and gas +reserves are inherently imprecise. +Actual future production, oil and gas prices, revenues, taxes, development expenditures, operating +expenses and quantities of recoverable oil and gas reserves most likely will vary from the +estimates. Any significant variance could materially affect the estimated quantities and present +value of reserves shown in this report. In addition, estimates of proved reserves may be adjusted +to reflect production history, results of exploration and development, prevailing oil and gas +prices and other factors, many of which are beyond our control. +Also, under MMS rules governing our deepwater Medusa property and +several of our shallow water, deep natural gas properties and prospects, we are eligible for +royalty suspensions depending on the difference between the average monthly New York Mercantile +Exchange (NYMEX) sales price for oil or gas and price thresholds set by the MMS. As a result, our +reserve estimates may increase or decrease depending upon the relation of price thresholds versus +the average NYMEX prices. +You should not assume that the present value of future net cash flows from our proved reserves +referred to in this report is the current market value of our estimated oil and gas reserves. In +accordance with SEC requirements, we generally base the estimated discounted future net cash flows +from our proved reserves +18 +Table of Contents +on prices and costs on the date of the estimate. Actual future prices and costs may differ +materially from those used in the present value estimate. +The discounted present value of our oil and gas reserves is prepared in accordance with guidelines +established by the SEC. A purchaser of reserves would use numerous other factors to value the +reserves. The discounted present value of reserves, therefore, does not necessarily represent the +fair market value of those reserves. +On December 31, 2008, approximately 26% of the discounted present value of our estimated net proved +reserves was proved undeveloped. Proved undeveloped reserves represented 24% of total proved +reserves. Most of these proved undeveloped reserves were attributable to our deepwater properties. +Development of these properties is subject to additional risks as described below. +Information about reserves constitutes forward-looking information. See “Forward-Looking +Statements” for information regarding forward-looking information. +Unless we are able to replace reserves which we have produced, our cash flows and production will +decrease over time. Our future success depends upon our ability to acquire, find and develop oil +and gas reserves that are economically recoverable. As is generally the case for Gulf of Mexico +properties, our producing properties usually have high initial production rates, followed by a +steep decline in production. As a result, we must continually locate and develop or acquire new oil +and gas reserves to replace those being depleted by production. We must do this even during periods +of low oil and gas prices when it is difficult to raise the capital necessary to finance these +activities. This is particularly so during the present banking and economic crisis coinciding with +periods of high operating costs when it is expensive to contract for drilling rigs and other +equipment and personnel necessary to explore for oil and gas. Without successful exploration or +acquisition activities, our reserves, production and revenues will decline rapidly. We cannot +assure you that we will be able to find and develop or acquire additional reserves at an acceptable +cost. +Also, because of the aggregate short life of our reserves, our return on the investment we make in +our oil and gas wells and the value of our oil and gas wells will depend significantly on prices +prevailing during relatively short production periods. +A significant part of the value of our production and reserves is concentrated in a small number of +offshore properties, and any production problems or inaccuracies in reserve estimates related to +those properties would adversely impact our business. During 2008, approximately 74% of our daily +production came from five of our properties in the Gulf of Mexico. Moreover, one property accounted +for 31% of our production during this period. In addition, at December 31, 2008, most of our proved +reserves were located in two fields in the Gulf of Mexico, with approximately 80% of our total net +proved reserves attributable to these properties. If mechanical problems, storms or other events +curtailed a substantial portion of this production or if the actual reserves associated with any +one of these producing properties are less than our estimated reserves, our results of operations +and financial condition could be adversely affected. +Our exploration projects increases the risks inherent in our oil and gas activities. Part of our +business strategy is to replace reserves through exploration, where the risks are greater than in +acquisitions and development drilling. Although we have been successful in exploration in the past, +we cannot assure you that we will continue to increase reserves through exploration or at an +acceptable cost. Additionally, we are often uncertain as to the future costs and timing of +drilling, completing and +19 +Table of Contents +producing wells. Our drilling operations may be curtailed, delayed or canceled as a result of +a variety of factors, including: +• +unexpected drilling conditions; +• +pressure or inequalities in formations; +• +equipment failures or accidents; +• +adverse weather conditions; +• +governmental requirements; and +• +shortages or delays in the availability of drilling rigs and the delivery of equipment. +We do not operate all of our properties and have limited influence over the operations of some of +these properties, particularly two of our deepwater properties. Our lack of control could result +in the following: +• +the operator may initiate exploration or development at a faster or slower pace than we +prefer; +• +the operator may propose to drill more wells or build more facilities on a project than +we have funds for or that we deem appropriate, which may mean that we are unable to +participate in the project or share in the revenues generated by the project even though we +paid our share of exploration costs; and +• +if an operator refuses to initiate a project, we may be unable to pursue the project. +Any of these events could materially reduce the value of our non-operated properties. +Our deepwater operations have special operational risks that may negatively affect the value of +those assets. Drilling operations in the deepwater area are by their nature more difficult and +costly than drilling operations in shallow water. Deepwater drilling operations require the +application of more advanced drilling technologies involving a higher risk of technological failure +and usually have significantly higher drilling costs than shallow water drilling operations. +Deepwater wells are completed using sub-sea completion techniques that require substantial time and +the use of advanced remote installation equipment. These operations involve a high risk of +mechanical difficulties and equipment failures that could result in significant cost overruns. +In deepwater, the time required to commence production following a discovery is much longer than in +shallow water and on-shore. Deepwater discoveries require the construction of expensive production +facilities and pipelines prior to production. We cannot estimate the costs and timing of the +construction of these facilities with certainty, and the accuracy of our estimates will be affected +by a number of factors beyond our control, including the following: +• +decisions made by the operators of our deepwater wells; +• +the availability of materials necessary to construct the facilities; +• +the proximity of our discoveries to pipelines; +• +the price of oil and natural gas; and +• +regulatory requirements. +Delays and cost overruns in the commencement of production will affect the value of our deepwater +prospects and the discounted present value of reserves attributable to those prospects. +20 +Table of Contents +Competitive industry conditions may negatively affect our ability to conduct operations. We +operate in the highly competitive areas of oil and gas exploration, development and production. We +compete for the purchase of leases in the Gulf of Mexico granted by the U. S. government and from +other oil and gas companies. These leases include exploration prospects as well as properties with +proved reserves. Factors that affect our ability to compete in the marketplace include: +• +our access to the capital necessary to drill wells and acquire properties; +• +our ability to acquire and analyze seismic, geological and other information relating to +a property; +• +our ability to retain the personnel necessary to properly evaluate seismic and other +information relating to a property; +• +the location of, and our ability to access, platforms, pipelines and other facilities +used to produce and transport oil and gas production; +• +the standards we establish for the minimum projected return on an investment of our +capital; and +• +the availability of alternate fuel sources. +Our competitors include major integrated oil companies, substantial independent energy companies, +and affiliates of major interstate and intrastate pipelines and national and local gas gatherers, +many of which possess greater financial, technological and other resources than we do. +Our competitors may use superior technology, which we may be unable to afford or which would +require costly investment by us in order to compete. Our industry is subject to rapid and +significant advancements in technology, including the introduction of new products and services +using new technologies. As our competitors use or develop new technologies, we may be placed at a +competitive disadvantage, and competitive pressures may force us to implement new technologies at a +substantial cost. In addition, our competitors may have greater financial, technical and personnel +resources that allow them to enjoy technological advantages and may in the future allow them to +implement new technologies before we can. We cannot be certain that we will be able to implement +technologies on a timely basis or at a cost that is acceptable to us. One or more of the +technologies that we currently use or that we may implement in the future may become obsolete, and +we may be adversely affected. For example, marine seismic acquisition technology has been +characterized by rapid technological advancements in recent years, and further significant +technological developments could substantially impair our 3-D seismic data’s value. +We may not be able to replace our reserves or generate cash flows if we are unable to raise +capital. We will be required to make substantial capital expenditures to acquire proved producing +properties, develop our existing reserves, and to discover new oil and gas reserves. Historically, +we have financed these expenditures primarily with cash from operations, proceeds from bank +borrowings and proceeds from the sale of debt and equity securities. See “Management’s Discussion +and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” +for a discussion of our capital budget. We cannot assure you that we will be able to raise capital +in the future. We also make offers to acquire oil and gas properties in the ordinary course of our +business. If these offers are accepted, our capital needs may increase substantially. +We expect +to continue using our senior secured revolving credit facility to borrow funds to supplement our +available cash. The amount we may borrow under our senior secured +revolving credit facility may not exceed a +borrowing base determined by the lenders under such facility based on their projections of our +future production, production costs, taxes, commodity prices and any other factors deemed relevant +by our lenders. We cannot control the assumptions the lenders use to calculate our borrowing base. +The lenders may, without our consent, adjust the borrowing base semiannually or in situations where +we purchase or sell assets or issue debt securities. If our +borrowings under the senior secured revolving +credit facility exceed the borrowing base, +the lenders may require that we repay the excess. If this were to occur, we might have to sell +assets or seek financing from other sources. Sales of assets could further reduce the amount of +our borrowing base. +21 +Table of Contents +We cannot assure you that we would be successful in selling assets or arranging substitute +financing. If we were not able to repay borrowings under our senior +secured revolving credit facility to +reduce the outstanding amount to less than the borrowing base, we would be in default under our +senior secured credit facility. For a description of our senior +secured revolving credit facility and its +principal terms and conditions, see “Management’s Discussion and Analysis of Financial Condition +and Results of Operations —Liquidity and Capital Resources” and Notes 7 and 18 to our Consolidated +Financial Statements. +Our decision to drill a prospect is subject to a number of factors, and we may decide to alter our +drilling schedule or not drill at all. A prospect is a property on which we have identified what +our geoscientists believe, based on available seismic and geological information, to be indications +of hydrocarbons. Our prospects are in various stages of evaluation, ranging from a prospect which +is ready to drill to a prospect which will require substantial additional seismic data processing +and interpretation. Whether we ultimately drill a prospect may depend on the following factors: +• +receipt of additional seismic data or the reprocessing of existing data; +• +material changes in oil or gas prices; +• +the costs and availability of drilling rigs; +• +the success or failure of wells drilled in similar formations or which would use the +same production facilities; +• +availability and cost of capital; +• +changes in the estimates of the costs to drill or complete wells; +• +our ability to attract other industry partners to acquire a portion of the working +interest to reduce exposure to costs and drilling risks; and +• +decisions of our joint working interest owners. +We will continue to gather data about our prospects and it is possible that additional information +may cause us to alter our drilling schedule or determine that a prospect should not be pursued at +all. You should understand that our plans regarding our prospects are subject to change. +Weather, unexpected subsurface conditions, and other unforeseen operating hazards may adversely +impact our ability to conduct business. There are many operating hazards in exploring for and +producing oil and gas, including: +• +our drilling operations may encounter unexpected formations or pressures, which could +cause damage to equipment or personal injury; +• +we may experience equipment failures which curtail or stop production; +• +we could experience blowouts or other damages to the productive formations that may +require a well to be re-drilled or other corrective action to be taken; and +• +because of these or other events, we could experience environmental hazards, including +release of oil and gas from spills, gas leaks, and ruptures. +In the event of any of the foregoing, we may be subject to interrupted production or substantial +environmental liability due to injury to persons or loss of life, damage to or destruction of +property, natural resources and equipment, pollution and other environmental damage, investigation +and remediation requirements, and fines and penalties and injunctive relief. Moreover, a +substantial portion of our operations are offshore and are subject to a variety of risks peculiar +to the marine environment such as capsizing, collisions, hurricanes and other adverse weather +conditions, which can result in substantial damage to facilities and interrupt production, as well +as more extensive governmental regulation. +22 +Table of Contents +We cannot assure you that we will be able to maintain adequate insurance at rates we consider +reasonable to cover our possible losses from operating hazards. The occurrence of a significant +event not fully insured or indemnified against could materially and adversely affect our financial +condition and results of operations. +We may not have production to offset hedges; by hedging, we may not benefit from price increases. +Part of our business strategy is to reduce our exposure to the volatility of oil and gas prices by +hedging a portion of our production. In a typical hedge transaction, we will have the right to +receive from the other parties to the hedge the excess of the fixed price specified in the hedge +over a floating price based on a market index, multiplied by the quantity hedged. If the floating +price exceeds the fixed price, we are required to pay the other parties this difference multiplied +by the quantity hedged. We are required to pay the difference between the floating price and the +fixed price when the floating price exceeds the fixed price regardless of whether we have +sufficient production to cover the quantities specified in the hedge. Significant reductions in +production at times when the floating price exceeds the fixed price could require us to make +payments under the hedge agreements even though such payments are not offset by sales of +production. Hedging will also prevent us from receiving the full advantage of increases in oil or +gas prices above the fixed amount specified in the hedge. We also enter into price “collars” to +reduce the risk of changes in oil and gas prices. Under a collar, no payments are due by either +party so long as the market price is above a floor set in the collar and below a ceiling. If the +price falls below the floor, the counter-party to the collar pays the difference to us and if the +price is above the ceiling, we pay the counter-party the difference. Another type of hedging +contract we have entered into is a put contract. Under a put, if the price falls below the set +floor price, the counter-party to the contract pays the difference to us. See “Quantitative and +Qualitative Disclosures About Market Risks” for a discussion of our hedging practices. +Compliance with environmental and other government regulations could be costly and could negatively +impact production. Our operations are subject to numerous laws and regulations governing the +operation and maintenance of our facilities and the discharge of materials into the environment or +otherwise relating to environmental protection. For a discussion of the material regulations +applicable to us, see “Regulations.” These laws and regulations may: +• +require that we acquire permits before commencing drilling; +• +impose operational and other conditions on our activities; +• +restrict the substances that can be released into the environment in connection with +drilling and production activities; +• +limit or prohibit drilling activities on protected areas such as wetlands, wilderness +areas or coral reefs; and +• +require measures to remediate or mitigate pollution and environmental impacts from +current and former operations, such as cleaning up spills or dismantling abandoned +production facilities. +Under these laws and regulations, we could be liable for costs of investigation, removal and +remediation, damages to and loss of use of natural resources, loss of profits or impairment of +earning capacity, property damages, costs of and increased public services, as well as +administrative, civil and criminal fines and penalties, and injunctive relief. We could also be +affected by more stringent laws and regulations adopted in the future, including any related +climate change and greenhouse gases. Under the common law, we could be liable for injuries to +people and property. We maintain limited insurance coverage for sudden and accidental +environmental damages. We do not believe that insurance coverage for environmental damages that +occur over time is available at a reasonable cost. Also, we do not believe that insurance coverage +for the full potential liability that could be caused by sudden and accidental environmental +damages is available at a reasonable cost. Accordingly, we may be subject to liability or we may be +required to cease production from properties in the event of environmental incidents. +23 +Table of Contents +Factors beyond our control affect our ability to market production and our financial results. The +ability to market oil and gas from our wells depends upon numerous factors beyond our control. +These factors include: +• +the extent of domestic production and imports of oil and gas; +• +the proximity of the gas production to gas pipelines; +• +the availability of pipeline capacity; +• +the demand for oil and gas by utilities and other end users; +• +the availability of alternative fuel sources; +• +the effects of inclement weather; +• +state and federal regulation of oil and gas marketing; and +• +federal regulation of gas sold or transported in interstate commerce. +Because of these factors, we may be unable to market all of the oil or gas we produce. In addition, +we may be unable to obtain favorable prices for the oil and gas we produce. +If oil and gas prices decrease further or remain depressed for extended periods of time, we may be +required to take additional writedowns of the carrying value of our oil and gas properties. We may +be required to writedown the carrying value of our oil and gas properties when oil and gas prices +are low or if we have substantial downward adjustments to our estimated net proved reserves, +increases in our estimates of development costs or deterioration in our exploration results. Under +the full-cost method which we use to account for our oil and gas properties, the net capitalized +costs of our oil and gas properties may not exceed the present value, discounted at 10%, of future +net cash flows from estimated net proved reserves, using period end oil and gas prices or prices as +of the date of our auditor’s report, plus the lower of cost or fair market value of our unproved +properties. If net capitalized costs of our oil and gas properties exceed this limit, we must +charge the amount of the excess to earnings. This type of charge will not affect our cash flows, +but will reduce the book value of our stockholders’ equity. We review the carrying value of our +properties quarterly, based on prices in effect as of the end of each quarter or at the time of +reporting our results. Once incurred, a writedown of oil and gas properties is not reversible at a +later date, even if prices increase. See Note 12 to our Consolidated Financial Statements. +There are inherent limitations in all control systems, and misstatements due to error or fraud that +could seriously harm our business may occur and not be detected. Our management, including our +Chief Executive and Financial Officers, do not expect that our internal controls and disclosure +controls will prevent all possible error and all fraud. A control system, no matter how well +conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of +the control system are met. In addition, the design of a control system must reflect the fact that +there are resource constraints and the benefit of controls must be relative to their costs. +Because of the inherent limitations in all control systems, an evaluation of controls can only +provide reasonable assurance that all material control issues and instances of fraud, if any, in +our company have been detected. These inherent limitations include the realities that judgments in +decision-making can be faulty and that breakdowns can occur because of simple error or mistake. +Further, controls can be circumvented by the individual acts of some persons or by collusion of two +or more persons. The design of any system of controls is based in part upon certain assumptions +about the likelihood of future events, and there can be no assurance that any design will succeed +in achieving its stated goals under all potential future conditions. Because of inherent +limitations in a cost-effective control system, misstatements due to error or fraud may occur and +not be detected. A failure of our controls and procedures to detect error or fraud could seriously +harm our business and results of operations. +24 +Table of Contents +Forward-Looking Statements +In this report, we have made many forward-looking statements. We cannot assure you that the plans, +intentions or expectations upon which our forward-looking statements are based will occur. Our +forward-looking statements are subject to risks, uncertainties and assumptions, including those +discussed elsewhere in this report. Forward-looking statements include statements regarding: +• +our oil and gas reserve quantities, and the discounted present value of these +reserves; +• +the amount and nature of our capital expenditures; +• +drilling of wells; +• +the timing and amount of future production and operating costs; +• +business strategies and plans of management; and +• +prospect development and property acquisitions. +Some of the risks, which could affect our future results and could cause results to differ +materially from those expressed in our forward-looking statements, include: +• +the current global economic downturn; +• +general economic conditions or including the availability of credit and access to +existing lines of credit; +• +the volatility of oil and natural gas prices; +• +the uncertainty of estimates of oil and natural gas reserves; +• +the impact of competition; +• +the availability and cost of seismic, drilling and other equipment; +• +operating hazards inherent in the exploration for and production of oil and natural +gas; +• +difficulties encountered during the exploration for and production of oil and +natural gas; +• +difficulties encountered in delivering oil and natural gas to commercial markets; +• +changes in customer demand and producers’ supply; +• +the uncertainty of our ability to attract capital and obtain financing on favorable +terms; +• +compliance with, or the effect of changes in, the extensive governmental +regulations regarding the oil and natural gas business including those related to climate change and greenhouse gases; +• +actions of operators of our oil and gas properties; and +• +weather conditions. +The information contained in this report, including the information set forth under the heading +“Risk Factors,” identifies additional factors that could affect our operating results and +performance. We urge you to carefully consider these factors and the other cautionary statements in +this report. Our forward-looking statements speak only as of the date made, and we have no +obligation to update these forward-looking statements. +Item 1.B. Unresolved Staff Comments +None. +25 +Table of Contents +ITEM 3. LEGAL PROCEEDINGS +We are a defendant in various legal proceedings and claims, which arise in the ordinary course of +our business. We do not believe the ultimate resolution of any such actions will have a material +affect on our financial position or results of operations. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +There were no matters submitted to a vote of security holders during the fourth quarter of 2008. +26 +Table of Contents +PART II. +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS +Our common stock trades on the New York Stock Exchange under the symbol “CPE”. The following table +sets forth the high and low sale prices per share as reported for the periods indicated. +Quarter Ended +High +Low +2007: +First quarter +$ +15.00 +$ +12.54 +Second quarter +15.19 +13.26 +Third quarter +15.68 +11.50 +Fourth quarter +17.21 +13.33 +2008: +First quarter +$ +19.22 +$ +13.42 +Second quarter +28.93 +17.63 +Third quarter +28.00 +16.18 +Fourth quarter +18.06 +1.02 +As of March 10, 2009 there were approximately 3,560 common stockholders of record. +We have never paid dividends on our common stock and intend to retain our cash flow from operations +for the future operation and development of our business. In addition, our primary credit facility +and the terms of our outstanding subordinated debt prohibit the payment of cash dividends on our +common stock. +Equity Compensation Plan Information. The following table summarizes information regarding +the number of shares of our common stock that are available for issuance under all of our existing +equity compensation plans as of December 31, 2008. +Number of securities +remaining available +Number of +Weighted- +for future issuance +securities +average +under equity +to be issued upon +exercise price of +compensation plan +exercise +outstanding +(excluding securities +of outstanding +options, warrants +reflected in column +options +and rights +(a)) +Plan Category +(a) +(b) +(c) +Equity +compensation plans +approved by +security holders +422,792 +$ +10.81 +351,479 +Equity +compensation plans +not approved by +security holders +90,483 +7.73 +42,466 +Total +513,275 +$ +10.27 +393,945 +27 +Table of Contents +Performance Graph +The following graph compares the yearly percentage change for the five years ended December 31, +2008, in the cumulative total shareholder return on the Company’s Common Stock against the +cumulative total return for the (i) Hemscott Industry and Market Index of SIC Group 123 (the +“Hemscott Group Index”) consisting of independent oil and gas drilling and exploration companies +and (ii) the New York Stock Exchange Market Index. The comparison of total return on an investment +for each of the periods assumes that $100 was invested on December 31, 2003 in the Company, the +Hemscott Group Index and the New York Stock Exchange Market Index, and that all dividends were +reinvested. +COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN +AMONG CALLON PETROLEUM COMPANY, +NYSE MARKET INDEX AND HEMSCOTT GROUP INDEX +ASSUMES $100 INVESTED ON DEC. 31, 2003 +ASSUMES DIVIDEND REINVESTED +FISCAL YEAR ENDING DEC. 31, 2008 +2003 +2004 +2005 +2006 +2007 +2008 +Callon Petroleum Company +$ +100 +$ +139 +$ +170 +$ +145 +$ +159 +$ +25 +Hemscott Group Index +$ +100 +$ +141 +$ +222 +$ +263 +$ +413 +$ +185 +NYSE Market Index +$ +100 +$ +113 +$ +122 +$ +143 +$ +151 +$ +95 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth, as of the dates and for the periods indicated, selected financial +information about us. The financial information for each of the five years in the period ended +December 31, 2008 has been derived from our audited Consolidated Financial Statements for such +periods. The information should be read in conjunction with “Management’s Discussion and Analysis +of Financial Condition and Results of Operations” and the Consolidated Financial Statements and +Notes thereto. The following information is not necessarily indicative of our future results. +28 +Table of Contents +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(In thousands, except per share amounts) +Years Ended December 31, +2008 +2007 +2006 +2005 +2004 +Statement of Operations Data: +Operating revenues: +Oil and gas sales +$ +141,312 +$ +170,768 +$ +182,268 +$ +141,290 +$ +119,802 +Operating expenses: +Lease operating expenses +19,208 +27,795 +28,881 +24,377 +22,308 +Depreciation, depletion and +amortization +64,054 +72,762 +65,283 +44,946 +47,453 +General and administrative +9,565 +9,876 +8,591 +8,085 +8,758 +Accretion expense +4,172 +3,985 +4,960 +3,549 +3,400 +Derivative expense +498 +— +150 +6,028 +1,371 +Impairment of oil and gas properties +485,498 +— +— +— +— +Total operating expenses +582,995 +114,418 +107,865 +86,985 +83,290 +Income (loss) from operations +(441,683 +) +56,350 +74,403 +54,305 +36,512 +Other (income) expenses: +Interest expense +26,705 +34,329 +16,480 +16,660 +20,137 +Other (income) +(1,379 +) +(1,172 +) +(1,869 +) +(998 +) +(357 +) +Loss on early extinguishment of debt +11,871 +— +— +— +3,004 +Total other (income) expenses +37,197 +33,157 +14,611 +15,662 +22,784 +Income (loss) before income taxes +(478,880 +) +23,193 +59,792 +38,643 +13,728 +Income tax expense (benefit) +(39,725 +) +8,506 +20,707 +13,209 +(6,697 +) +Income (loss) before equity in earnings of +Medusa Spar LLC +(439,155 +) +14,687 +39,085 +25,434 +20,425 +Equity in earnings of Medusa Spar +LLC, net of tax +262 +507 +1,475 +1,342 +1,076 +Net income (loss) +(438,893 +) +15,194 +40,560 +26,776 +21,501 +Preferred stock dividends +— +— +— +318 +1,272 +Net income (loss) available to common +shares +$ +(438,893 +) +$ +15,194 +$ +40,560 +$ +26,458 +$ +20,229 +Net income (loss) per common share: +Basic +$ +(20.68 +) +$ +0.73 +$ +2.00 +$ +1.43 +$ +1.28 +Diluted +$ +(20.68 +) +$ +0.71 +$ +1.90 +$ +1.28 +$ +1.22 +Shares used in computing net income (loss) +per common share: +Basic +21,222 +20,776 +20,270 +18,453 +15,796 +Diluted +21,222 +21,290 +21,363 +20,883 +17,678 +29 +Table of Contents +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(In thousands, except per share amounts) +Years Ended December 31, +2008 +2007 +2006 +2005 +2004 +Balance Sheet Data (end of period): +Oil and gas properties, net +$ +159,252 +$ +681,706 +$ +547,027 +$ +447,364 +$ +406,690 +Total assets +$ +266,090 +$ +792,482 +$ +625,527 +$ +533,776 +$ +457,523 +Long-term debt, less current portion +$ +272,855 +$ +392,012 +$ +225,521 +$ +188,813 +$ +192,351 +Stockholders’ equity +$ +(129,804 +) +$ +287,075 +$ +281,363 +$ +228,048 +$ +198,312 +We follow the full-cost method of accounting for oil and gas properties. Under this method of +accounting, our net capitalized costs to acquire, explore and develop oil and gas properties may +not exceed the sum of (1) the estimated future net revenues from proved reserves at current prices +discounted at 10% and (2) the lower of cost or market of unevaluated properties, net of tax (the +full-cost ceiling amount). If these capitalized costs exceed the full-cost ceiling amount, the +excess is charged to expense. For the year ended December 31, 2008, the Company recorded a $485.5 +million impairment of oil and gas properties as a result of the ceiling test. See Note 12 to the +Consolidated Financial Statements. +30 +Table of Contents +ITEM 7 . MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND +RESULTS OF OPERATIONS +The following discussion is intended to assist in an understanding of our financial condition and +results of operations. Our consolidated financial statements and notes thereto contain detailed +information that should be referred to in conjunction with the following discussion. See Item 8 +“Financial Statements and Supplementary Data.” +General +We have been engaged in the exploration, development, acquisition and production of oil and gas +properties since 1950. In the past several years, our activities have been focused in the shelf and +deepwater areas of the Gulf of Mexico. Production from wells in this area is characterized by high +initial production rates and steep decline curves. Accordingly, we are required to make material +expenditures to explore for and discover reserves to replace those produced. +Disruptions in Capital Markets. The capital markets are experiencing significant disruptions, +and many financial institutions have liquidity concerns, prompting government intervention to +mitigate pressure on the credit markets. Our primary exposure to the current credit market crisis +includes our senior secured revolving credit facility, senior notes and counterparty nonperformance +risks. +Our senior secured revolving credit facility was committed in the amount of $70 million as of December 31, 2008. Subsequent to December 31, 2008, our +borrowing base redetermination was completed and reduced to $48 million due to lower commodity prices. In addition, a Monthly Commitment Reduction (“MCR”) will be implemented commencing June 1, 2009 in the amount of $4.33 million per month. If not extended, the credit facility matures in September 25, 2012. +Should current credit market tightening be prolonged for several years, future extensions of our +credit facility may contain terms that are less favorable than those of our current credit +facility. The amounts which may be outstanding under our credit facility are limited by a +borrowing base, which is established by our lenders and based on the value of our proved reserves +using prices, costs and other assumptions determined by our lenders. Continued disruptions in the +capital markets could cause our lenders to be more restrictive in calculating our borrowing base. See +Note 18 to the Consolidated Financial Statements. +We have outstanding $200 million of senior notes due 2010. Continued disruptions in the capital +markets could make it more difficult or expensive to refinance those notes when they come due. +Current market conditions also elevate the concern over counterparty risks related to our commodity +derivative contracts and trade credit. At December 31, 2008, our open commodity derivative +instruments were in a net receivable position with a fair value of $21.8 million. We have all of +our commodity derivative instruments with a major financial +institution. Should the +financial counterparty not perform, we may not realize the benefit of some of our derivative +instruments under lower commodity prices and we could incur a loss. +We sell our production to a variety of purchasers. Some of these parties may experience liquidity +problems. Credit enhancements have been obtained from some parties in the way of parental +guarantees or letters of credit; however, we do not have all of our trade credit enhanced through +guarantees or credit support. +Reduced Prices for Oil and Gas Production . The United States and world economies are currently in +a recession which could last through 2009 and perhaps longer. Both oil and gas prices have +undergone significant decline during the second half of 2008 and into 2009 as a result of the +reduced economic activity brought on by the recession. Continued lower commodity prices will reduce +our cash flows from operations. To mitigate the impact of lower commodity prices on our cash flows, +we have entered into crude oil and natural gas commodity contracts for 2009. See Note 8 to our Consolidated Financial +Statements. Depending on the length of the current recession, commodity prices may stay depressed +or decline further, thereby causing a prolonged downturn, which would further reduce our cash flows +from operations. This could cause us to alter our business plans including reducing or delaying +our exploration and development program spending and other cost reduction initiatives. +31 +Table of Contents +Abandonment of the Entrada Project +In late November 2008, we and our joint working interest owner, CIECO, decided to abandon the +Entrada project. Under the terms of our agreements with CIECO, Callon Entrada is responsible for +its share of the costs to plug and abandon the Entrada project, which we estimate to be $46 +million, $23 million net to Callon Entrada. In addition, prior to abandonment of the project, CIECO failed to +fund two loan requests totaling $40 million under our non-recourse credit agreement with them. +CIECO also failed to fund its working interest share of a settlement +payment to terminate a drilling contract +for the Entrada project. Callon has paid its share of the settlement payment. +We continue to discuss with CIECO its failure to fund $40 million in loan requests and its share of +a settlement payment to terminate a drilling contract. Because these discussions are in the early +stages, no assurances can be made regarding the outcome of these discussions. We do not believe +that we have waived any of our rights under the agreements with CIECO regarding the loan requests +or the drilling contract settlement. +The CIECO Non-Recourse Credit Agreement +Principal and interest outstanding under the credit agreement with CIECO is non-recourse to Callon +Entrada and is not guaranteed by Callon Petroleum or any of its subsidiaries. The principal and +interest under the non-recourse credit agreement is secured by a lien on substantially all of +Callon Entrada’s assets. Included in these assets are the Entrada leases and equipment purchased +for the development project. At December 31, 2008 there was no value included on the balance sheet +for these assets. +CIECO has not declared Callon Entrada to be in default under the non-recourse credit agreement. +The lenders under our senior secured revolving credit facility have +amended the Second Amended and Restated Credit Agreement dated +September 25, 2008 to state that a default under the +Callon Entrada non-recourse credit facility will not be a default under their facility. In +addition, this amendment eliminates a possible cross default with regard +to our $200 million senior notes due +2010. Accordingly, we do not believe that a default under the CIECO agreement will have a material +negative impact on our financial position, results of operations and +cash flows. See Note 18 to the Consolidated Financial Statements. +Other Events in 2008 +In addition, the following events impacted our business in 2008: +Asset +Impairments — As required under the full-cost +accounting rules of the SEC, we assessed the recoverability +of our oil and gas properties. Due to the depressed economic environment, coupled with a severe +decrease in commodity prices during the fourth quarter of 2008 and the abandonment of the Entrada +project, we determined that our oil and gas properties were impaired. For 2008, total pre-tax +(non-cash) asset impairment charges were $485.5 million. See Critical Accounting Policies - +Impairment of Proved Oil and Gas Properties and Other Investments, and Impairment of Unproved Oil +and Gas Properties. +Deferred Tax Asset Valuation Allowance — As a result of incurring losses on an aggregate basis for +the three-year period ended December 31, 2008, we established a full valuation allowance in the +amount of $128 million on the tax benefit associated with the federal and state net operating loss +carryforwards as of December 31, 2008. See Critical Accounting Policies — Income Taxes. +Hurricanes Gustav and Ike — In August and September, Hurricanes Gustav and Ike moved through the +Gulf of Mexico. Inspection of our facilities and equipment indicated there was no major damage from +the hurricanes, although damage to third-party processing and pipeline facilities has slowed +reinstatement of production from our Gulf of Mexico assets. Temporary shut-ins of production +reduced volumes on average 12.8 million cubic feet of natural gas equivalent (“MMcfe”) per day +during third quarter 2008 and 18.0 MMcfe per day during fourth quarter 2008. +32 +Table of Contents +2009 OUTLOOK +We expect the mid-point of our 2009 crude oil and gas production to be slightly above our 2008 +results. The expected year-over-year change in production is impacted by several factors including: +• +the amount of development capital expenditures; +• +allocation of capital expenditures to acquire producing properties; and +• +natural field decline in the deepwater Gulf of Mexico and Gulf Coast areas of our US +operations. +Factors potentially impacting our expected production profile include: +• +our reduced level of capital expenditures, as discussed below; +• +potential hurricane-related volume curtailments in the Gulf of Mexico and Gulf Coast +areas as occurred with Hurricanes Gustav and Ike; and +• +the timeliness of restoration of pipeline and facilities after an inclement weather +event necessary to increase our Gulf of Mexico production. +2009 Budget —Due to the uncertain economic and commodity price environment, we have designed a +flexible capital spending program that will be responsive to conditions that develop during +2009. Our preliminary base capital program, including plugging and abandonment, for 2009 is $75 +million, which is relatively flat with 2008 budget, excluding the Entrada project, of $71 +million. However, depending on commodity prices and other economic conditions we experience in +2009, this base capital program may be adjusted up or down. +We expect that the 2009 budget will be funded primarily from cash flows from operations, cash on +hand, and borrowings under our senior secured revolving credit facility and/or other financing. We +will evaluate the level of capital spending throughout the year based on drilling results, +commodity prices, cash flows from operations and property acquisitions and divestitures. +Inflation has not had a material impact on us and is not expected to have a material impact on us +in the future. +Summary of Significant Accounting Policies +Property and Equipment. We follow the full-cost method of accounting for oil and gas properties +whereby all costs incurred in connection with the acquisition, exploration and development of oil +and gas reserves, including certain overhead costs, are capitalized into the “full-cost pool.” The +amounts we capitalize into the full-cost pool are depleted (charged against earnings) using the +unit-of-production method. The full-cost method of accounting for our proved oil and gas +properties requires that we make estimates based on assumptions as to future events that could +change. These estimates are described below. +Depreciation, Depletion and Amortization (DD&A) of Oil and Gas Properties . We calculate depletion +by using the net capitalized costs in our full-cost pool plus estimated future development costs +(combined, the depletable base) and our estimated net proved reserve quantities. Capitalized +costs added to the full-cost pool include the following: +33 +Table of Contents +• +the cost of drilling and equipping productive wells, dry hole costs, acquisition costs +of properties with proved reserves, delay rentals and other costs related to exploration +and development of our oil and gas properties; +• +our payroll and general and administrative costs and costs related to fringe benefits +paid to employees directly engaged in the acquisition, exploration and/or development of +oil and gas properties as well as other directly identifiable general and administrative +costs associated with such activities. Such capitalized costs do not include any costs +related to our production of oil and gas or our general corporate overhead; +• +costs associated with properties that do not have proved reserves classified as +unevaluated property costs and are excluded from the depletable base. These unevaluated +property costs are added to the depletable base at such time as wells are completed on the +properties, the properties are sold or we determine these costs have been impaired. Our +determination that a property has or has not been impaired (which is discussed below) +requires that we make assumptions about future events; +• +estimated costs to dismantle, abandon and restore properties that are capitalized to the +full-cost pool when the related liabilities are incurred under SFAS 143; and +• +our estimates of future costs to develop proved properties are added to the full-cost +pool for purposes of the DD&A computation. We use assumptions based on the latest +geologic, engineering, regulatory and cost data available to us to estimate these amounts. +However, the estimates we make are subjective and may change over time. Our estimates of +future development costs are periodically updated as additional information becomes +available. +Capitalized costs included in the full-cost pool plus estimated future development costs are +depleted and charged against earnings using the unit-of-production method. Under this method, we +estimate the proved reserves quantities at the beginning of each accounting period. For each Mcfe +produced during the period, we record a depletion charge equal to the amount included in the +depletable base (net of accumulated depreciation, depletion and amortization) divided by our +estimated net proved reserve quantities. +Because we use estimates and assumptions to calculate proved reserves (as discussed below) and the +amounts included in the depletable base, our depletion rates may materially change if actual +results differ from these estimates. +Ceiling Test . Under the full-cost accounting rules of the SEC, we review the carrying value of our +proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and gas +properties, net of accumulated depreciation, depletion and amortization and deferred income taxes, +may not exceed the present value of estimated future net cash flows from proved oil and gas +reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of +related tax effects (the full-cost ceiling amount). These rules generally require pricing future oil and gas production at the unescalated market price for +oil and gas at the end of each fiscal quarter and require a write-down if the “ceiling” is +exceeded. However, if prices recover sufficiently subsequent to the balance sheet date before the +release of the financial statements then use of the subsequent pricing is allowed and no write-down +would be required. Given the volatility of oil and gas prices, it is reasonably possible that our +estimate of discounted future net cash flows from proved oil and gas reserves could change in the +near term. If oil and gas prices decline significantly, even if only for a short period of time, +it is possible that write-downs of oil and gas properties could occur in the future. See Note 12 +to our Consolidated Financial Statements. +Estimating Reserves and Present Value of Estimated Future Net Cash Flows . The estimates of +quantities of proved oil and gas reserves and the discounted present value of estimated future net +cash flows from such reserves at the end of each quarter are based on numerous assumptions, which +are likely to change over time. These assumptions include: +34 +Table of Contents +• +the prices at which we can sell our oil and gas production in the future. Oil and gas +prices are volatile, but we are required to assume that they will not change from the +prices in effect at the end of the quarter. In general, higher oil and gas prices will +increase quantities of proved reserves and the present value of estimated future net cash +flows from such reserves, while lower prices will decrease these amounts. Because our +properties have relatively short productive lives, changes in prices will affect the +present value of estimated future net cash flows more than the estimated quantities of oil +and gas reserves; +• +the costs to develop and produce our reserves and the costs to dismantle our production +facilities when reserves are depleted. These costs are likely to change over time, but we +are required to assume that costs in effect at the end of the quarter will not change. +Increases in costs will reduce estimated oil and gas quantities and the present value of +estimated future net cash flows, while decreases in costs will increase such amounts. +Because our properties have relatively short productive lives, changes in costs will affect +the present value of estimated future net cash flows more than the estimated quantities of +oil and gas reserves; and +• +the potential royalties payable to the Mineral Management Service. See Note 10 of our +consolidated financial statements for a more detailed discussion. +In addition, the process of estimating proved oil and gas reserves requires that our independent +and internal reserve engineers exercise judgment based on available geological, geophysical and +technical information. We have described the risks associated with reserve estimation and the +volatility of oil and gas prices under “Risk Factors”. +Sales of oil and gas properties are +accounted for as adjustments to the net full cost pool with no gain or loss recognized, unless the +adjustment would significantly alter the relationship between capitalized costs and proved reserves. +Unproved Properties . Costs associated with properties that do not have proved reserves, including +capitalized interest, are excluded from the depletable base. These unproved properties are +included in the line item “Unevaluated properties excluded from amortization.” Unproved property +costs are transferred to the depletable base when wells are completed on the properties or the +properties are sold. In addition, we are required to determine whether our unproved properties are +impaired and, if so, include the costs of such properties in the depletable base. We determine +whether an unproved property should be impaired by periodically reviewing our exploration program +on a property by property basis. This determination may require the exercise of substantial +judgment by our management. +Asset Retirement Obligations. We account for asset retirement obligations in accordance with +Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” +(“SFAS 143”), which essentially requires entities to record the fair value of a liability for +obligations associated with the retirement of tangible long-lived assets and the associated asset +retirement costs. Interest is accreted on the present value of the asset retirement obligation and +reported as accretion expense within operating expenses in the Consolidated Statements of +Operations. See Note 11 to our Consolidated Financial Statements. +Derivatives. We periodically use derivative financial instruments to manage oil and gas price risk +on a limited amount of our future production and do not use these instruments for trading purposes. +Settlement of derivative contracts are generally based on the difference between the contract +price or prices specified in the derivative instrument and a NYMEX price or other cash or futures +index price. Such derivatives are accounted for under Statement of Financial Accounting Standards +No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended. +Our derivative contracts that are accounted for as cash flow hedges under SFAS 133 are recorded at +fair market value and the changes in fair value are recorded through other comprehensive income +(loss), net of tax, in stockholders’ equity. The cash settlements on these contracts are recorded +as an increase or decrease in oil and gas sales. The changes in fair value related to ineffective +derivative contracts are recognized as +derivative expense (income). The cash settlement on these contracts is also recorded within +derivative expense (income). See Note 8 to our Consolidated Financial Statements. +35 +Table of Contents +Our derivative contracts are carried at fair value on our consolidated balance sheet under the +caption “Fair Market Value of Derivatives”. The oil and gas derivative contracts are settled based +upon reported prices on NYMEX. The estimated fair value of these contracts is based upon closing +exchange prices on NYMEX and in the case of collars and floors, the time value of options. See +Note 9, “Fair Value Measurements” to our Consolidated Financial Statements. +Fair Value Measurements. Effective January 1, 2008, we adopted Statement of Financial Accounting +Standard No. 157, (“SFAS 157”), Fair Value Measurements. SFAS 157 defines fair value, establishes +a framework for measuring fair value and requires enhanced disclosures about fair value +measurements. We also adopted Statement of Financial Accounting Standard No. 159 “The Fair Value +Option for Financial Assets and Liabilities (“SFAS 159”), which permits entities to choose to +measure various financial instruments and certain other items at fair value. See Note 9 to our +Consolidated Financial Statements. +Income Taxes. We account for income taxes in accordance with Statement of Financial Accounting +Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”). Provisions for income taxes include +deferred taxes resulting primarily from temporary differences due to different reporting methods +for oil and gas properties for financial reporting purposes and income tax purposes. SFAS 109 +provides for the recognition of a deferred tax asset for net operating loss carryforwards, +statutory depletion carryforward and tax credit carryforwards, net of a valuation allowance. The +valuation allowance is provided for that portion of the asset for which it is deemed more likely +than not will not be realized. +We adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 “Accounting for +Uncertainty in Income Taxes” (“FIN 48”), effective January 1, 2007. FIN 48 clarifies the +accounting for income taxes by prescribing the minimum recognition threshold a tax position is +required to meet before being recognized in the financial statements. FIN 48 also provides +guidance on derecognition, measurement, classification, interest and penalties, and disclosure. +See Note 5 to our Consolidated Financial Statements. +Share-Based Compensation. Effective January 1, 2006, we adopted Statement of Financial Accounting +Standard No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”) utilizing the modified +prospective transition method. Prior to the adoption of SFAS 123R, we accounted for stock option +grants in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued +to Employees” (the intrinsic value method) and, accordingly, recognized no compensation expense for +stock option grants. +Under the modified prospective transition method, SFAS 123R applies to new awards, unvested awards +as of January 1, 2006 and awards that were outstanding on January 1, 2006 that are subsequently +modified, repurchased or cancelled. Under the modified prospective transition method, compensation +cost recognized in 2006 includes compensation cost for all share-based payments granted prior to, +but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in +accordance with the original provisions of Statement of Financial Accounting Standard No. 123 +“Accounting for Stock-Based Compensation,” (“SFAS 123”) and compensation cost for all share-based +payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in +accordance with the provisions of SFAS 123R. Prior periods were not restated to reflect the impact +of adopting the new standard. SFAS 123R also requires the cash flows from tax benefits resulting +from tax deductions in excess of compensation cost recognized for stock options exercised (excess +tax benefits) to be classified as financing cash flows. As a result of most of our stock-based +compensation being in the form of restricted stock, the impact of the adoption of SFAS 123R on +income +before taxes, net income and basic and diluted earnings per share for the year ended December 31, +2006 was immaterial. See Note 3 to our Consolidated Financial Statements. +36 +Table of Contents +New Accounting Standards +In December 2007, the FASB issued Statement of Financial Accounting Standard No. 141 (R) as +amended, “Business Combinations”, (“SFAS 141R”). The objective of SFAS 141R is to improve the +relevance, representational faithfulness, and comparability of the information that a reporting +entity provides in its financial reports about a business combination and its effects. To +accomplish that, SFAS 141R establishes principles and requirements for how the acquirer (a) +recognizes and measures in its financial statements the identifiable assets acquired, the +liabilities assumed, and any noncontrolling interest in the acquiree, (b) recognizes and measures +the goodwill acquired in the business combination or a gain from a bargain purchase, and (c) +determines what information to disclose to enable users of the financial statements to evaluate the +nature and financial effects of the business combination. SFAS 141R is effective for business +combinations with an acquisition date on or after the beginning of annual reporting period +beginning on or after December 15, 2008. We do not have an acquisition planned at this time and +can not evaluate the impact SFAS 141R will have on future financial +statements. +In December 2007, the FASB issued Statement of Financial Accounting Standard No. 160 as amended, +“Noncontrolling Interest in Consolidated Financial Statement”, (“SFAS 160”). The objective of SFAS +160 is to improve the relevance, comparability, and transparency of the financial information that +a reporting entity provides in its consolidated financial statements by establishing accounting +and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation +of a subsidiary. SFAS 160 is effective for first fiscal year and interim periods within the fiscal +year, beginning on or after December 15, 2008. We do not have a noncontrolling interest in a +subsidiary at this time and can not evaluate the impact SFAS 160 will have on future financial +statements. +In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, “Disclosures +about Derivative Instruments and Hedging Activities” – an amendment of SFAS Statement No. 133 +(“SFAS 161”). SFAS 161 changes the disclosure requirements for derivative instruments and hedging +activities. Under SFAS 161, entities are required to provide enhanced disclosures about (a) how +and why an entity uses derivative instruments, (b) how derivative instruments and related hedged +items are accounted for under Statement 133 and its related interpretations, and (c) how derivative +instruments and related hedged items affect an entity’s financial position, financial performance, +and cash flows. The new disclosure standard is effective for financial statements issued for +fiscal years and interim periods beginning after November 15, 2008, with early application +encouraged. The Statement encourages, but does not require, comparative disclosures for earlier +periods at initial adoption. We are currently evaluating the impact that SFAS 161 will have on its +financial statements. +In +December 2008 the SEC unanimously approved amendments to revise its +oil and gas reserves estimation and disclosure requirements. The +amendments, among other things: +• +allows the use of new technologies to determine proved +reserves; +• +permits the optional disclosure of probable and possible +reserves; +• +modifies the prices used to estimate reserves for SEC disclosure +purposes to a 12-month average price instead of a period-end price; +and +• +requires that if a third party is primarily responsible for +preparing or auditing the reserve estimates, the company make +disclosures relating to the independence and qualifications of the +third party, including filing as an exhibit any report received from +the third party. +The +revised rules are effective January 1, 2010. The new requirements do +not have an impact on our 2008 financial statements. +Liquidity and Capital Resources +Historically, our primary sources of capital have been cash flows from operations, borrowings from +financial institutions and the sale of debt and equity securities. Net cash and cash equivalents +decreased by $36 million during 2008 to $17 million. Cash provided from operating activities +during 2008 totaled $93 million, a decrease of 15% from $109 million in 2007. +On September 25, 2008, we closed on a four-year second amended and restated senior secured +revolving credit facility with Union Bank of California, N.A +as administrative agent and issuing lender. The borrowing base which is +reviewed and redetermined semi-annually was $70 million at December 31, 2008. There were no +borrowings under the credit facility at December 31, 2008; however we had a letter of credit +outstanding in the amount of $15 million to secure payments under a drilling contract for the Ocean +Victory with Diamond Offshore for the +37 +Table of Contents +development of Entrada. +Subsequent to December 31, 2008, we entered into the first amendment of the Second Amended and +Restated Credit Agreement dated September 25, 2008, which states that a default under the Entrada +non-recourse loan would not constitute a default under our senior secured revolving credit +facility. The amendment set the borrowing base at $48 million and implemented a Monthly Commitment +Reduction (MCR) commencing on June 1, 2009 in the amount of $4.33 million per month. The borrowing +base and MCR are both subject to re-determination August 1, 2009 and quarterly thereafter. The amendment is not expected to have a material impact on our financial +condition, operations or cash flows. See Notes 7, 15 and 18 to our Consolidated Financial +Statements. +In April 2008, we entered into a non-recourse credit agreement with CIECO pursuant to which we +could borrow up to $150 million, plus interest expense incurred of up to $12 million, to finance +the development of the Entrada project. This credit facility is secured by the Entrada Field and +related assets. During the year we borrowed $78.4 million under the facility and as of December +31, 2008, CIECO had failed to fund $40 million of loan request which were due in October and +November of 2008. We are in discussions with CIECO with regard to the loan requests. Because +these discussions are in early stages, no assurances can be made regarding the outcome of these +discussions. We do not believe that we have waived any of our rights under our agreements with +CIECO. The Company has not classified any of this facility as current and has not included any +amounts due in the five year maturities as it believes, based on the advice of counsel, that the +Callon Entrada credit agreement does not obligate Callon or any of its subsidiaries (other than +Callon Entrada) to pay principal, accrued interest or other amounts which may be owed under such +credit agreement. +In December 2003 and March 2004, we closed on our 9.75% senior notes due 2010 in the aggregate +principal amount of $200 million. The net proceeds from these notes and the public offering of +3,450,000 shares of common stock in the second quarter of 2004 were used to restructure our debt +that was maturing in 2004 and 2005. See Note 7 to the Consolidated Financial Statements for a more +detailed discussion of long-term debt. +The indenture governing our 9.75% senior notes due 2010 and our senior secured revolving credit +facility contain various covenants including restrictions on additional indebtedness and payment of +cash dividends. In addition, our senior secured revolving credit facility contains covenants for +maintenance of certain financial ratios. We were in compliance with these covenants at December +31, 2008. +Our current planned capital expenditures for 2009, total $65 million and include capitalized +interest and general and administrative expenses. The current portion of our asset retirement +obligation will require an additional $10 million resulting in capital expenditures of $75 million +for 2009. The current capital expenditure plans for 2009 include: +• +the acquisition of proved producing properties in the Gulf Coast Region; +• +lease and seismic acquisition; and +• +capitalized interest and overhead. +We believe that our operating cash flow and our credit facilities will be adequate to meet our +capital, debt repayment, and operating requirements for 2009. We fund our day-to-day operating +expenses and capital expenditures from operating cash flow, supplemented as needed by borrowings +under our credit facilities. +The following table describes our outstanding contractual obligations as of December 31, 2008 (in +thousands): +38 +Table of Contents +Payments due by Period +More +Contractual +Less Than +One-Three +Three-Five +Than-Five +Obligations +Total +One Year +Years +Years +Years +Senior Secured Credit Facility +$ +— +$ +— +$ +— +$ +— +$ +— +9.75% Senior Notes +200,000 +— +200,000 +— +— +Callon Entrada Credit Facility (1) +78,435 +— +— +— +78,435 +Throughput Commitments: +Medusa Oil Pipeline +214 +51 +101 +35 +27 +$ +278,649 +$ +51 +$ +200,101 +$ +35 +$ +78,462 +(1) The Callon Entrada Credit Facility is a direct obligation of Callon Entrada Company, an +indirect, wholly-owned subsidiary of Callon Petroleum. The Callon Entrada Credit Facility is +secured by a lien on the assets of Callon Entrada, which generally are comprised of the Entrada +Field and related equipment. Neither Callon Petroleum nor any other subsidiary of Callon Petroleum +guaranteed or otherwise agreed to pay the principal or interest payments due on the Callon Entrada +Credit Facility, so such facility is effectively non-recourse to Callon Petroleum and its other +subsidiaries. +Off-Balance Sheet Arrangements +We have a 10% ownership interest in Medusa Spar LLC (“LLC”), which is a limited liability company +that owns a 75% undivided ownership interest in the deepwater spar production facilities at our +Medusa Field in the Gulf of Mexico. In December 2003, we contributed a 15% undivided ownership interest in +the production facility to the LLC in return for approximately $25 million in cash and a 10% +ownership interest in the LLC. The LLC earns a tariff based upon production volume throughput from +the Medusa area. We are obligated to process our share of production from the Medusa Field and any +future discoveries in the area through the spar production +facilities. This arrangement allowed us +to defer the cost of the spar production facility over the life of the Medusa Field. Our cash +proceeds were used to reduce the balance outstanding under our senior secured credit facility. The +LLC used the cash proceeds from $83.7 million of non-recourse financing and a cash contribution by +one of the LLC owners to acquire its 75% interest in the spar. In the second quarter at 2008, the +non-recourse financing was extinguished. The balance of Medusa Spar LLC is owned by Oceaneering +International, Inc. and Murphy. We are accounting for our 10% ownership interest in the LLC under +the equity method. +39 +Table of Contents +Results of Operations +The following table sets forth certain operating information with respect to our oil and gas +operations for each of the three years in the period ended December 31, 2008. +December 31, +2008 +2007 +2006 +Production: +Oil (MBbls) +942 +1,063 +1,634 +Gas (MMcf) +5,839 +12,340 +10,977 +Total production (MMcfe) +11,494 +18,718 +20,780 +Average daily production (MMcfe) +31.4 +51.3 +56.9 +Average sales price: +Oil (per Bbl) (a) +$ +88.07 +$ +67.63 +$ +57.33 +Gas (per Mcf) +$ +9.99 +$ +8.01 +$ +8.07 +Total (per Mcfe) +$ +12.29 +$ +9.12 +$ +8.77 +Oil and gas revenues (in thousands): +Oil revenue +$ +82,963 +$ +71,891 +$ +93,665 +Gas revenue +58,349 +98,877 +88,603 +Total +$ +141,312 +$ +170,768 +$ +182,268 +Lease operating expenses (in thousands) +$ +19,208 +$ +27,795 +$ +28,881 +Additional per Mcfe data: +Sales price +$ +12.29 +$ +9.12 +$ +8.77 +Lease operating expenses +1.67 +1.48 +1.39 +Operating margin +$ +10.62 +$ +7.64 +$ +7.38 +Depletion +$ +5.57 +$ +3.89 +$ +3.14 +General and administrative (net of management fees) +$ +.83 +$ +.53 +$ +.41 +(a) Below is a reconciliation of the average NYMEX price to the average realized sales price per +barrel of oil: +Average NYMEX oil price +$ +99.67 +$ +72.33 +$ +66.22 +Basis differential and quality adjustments +(1.15 +) +(4.08 +) +(7.03 +) +Transportation +(1.15 +) +(1.15 +) +(1.25 +) +Hedging +(9.30 +) +0.53 +(0.61 +) +Average realized oil price +$ +88.07 +$ +67.63 +$ +57.33 +Comparison of Results of Operations for the Years Ended December 31, 2008 and 2007 +Oil and Gas Revenues +Total oil and gas revenues decreased 17% from $170.8 million in 2007 to $141.3 million in 2008 +primarily due to lower gas production. Total production on an equivalent basis for 2008 decreased +by 39% versus 2007. +Gas production during 2008 totaled 5.8 Bcf and generated $58.3 million in revenues compared to 12.3 +Bcf and $98.9 million in revenues during the same period in 2007. Average gas prices realized for +2008 were $9.99 per Mcf compared to $8.01 per Mcf during the same period in 2007. The 53% decrease +in 2008 production was primarily due to the sale of our Mobile Bay Field on Blocks 952, 953, and +955, effective May 1, 2007, a lower number of producing wells, downtime resulting from Hurricanes +Gustav and Ike and normal and expected declines in production from our older properties. Three of +our gas wells were shut-in due to early water production, two of which are now scheduled for +plugging and abandonment, and the third was sold for the plugging and abandonment liability. In +addition, our High Island Block A-540 well was shut in during the second quarter of 2008, due to a +plugged flowline, and management has determined it to be uneconomic to repair. +40 +Table of Contents +Oil production during 2008 totaled 942,000 barrels and generated $83.0 million in revenues compared +to 1,063,000 barrels and $71.9 million in revenues for the same period in 2007. Average oil prices +realized in 2008 were $88.07 per barrel compared to $67.63 per barrel in 2007. The 11% decrease in +2008 production was primarily due to downtime resulting from Hurricanes Gustav and Ike and normal +and expected declines in producing wells. In addition, our High Island Block A-540 well was shut +in during the second quarter of +2008, due to a plugged flowline, and management has determined it to be uneconomic to repair. See +the Results of Operations table for a reconciliation of the realized oil prices to average NYMEX. +Lease Operating Expenses +Lease operating expenses for 2008 decreased by 31% to $19.2 million compared to $27.8 million for +the same period in 2007. The decrease was primarily due to the sale of the Mobile Bay Field on +Blocks 952, 953 and 955 effective May 1, 2007, a lower number of producing wells and downtime in +the third and fourth quarters of 2008 caused by Hurricanes Gustav and Ike resulting in lower +throughput charges. Three of our gas wells were shut-in due to early water production, two of +which are now scheduled for plugging and abandonment, and the third was sold for the plugging and +abandonment liability. In addition, our High Island Block A-540 well was shut in during the second +quarter of 2008, due to a plugged flowline, and management has determined it to be uneconomic to +repair. +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization for 2008 and 2007 totaled $64.1 million and $72.8 million, +respectively. The 12% decrease was due to lower production volumes which were partially offset by +a higher depletion rate. The 43% increase in the depletion rate from 2007 to 2008 was higher +Entrada development costs in addition to the abandonment of operations. +Impairment of Oil and Gas Properties +During the fourth quarter of 2008, capitalized costs of oil and gas properties, net of accumulated +amortization and deferred taxes relating to oil and gas properties exceeded the sum of (1) the +estimated future net revenues from proved reserves at current prices discounted at 10% and (2) the +lower of cost or market of unevaluated properties, net of tax effects. As a result, the excess in +the amount of $485.5 million was expensed as an impairment of oil and gas properties for the year +ended December 31, 2008. See Note 12 to the Consolidated Financial Statements. +Accretion Expense +Accretion expense for 2008 and 2007 of $4.2 million and $4.0 million, respectively, represents +accretion of our asset retirement obligations. See Note 11 to the Consolidated Financial +Statements. +General and Administrative +General and administrative expenses for 2008, net of amounts capitalized, were $9.6 million +compared to $9.9 million in 2007, or a 3% decrease. +41 +Table of Contents +Interest Expense +Interest expense decreased to $26.7 million in 2008 compared to $34.3 million in 2007. This +decrease was due to the retirement of the $200 million senior revolving credit facility associated +with the Entrada acquisition. See Notes 7 and 15 to the Consolidated Financial Statement for more +details. +Loss on Early Extinguishment of Debt +Due to the early extinguishment of the $200 million senior revolving credit facility on April 8, +2008, we incurred expenses of $11.9 million consisting of $6.3 million in cash pre-payment +penalties plus a non-cash charge of $5.6 million related to the amortization expense associated +with the deferred financing costs related to the senior revolving credit facility. See Notes 7 and +15 to the Consolidated Financial Statements for more details. +Income Taxes +For 2008, we recorded an income tax benefit of $39.7 million compared to an income tax expense of +$8.5 million in 2007. The income tax benefit in 2008 was primarily the result of expensing the +impairment of oil and gas properties in the amount of $485.5 million. We evaluated our deferred +income tax asset in light of our reserve quantity estimates, our long-term outlook for oil and gas +prices and our expected level of future revenues and expenses and based upon this evaluation, we +believe it is more likely than not, that we will not realize the recorded deferred income tax +asset. As a result, we have established a valuation allowance in the amount of $128 million, the +amount of the deferred income tax asset. See Note 5 to the Consolidated Financial Statements. +Comparison of Results of Operations for the Years Ended December 31, 2007 and 2006 +Oil and Gas Revenues +Total oil and gas revenues decreased 6% from $182.3 million in 2006 to $170.8 million in 2007 +primarily due to lower oil production. Total production on an equivalent basis for 2007 decreased +by 10% versus 2006. +Gas production during 2007 totaled 12.3 Bcf and generated $98.9 million in revenues compared to +11.0 Bcf and $88.6 million in revenues during the same period in 2006. Average gas prices realized +for 2007 were $8.01 per Mcf compared to $8.07 per Mcf during the same period in 2006. The 12% +increase in 2007 production was primarily attributable to new discoveries brought on line. The +increase was partially offset by the sale of the Mobile Bay 952,953,955 Field in the second quarter +of 2007, early water production from East Cameron Block 90, High Island Block 73 and North Padre +Island Block 913 and normal and expected declines in production from our High Island Block 119 and +Mobile Bay area fields and older properties. In addition, remedial work with wireline and coil +tubing was performed to correct mechanical problems on the A-1 well at Medusa in the fourth quarter +of 2006 that resulted in production being restored at a lower rate. +Oil production during 2007 totaled 1,063,000 barrels and generated $71.9 million in revenues +compared to 1,634,000 barrels and $93.7 million in revenues for the same period in 2006. Average +oil prices realized in 2007 were $67.63 per barrel compared to $57.33 per barrel in 2006. The 35% +decrease in production was primarily due to the A-1 well at Medusa having mechanical problems which +required remedial work in +the +42 +Table of Contents +fourth quarter of 2006 and resulted in production being restored at a +lower rate. In addition, the #1 well at Habanero became uneconomic as expected in the third +quarter of 2007 and was sidetracked and completed as planned in an updip location in the reservoir. +Production from the sidetrack well commenced in October 2007. See the Results of Operations table +for a reconciliation of the realized oil prices to average NYMEX. +Lease Operating Expenses +Lease operating expenses for 2007 decreased by 4% to $27.8 million compared to $28.9 million for +the same period in 2006. The decrease was primarily due to the sale of the Mobile Bay 952, 953, +955 Field effective May, 2007, lower throughput charges at Habanero and the shut-in of our South +Marsh Island 261 Field, which is scheduled to be plugged and abandoned. The decrease was partially +offset by additional operating costs associated with or new discoveries. +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization for 2007 and 2006 were $72.8 million and $65.3 million, +respectively. The 11% increase was due to higher depletion rate resulting from higher costs +associated with our exploration and development activities in the Gulf of Mexico. +Accretion Expense +Accretion expense for 2007 and 2006 of $4.0 million and $5.0 million, respectively, represents +accretion of our asset retirement obligations. See Note 11 to the Consolidated Financial +Statements. +General and Administrative +General and administrative expenses for 2007, net of amounts capitalized, were $9.9 million +compared to $8.6 million in 2006. The 15% increase was a result of additions to our technical +staff and higher compensation costs. +Interest Expense +Interest expense increased to $34.3 million in 2007 compared to $16.5 million in 2006. This +increase was due to the new debt associated with the Entrada acquisition. See Notes 7 and 15 to +the Consolidated Financial Statements for more details. +Income Taxes +For 2007, income tax expense was $8.5 million compared to $20.7 million in 2006. The 59% decrease +was primarily due to a decrease in income before income taxes arising mainly out of the reduced oil +production and increased interest expense during the year. +43 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS +Commodity Price Risk +The Company’s revenues are derived from the sale of its crude oil and natural gas production. The +prices for oil and gas remain extremely volatile and sometimes experience large fluctuations as a +result of relatively small changes in supply, weather conditions, economic conditions and +government actions. From time to time, the Company enters into derivative financial instruments to +manage oil and gas price risk. +The Company may utilize fixed price “swaps”, which reduce the Company’s exposure to decreases in +commodity prices and limit the benefit the Company might otherwise have received from any increases +in commodity prices. +The Company may utilize price “collars” to reduce the risk of changes in oil and gas prices. Under +these arrangements, no payments are due by either party as long as the market price is above the +floor price and below the ceiling price set in the collar. If the price falls below the floor, the +counter-party to the collar pays the difference to the Company, and if the price rises above the +ceiling, the counter-party receives the difference from the Company. +Callon may purchase “puts” which reduce the Company’s exposure to decreases in oil and gas prices +while allowing realization of the full benefit from any increases in oil and gas prices. If the +price falls below the floor, the counter-party pays the difference to the Company. +The Company enters into these various agreements from time to time to reduce the effects of +volatile oil and gas prices and does not enter into derivative transactions for speculative +purposes. However, certain of the Company’s derivative positions may not be designated as hedges +for accounting purposes. See Note 8 to the Consolidated Financial Statements for a description of +the Company’s hedged position at December 31, 2008. +Based on projected annual sales volumes for 2009 (excluding incremental production from 2008 +exploratory drilling), a 10% decline in the prices Callon receives for its crude oil and natural +gas production would have an approximate $4.5 million impact on our revenues. +44 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +Report +of Independent Registered Public Accounting Firm +46 +Consolidated Balance Sheets as of December 31, 2008 +and 2007 +47 +Consolidated Statements of Operations for Each of the Three Years +in the Period Ended December 31, 2008 +48 +Consolidated Statements of Stockholders’ Equity +for Each of the Three Years in the Period Ended December 31, +2008 +49 +Consolidated Statements of Cash Flows for Each of the Three Years +in the Period Ended December 31, 2008 +50 +Notes +to Consolidated Financial Statements +51 +45 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited the accompanying consolidated balance sheets of Callon Petroleum Company as of +December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ +equity and cash flows for each of the three years in the period ended December 31, 2008. These +financial statements are the responsibility of the Company’s management. Our responsibility is to +express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting +Oversight Board (United States). Those standards require that we plan and perform the audit to +obtain reasonable assurance about whether the financial statements are free of material +misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and +disclosures in the financial statements. An audit also includes assessing the accounting +principles used and significant estimates made by management, as well as evaluating the overall +financial statement presentation. We believe that our audits provide a reasonable basis for our +opinion. +In our opinion, the financial statements referred to above present fairly, in all material +respects, the consolidated financial position of Callon Petroleum Company as of December 31, 2008 +and 2007, and the consolidated results of its operations and its cash flows for each of the three +years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting +principles. +As discussed in Note 2 to the financial statements, in 2007 the Company changed its method of +accounting for income taxes. +We also have audited, in accordance with the standards of the Public Company Accounting +Oversight Board (United States), Callon Petroleum Company’s internal control over financial +reporting as of December 31, 2008, based on criteria established in Internal Control—Integrated +Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our +report dated March 19, 2009, expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 19, 2009 +46 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(In thousands, except share data) +December +31, +2008 +2007 +ASSETS +Current assets: +Cash and cash equivalents +$ +17,126 +$ +53,250 +Accounts receivable +44,290 +22,073 +Restricted investments +— +100 +Fair market value of derivatives +21,780 +— +Other current assets +1,103 +6,592 +Total current assets +84,299 +82,015 +Oil and gas properties, full-cost accounting method: +Evaluated properties +1,581,698 +1,349,904 +Less accumulated depreciation, depletion and amortization +(1,455,275 +) +(738,374 +) +126,423 +611,530 +Unevaluated properties excluded from amortization +32,829 +70,176 +Total oil and gas properties +159,252 +681,706 +Other property and equipment, net +2,536 +1,986 +Restricted investments +4,759 +4,525 +Investment in Medusa Spar LLC +12,577 +12,673 +Other assets, net +2,667 +9,577 +Total assets +$ +266,090 +$ +792,482 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable and accrued liabilities +$ +76,516 +$ +37,698 +Asset retirement obligations +9,151 +9,810 +Fair market value of derivatives +— +5,205 +Total current liabilities +85,667 +52,713 +9.75% Senior Notes +194,420 +192,012 +Callon Entrada Credit Facility (non-recourse) +78,435 +— +Senior Revolving Credit Facility +— +200,000 +Total long-term debt +272,855 +392,012 +Asset retirement obligations +33,043 +27,027 +Deferred tax liability +— +32,190 +Other long-term liabilities +4,329 +1,465 +Total liabilities +395,894 +505,407 +Stockholders’ equity: +Preferred Stock, $.01 par value; 2,500,000 shares authorized; +— +— +Common Stock, $.01 par value; 30,000,000 shares +authorized; 21,621,142 shares and 20,891,145 shares issued +outstanding at December 31, 2008 and 2007, respectively +216 +209 +Capital in excess of par value +227,803 +223,336 +Other comprehensive income (loss) +14,157 +(3,383 +) +Retained (deficit) earnings +(371,980 +) +66,913 +Total stockholders’ equity +(129,804 +) +287,075 +Total liabilities and stockholders’ equity +$ +266,090 +$ +792,482 +The accompanying notes are an integral part of these financial statements. +47 +Table of Contents +Callon Petroleum Company +Consolidated Statements of Operations +(In thousands, except per share amounts) +Year Ended December 31, +2008 +2007 +2006 +Operating revenues: +Oil sales +$ +82,963 +$ +71,891 +$ +93,665 +Gas sales +58,349 +98,877 +88,603 +Total operating revenues +141,312 +170,768 +182,268 +Operating expenses: +Lease operating expenses +19,208 +27,795 +28,881 +Depreciation, depletion and amortization +64,054 +72,762 +65,283 +General and administrative +9,565 +9,876 +8,591 +Accretion expense +4,172 +3,985 +4,960 +Derivative expense +498 +— +150 +Impairment of oil and gas properties +485,498 +— +— +Total operating expenses +582,995 +114,418 +107,865 +Income (loss) from operations +(441,683 +) +56,350 +74,403 +Other (income) expenses: +Interest expense +26,705 +34,329 +16,480 +Loss on early extinguishment of debt +11,871 +— +— +Other income +(1,379 +) +(1,172 +) +(1,869 +) +Total other (income) expenses +37,197 +33,157 +14,611 +Income (loss) before income taxes +(478,880 +) +23,193 +59,792 +Income tax (benefit) expense +(39,725 +) +8,506 +20,707 +Income (loss) before equity in earnings of Medusa Spar LLC +(439,155 +) +14,687 +39,085 +Equity in earnings of Medusa Spar LLC, net of tax +262 +507 +1,475 +Net income (loss) available to common shares +$ +(438,893 +) +$ +15,194 +$ +40,560 +Net income (loss) per common share: +Basic +$ +(20.68 +) +$ +0.73 +$ +2.00 +Diluted +$ +(20.68 +) +$ +0.71 +$ +1.90 +Shares used in computing net income (loss) per share +amounts: +Basic +21,222 +20,776 +20,270 +Diluted +21,222 +21,290 +21,363 +The accompanying notes are an integral part of these financial statements. +48 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(In thousands) +Unearned +Accumulated +Total +Restricted +Capital in +Other +Retained +Stock- +Preferred +Common +Stock +Excess of +Comprehensive +Earnings +holders’ +Stock +Stock +Compensation +Par Value +Income (Loss) +(Deficit) +Equity +Balances, December 31, 2005 +$ +— +$ +194 +$ +(3,334 +) +$ +220,360 +$ +(331 +) +$ +11,159 +$ +228,048 +Comprehensive income: +Net income +— +— +— +— +— +40,560 +Other comprehensive income +— +— +— +— +8,983 +— +Total comprehensive income +49,543 +Shares issued pursuant to employee +benefit and option plan +— +2 +— +(441 +) +— +— +(439 +) +Tax benefits related to stock +compensation plans +— +— +— +1,356 +— +— +1,356 +Adoption of 123R +3,334 +(3,334 +) +— +— +Restricted stock +— +1 +— +2,854 +— +— +2,855 +Warrants +— +10 +— +(10 +) +— +— +— +Balances, December 31, 2006 +— +207 +— +220,785 +8,652 +51,719 +281,363 +Comprehensive income: +Net income +— +— +— +— +— +15,194 +Other comprehensive loss +— +— +— +— +(12,035 +) +— +Total comprehensive income +3,159 +Tax benefits related to stock +compensation plans +— +— +— +163 +— +— +163 +Restricted stock +— +2 +— +2,388 +— +— +2,390 +Balances, December 31, 2007 +— +209 +— +223,336 +(3,383 +) +66,913 +287,075 +Comprehensive income (loss): +Net loss +— +— +— +— +— +(438,893 +) +Other comprehensive income +— +— +— +— +17,540 +— +Total comprehensive loss +(421,353 +) +Shares issued pursuant to employee +benefit and option plan +— +1 +— +(1,153 +) +— +— +(1,152 +) +Tax benefits related to stock +compensation plans +— +— +— +2,050 +— +— +2,050 +Restricted stock +— +1 +— +3,575 +— +— +3,576 +Warrants +— +5 +— +(5 +) +— +— +— +Balances, December 31, 2008 +$ +— +$ +216 +$ +— +$ +227,803 +$ +14,157 +$ +(371,980 +) +$ +(129,804 +) +The accompanying notes are an integral part of these financial statements. +49 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In thousands) +Years Ended December 31, +2008 +2007 +2006 +Cash flows from operating activities: +Net income (loss) +$ +(438,893 +) +$ +15,194 +$ +40,560 +Adjustments to reconcile net income (loss) to +cash provided by operating activities: +Depreciation, depletion and amortization +64,862 +73,677 +65,929 +Impairment of oil and gas properties +485,498 +— +— +Accretion expense +4,172 +3,985 +4,960 +Amortization of deferred financing costs +4,185 +3,009 +2,221 +Non-cash loss on early extinguishment of debt +5,598 +— +— +Equity in earnings of Medusa Spar, LLC +(262 +) +(507 +) +(1,475 +) +Non-cash derivative expense +— +— +150 +Deferred income tax (benefit) expense +(39,725 +) +8,506 +20,707 +Non-cash charge related to compensation plans +1,550 +849 +1,420 +Excess tax benefits from share-based payment arrangements +(2,050 +) +(163 +) +(1,449 +) +Changes in current assets and liabilities: +Accounts receivable +(22,215 +) +6,658 +(2,107 +) +Other current assets +5,489 +(619 +) +(3,975 +) +Current liabilities +22,987 +(2,057 +) +11,311 +Change in gas balancing receivable +630 +(938 +) +(311 +) +Change in gas balancing payable +156 +889 +133 +Change in other long-term liabilities +2,708 +(10 +) +(2 +) +Change in other assets, net +(1,458 +) +810 +(2,588 +) +Cash provided by operating activities +93,232 +109,283 +135,484 +Cash flows from investing activities: +Capital expenditures +(176,536 +) +(127,409 +) +(167,979 +) +Entrada acquisition +— +(150,000 +) +— +Proceeds from sale of mineral interests +167,349 +60,931 +— +Distribution from Medusa Spar, LLC +498 +687 +1,078 +Cash used by investing activities +(8,689 +) +(215,791 +) +(166,901 +) +Cash flows from financing activities: +Change in accrued liabilities to be refinanced +— +— +(5,000 +) +Increases in debt +94,435 +229,000 +88,000 +Payments on debt +(216,000 +) +(64,000 +) +(53,000 +) +Deferred financing costs +— +(6,429 +) +— +Equity issued related to employee stock plans +(1,152 +) +— +(438 +) +Excess tax benefits from share-based payment arrangements +2,050 +163 +1,449 +Capital leases +— +(872 +) +(263 +) +Cash (used) provided by financing activities +(120,667 +) +157,862 +30,748 +Net (decrease) increase in cash and cash equivalents +(36,124 +) +51,354 +(669 +) +Cash and cash equivalents: +Balance, beginning of period +53,250 +1,896 +2,565 +Balance, end of period +$ +17,126 +$ +53,250 +$ +1,896 +The accompanying notes are an integral part of these financial statements. +50 +Table of Contents +CALLON PETROLEUM COMPANY +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +General +Callon Petroleum Company (“the Company” or “Callon”) was organized under the laws of the state of +Delaware in March 1994 to serve as the surviving entity in the consolidation and combination of +several related entities (referred to herein collectively as the “Constituent Entities”). The +combination of the businesses and properties of the Constituent Entities with the Company was +completed on September 16, 1994 (“Consolidation”). +As a result of the Consolidation, all of the businesses and properties of the Constituent Entities +are owned (directly or indirectly) by the Company. Certain registration rights were granted to the +stockholders of certain of the Constituent Entities. See Note 10. +The Company and its predecessors have been engaged in the acquisition, development and exploration +of crude oil and natural gas since 1950. The Company’s properties are geographically concentrated +in the Gulf Coast Region. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Principles of Consolidation and Reporting +The Consolidated Financial Statements include the accounts of the Company, and its subsidiary, +Callon Petroleum Operating Company (“CPOC”). CPOC also has subsidiaries, namely Callon Offshore +Production, Inc., Callon Entrada Company (“Callon Entrada”) and Mississippi Marketing, Inc. All intercompany accounts +and transactions have been eliminated. Certain prior year amounts have been reclassified to +conform to presentation in the current year. +Use of Estimates +The preparation of financial statements in conformity with U.S. generally accepted accounting +principles requires management to make estimates and assumptions that affect the reported amounts +of assets and liabilities and disclosure of contingent assets and liabilities at the date of the +financial statements and the reported amounts of revenues and expenses during the reporting period. +Actual results could differ from those estimates. +Asset Retirement Obligations +The Company accounts for asset retirement obligations in accordance with Statement of Financial +Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”), which +essentially requires entities to record the fair value of a liability for obligations associated +with the retirement of tangible long-lived assets and the associated asset retirement costs. +Interest is accreted on the present value of the asset retirement obligation and reported as +accretion expense within operating expenses in the consolidated statements of operations. See Note +11. +51 +Table of Contents +Oil and Gas Properties +The Company follows the full-cost method of accounting for oil and gas properties whereby all costs +incurred in connection with the acquisition, exploration and development of oil and gas reserves, +including certain overhead costs, are capitalized. Such amounts include the cost of drilling and +equipping productive wells, dry hole costs, lease acquisition costs, delay rentals, interest +capitalized on unevaluated leases, other costs related to exploration and development activities, +and site restoration, dismantlement and abandonment costs capitalized under SFAS 143. General and +administrative costs capitalized include salaries and related fringe benefits paid to employees +directly engaged in the acquisition, exploration and/or development of oil and gas properties as +well as other directly identifiable general and administrative costs associated with such +activities. Such capitalized costs ($12.6 million in 2008, $10.8 million in 2007 and $9.6 million +in 2006) do not include any costs related to production or general corporate overhead. Costs +associated with unevaluated properties, including capitalized interest on such costs, are excluded +from amortization. Unevaluated property costs are transferred to evaluated property costs at such +time as wells are completed on the properties or management determines that these costs have been +impaired. +Costs of oil and gas properties, including future development costs, which have proved reserves and +properties which have been determined to be worthless, are depleted using the unit-of-production +method based on proved reserves. If the total capitalized costs of oil and gas properties, net of +accumulated amortization and deferred taxes relating to oil and gas properties, exceed the sum of +(1) the estimated future net revenues from proved reserves at current prices discounted at 10% and +(2) the lower of cost or market of unevaluated properties, net of tax effects (the full-cost +ceiling amount), then such excess is charged to expense during the period in which the excess +occurs. See Note 12. +Upon the acquisition or discovery of oil and gas properties, management estimates the future net +costs to be incurred to dismantle, abandon and restore the property using available geological, +engineering and regulatory data. Such cost estimates are periodically updated for changes in +conditions and requirements. In accordance with SFAS 143, such costs are capitalized to the +full-cost pool when the related liabilities are incurred. In accordance with SEC Staff Accounting +Bulletin No. 106, assets recorded in connection with the recognition of an asset retirement +obligation pursuant to SFAS 143 are included as part of the costs subject to the full-cost ceiling +limitation. The future cash outflows associated with settling the recorded asset retirement +obligations are excluded from the computation of the present value of estimated future net revenues +used in determining the full-cost ceiling amount. +Sales of oil and gas properties are +accounted for as adjustments to the net full cost pool with no gain or loss recognized, unless the +adjustment would significantly alter the relationship between capitalized costs and proved reserves. +Property and Equipment +Depreciation of other property and equipment is provided using the straight-line method over +estimated lives of three to 20 years. Depreciation expense of $437,000, $457,000 and $351,000 +relating to other property and equipment was included in general and administrative expenses in the +Company’s consolidated statements of operations for the years ended December 31, 2008, 2007 and +2006, respectively. The accumulated depreciation on other property and equipment was $11.6 million +and $11.2 million as of December 31, 2008 and 2007, respectively. +52 +Table of Contents +Investment in Medusa Spar LLC +The Company has a 10% ownership interest in Medusa Spar, LLC (“LLC”), which is a limited liability +company that owns a 75% undivided ownership interest in the deepwater spar production facilities on +Callon’s Medusa Field in the Gulf of Mexico. In December 2003, the Company contributed a 15% +undivided ownership interest in the production facility to the LLC in return for approximately $25 +million in cash and a 10% ownership interest in the LLC. The LLC earns a tariff based upon +production volume throughput from the Medusa area. Callon is obligated to process its share of +production from the Medusa Field and any future discoveries in the area through the spar production +facilities. This arrangement allowed Callon to defer the cost of the spar production facility over +the life of the Medusa Field. The Company’s cash proceeds were used to reduce the balance +outstanding under its senior secured credit facility. The LLC used the cash proceeds from $83.7 +million of non-recourse financing and a cash contribution by one of the LLC owners to acquire its +75% interest in the spar. During the second quarter of 2008, the non-recourse financing was +extinguished. The balance of Medusa Spar LLC is owned by Oceaneering International, Inc. +(NYSE:OII) and Murphy Oil Corporation (NYSE:MUR). The Company is accounting for its 10% ownership +interest in the LLC under the equity method. +Natural Gas Imbalances +The Company follows the entitlement method of accounting for its proportionate share of gas +production on a well-by-well basis, recording a receivable to the extent that a well is in an +“undertake” position and recording a liability to the extent that a well is in an “overtake” +position. Gas balancing receivables were $1.0 million and $1.7 million as of December 31, 2008 and +2007, respectively. Gas balancing payables were $1.5 million and $1.3 million as of December 31, +2008 and 2007, respectively. +Derivatives +The Company periodically uses derivative financial instruments to manage oil and gas price risk on +a limited amount of its future production and does not use these instruments for trading purposes. +Settlement of derivative contracts is generally based on the difference between the contract price +or prices specified in the derivative instrument and a New York +Mercantile Exchange (NYMEX) price or other cash or futures index +price. Such derivatives are accounted for under Statement of Financial Accounting Standards No. +133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended. +The Company’s derivative contracts that are accounted for as cash flow hedges under SFAS 133 are +recorded at fair market value and the changes in fair value are recorded through other +comprehensive income (loss), net of tax, in stockholders’ equity. The cash settlements on these +contracts are recorded as an increase or decrease in oil and gas sales. The changes in fair value +related to ineffective derivative contracts are recognized as derivative expense (income). The +cash settlement on these contracts is also recorded within derivative expense (income). See Note +8. +Callon’s derivative contracts are carried at fair value on the Company’s consolidated balance sheet +under the caption “Fair Market Value of Derivatives”. The oil and gas derivative contracts are +settled based upon reported prices on NYMEX. The estimated fair value of these contracts is based +upon closing exchange prices on NYMEX and in the case of collars and floors, the time value of +options. See Note 9, “Fair Value Measurements.” +53 +Table of Contents +Income Taxes +The Company accounts for income taxes in accordance with Statement of Financial Accounting +Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”). Provisions for income taxes include +deferred taxes resulting primarily from temporary differences due to different reporting methods +for oil and gas properties for financial reporting purposes and income tax purposes. SFAS 109 +provides for the recognition of a deferred tax asset for net operating loss carryforwards, +statutory depletion carryforward and tax credit carryforwards, net of a valuation allowance. The +valuation allowance is provided for that portion of the asset for which it is deemed more likely +than not will not be realized. +Callon adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 “Accounting for +Uncertainty in Income Taxes” (“FIN 48”), effective January 1, 2007. FIN 48 clarifies the +accounting for income taxes by prescribing the minimum recognition threshold a tax position is +required to meet before being recognized in the financial statements. FIN 48 also provides +guidance on derecognition, measurement, classification, interest and penalties, and disclosure. +See Note 5. +Earnings per Share +The Company accounts for earnings per share (“EPS”) in accordance with Statement of Financial +Accounting Standards No. 128, “Earnings Per Share” (“SFAS 128”). SFAS 128 requires all entities +with publicly held common stock or potential common stock must disclose EPS — basic and diluted. +Basic EPS is computed by dividing reported earnings available to common stockholders by weighted +average shares outstanding. Diluted EPS reflects the potential dilution that could occur if +securities or other contracts to issue common stock were exercised or converted into common stock +or resulted in the issuance of common stock that then shared in the earnings of the entity. The +earnings component of EPS is limited to earnings applicable to common shares or earnings after +deduction of preferred stock dividends if incurred. If discontinued operations, extraordinary +items, and /or the cumulative effect of a change in accounting principles are reported, EPS +information is required for each of the following: (a) income from continuing operations, (b) +income before extraordinary items, (c) the cumulative effect of the change in accounting principle, +net of tax, and (d) net income. See note 4. +Stock-Based Compensation +Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standard No. 123 +(revised 2004), “Share-Based Payment,” (“SFAS 123R”) utilizing the modified prospective transition +method. Prior to the adoption of SFAS 123R, the Company accounted for stock option grants in +accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to +Employees” (the intrinsic value method) and, accordingly, recognized no compensation expense for +stock option grants. +Under the modified prospective transition method, SFAS 123R applies to new awards, unvested awards +as of January 1, 2006 and awards that were outstanding on January 1, 2006 that are subsequently +modified, repurchased or cancelled. Under the modified prospective transition method, compensation +cost recognized in 2008, 2007 and 2006 includes compensation cost for all share-based payments +granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value +estimated in accordance with the original provisions of Statement of Financial Accounting Standard +No. 123 “Accounting for Stock-Based Compensation,” (“SFAS 123”) and compensation cost for all +share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value +estimated in accordance with the provisions of SFAS 123R. Prior periods were not restated to +reflect the impact of adopting the new standard. +SFAS 123R requires the cash flows from tax benefits resulting from tax deductions in excess of +compensation cost recognized for stock options exercised (excess tax benefits) to be classified as +financing cash flows. The +$2.1 million, $163,000 and $1.4 million of excess tax benefits classified as a financing cash +inflow for the years ended December 31, 2008, 2007 and 2006, respectively would have been +classified as an operating cash +54 +Table of Contents +flow had the Company not adopted SFAS 123R. There were no stock +option exercises in the year ended December 31, 2007 and no cash proceeds from the exercise of +stock options for the years ended December 31, 2008 and 2006 due to the fact that all options were +exercised through net-share settlements. As a result of most of the Company’s stock-based +compensation being in the form of restricted stock, the impact of the adoption of SFAS 123R on +income before taxes, net income and basic and diluted earnings per share for the year ended +December 31, 2006 was not significant. See Note 3. +Accounts Receivable +Accounts receivable consists primarily of accrued oil and gas production receivables. The balance +in the reserve for doubtful accounts netted within accounts receivable was $65,000 at both December +31, 2008 and 2007. There were no provisions to expense in the three-year period ended December 31, +2008. +Major Customers +The Company’s production is generally sold on month-to-month contracts at prevailing prices. The +following table identifies customers to whom it sold a significant percentage of its total oil and +gas production during each of the years ended: +December 31, +2008 +2007 +2006 +Shell Trading Company +33 +% +25 +% +41 +% +Louis Dreyfus Energy Services +16 +% +20 +% +25 +% +StatoilHydro +— +13 +% +— +Plains Marketing, L.P. +23 +% +10 +% +11 +% +Because alternative purchasers of oil and gas are readily available, the Company believes that the +loss of any of these purchasers would not result in a material adverse effect on its ability to +market future oil and gas production. +Statements of Cash Flows +The Company considers all highly liquid investments with an original maturity of three months or +less to be cash equivalents. +The Company paid no federal income taxes for the three years in the period ended December 31, 2008. +During the years ended December 31, 2008, 2007 and 2006, the Company made cash payments for +interest of $27.0 million, $37.6 million and $20.5 million, respectively. +Fair Value of Financial Instruments +Fair value of cash and cash equivalents, accounts receivable and accounts payable, approximated +book value at December 31, 2008 and 2007. The fair value of the senior revolving credit facility +approximated book value at December 31, 2008. The senior secured +revolving credit facility and capital lease +had no balance outstanding at December 31, 2008 and the fair value approximated book value at +December 31, 2008. The Company’s 9.75% Senior Notes due 2010 had an estimated fair market value of +52% and 94% of face value at December 31, 2008 and 2007, respectively. +55 +Table of Contents +Fair Value Measurements +Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standard No. 157, +(“SFAS 157”), Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for +measuring fair value and requires enhanced disclosures about fair value measurements. The adoption +of SFAS 157 did not have a significant impact on the Company’s financial statements. The Company +also adopted Statement of Financial Accounting Standard No. 159 “The Fair Value Option for +Financial Assets and Liabilities (“SFAS 159”) on January 1, 2008, which permits entities to choose +to measure various financial instruments and certain other items at fair value. The Adoption of +SFAS 159 did not have an impact on the Company’s financial statements. See Note 9. +Accounting Pronouncements +In December 2007, the FASB issued Statement of Financial Accounting Standard No. 141 (R) as +amended, “Business Combinations”, (“SFAS 141R”). The objective of SFAS 141R is to improve the +relevance, representational faithfulness, and comparability of the information that a reporting +entity provides in its financial reports about a business combination and its effects. To +accomplish that, SFAS 141R establishes principles and requirements for how the acquirer (a) +recognizes and measures in its financial statements the identifiable assets acquired, the +liabilities assumed, and any noncontrolling interest in the acquiree, (b) recognizes and measures +the goodwill acquired in the business combination or a gain from a bargain purchase, and (c) +determines what information to disclose to enable users of the financial statements to evaluate the +nature and financial effects of the business combination. SFAS 141R is effective for business +combinations with an acquisition date on or after the beginning of annual reporting period +beginning on or after December 15, 2008. The Company does not have an acquisition planned at this +time and can not evaluate the impact SFAS 141R will have on future +financial statements. +In December 2007, the FASB issued Statement of Financial Accounting Standard No. 160 as amended, +“Noncontrolling Interest in Consolidated Financial Statement”, (“SFAS 160”). The objective of SFAS +160 is to improve the relevance, comparability, and transparency of the financial information that +a reporting entitiy provides in its consolidated financial statements by establishing accounting +and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation +of a subsidiary. SFAS 160 is effective for first fiscal year and interim periods within the fiscal +year, beginning on or after December 15, 2008. The Company doe not have a noncontrolling interest +in a subsidiary at this time and can not evaluate the impact SFAS 160 will have on future financial +statements. +In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, “Disclosures +about Derivative Instruments and Hedging Activities” — an amendment of SFAS Statement No. 133 +(“SFAS 161”). SFAS 161 changes the disclosure requirements for derivative instruments and hedging +activities. Under SFAS 161, entities are required to provide enhanced disclosures about (a) how +and why an entity uses derivative instruments, (b) how derivative instruments and related hedged +items are accounted for under Statement 133 and its related interpretations, and (c) how derivative +instruments and related hedged items affect an entity’s financial position, financial performance, +and cash flows. The new disclosure standard is effective for financial statements issued for +fiscal years and interim periods beginning after November 15, 2008, with early application +encouraged. The Statement encourages, but does not require, comparative disclosures for earlier +periods at initial adoption. Callon is currently evaluating the impact that SFAS 161 will have on +its financial statements. +In +December 2008 the SEC unanimously approved amendments to revise its +oil and gas reserves estimation and disclosure requirements. The +amendments, among other things: +• +allows the use of new technologies to determine proved +reserves; +• +permits the optional disclosure of probable and possible +reserves; +• +modifies the prices used to estimate reserves for SEC disclosure +purposes to a 12-month average price instead of a period-end price; +and +• +requires that if a third party is primarily responsible for +preparing or auditing the reserve estimates, the company make +disclosures relating to the independence and qualifications of the +third party, including filing as an exhibit any report received from +the third party. +The revised rules are effective January 1, 2010. The new requirements do +not have an impact on the Company’s 2008 financial statements. +3. STOCK-BASED COMPENSATION +The Company has various stock plans (“Plans”) under which employees of the Company and its +subsidiaries and non-employee members of the Board of Directors of the Company have been or may be +granted certain stock-based compensation. For further discussion of the Plans, refer to Note 13. +56 +Table of Contents +For the year ended December 31, 2008, the Company recorded stock-based compensation expense of $4.5 +million, of which $2.5 million was included in general and administrative expenses and $2.0 million +was capitalized to oil and gas properties. For the year ended December 31, 2007, the Company +recorded stock-based compensation expense of $2.9 million, of which $1.4 million was included in +general and administrative expenses and $1.5 million was capitalized to oil and gas properties. +For the year ended December 31, 2006, the Company recorded stock-based compensation expense of $3.5 +million, of which $1.8 million was included in general and administrative expenses and $1.7 million +was capitalized to oil and gas properties. Shares available for future stock option or restricted +stock grants to employees and directors under existing plans were 393,945 at December 31, 2008. +Stock Options +The Company uses the Black-Scholes option pricing model to estimate the fair value of stock option +awards with the following weighted-average assumptions for the +indicated periods. There were no stock options issued during 2008. +Years Ended +December 31, +2007 +2006 +Dividend yield +— +— +Expected volatility +36.2 +% +38.9 +% +Risk-free interest rate +4.7 +% +4.6 +% +Expected life of option (in years) +5 +5 +Weighted-average grant-date fair value +$ +5.64 +$ +7.72 +Forfeiture rate +2.0 +% +7.5 +% +The assumptions above are based on multiple factors, including historical exercise patterns of +employees with respect to exercise and post-vesting employment termination behaviors, expected +future exercising patterns and the historical volatility of the Company’s stock price. +The following table represents stock option activity for the three years ended December 31, 2008: +2008 +2007 +2006 +Wtd Avg +Wtd Avg +Wtd Avg +Shares +Ex Price +Shares +Ex Price +Shares +Ex Price +Outstanding, beginning of year +755,225 +$ +10.00 +740,225 +$ +9.93 +1,205,558 +$ +10.11 +Granted (at market) +— +— +30,000 +14.27 +15,000 +18.69 +Exercised +(238,950 +) +9.34 +— +— +(480,333 +) +10.66 +Forfeited +(3,000 +) +15.97 +— +— +— +— +Expired +— +— +(15,000 +) +15.31 +— +— +Outstanding, end of year +513,275 +$ +10.27 +755,225 +$ +10.00 +740,225 +$ +9.93 +Exercisable, end of year +488,075 +$ +9.91 +710,225 +$ +9.57 +695,225 +$ +9.44 +Weighted-average remaining +Contract life: +Outstanding options at +end of period +2.92 yrs. +3.39 yrs. +4.06 yrs. +Outstanding +exercisable at +end of period +2.68 yrs. +3.08 yrs. +3.76 yrs. +As of December 31, 2008, the aggregate intrinsic value of options outstanding and options +exercisable was zero. As of December 31, 2007 and 2006, the aggregate intrinsic value of options +outstanding was $5.0 million and $3.9 million and the aggregate intrinsic value of options +exercisable was $4.9 million and $3.9 million, respectively. Total intrinsic value of options +exercised was $4.1 million for both the years ended December 31, +2008 and 2006. At December 31, 2008, there was $116,000 of unrecognized compensation cost related +to unvested stock options, which is expected to be recognized over a weighted-average period of +two years. +57 +Table of Contents +Restricted Stock +The Plans allow for the issuance of restricted stock awards. The unearned stock-based compensation +related to these awards is being amortized to compensation expense on a straight-line basis over +the requisite service period for the entire award. The compensation expense for these awards was +determined based on the market price of our stock at the date of grant applied to the total numbers +of shares that were anticipated to fully vest. As of December 31, 2008, there was $6.9 million of +unrecognized compensation cost associated with these awards, which is expected to be recognized +over a weighted average period of 1.8 years. +The following table represents unvested restricted stock activity for the year ended December 31, +2008: +Weighted-Average +Number of +Grant-Date +Shares +Fair Value +Outstanding shares at beginning of period +487,450 +$ +15.17 +Granted +242,600 +20.73 +Vested +(206,950 +) +16.05 +Forfeited +(13,800 +) +16.08 +Outstanding shares at end of period +509,300 +$ +17.43 +For the years ended December 31, 2008, 2007 and 2006 the Company recognized non-cash compensation +expense associated with the restricted stock awards of $4.3 million, $2.7 million and $3.4 million, +respectively. +4. NET INCOME PER SHARE +Basic net income per common share was computed by dividing net income by the weighted average +number of shares of common stock outstanding during the year. Diluted net income per common share +was determined on a weighted average basis using common shares issued and outstanding adjusted for +the effect of stock options and restricted stock considered common stock equivalents computed using +the treasury stock method. +58 +Table of Contents +A reconciliation of the basic and diluted net income per share computation is as follows (in +thousands, except per share amounts): +2008 +2007 +2006 +(a) Net income (loss) available to common shares +$ +(438,893 +) +$ +15,194 +$ +40,560 +(b) Weighted average shares outstanding +21,222 +20,776 +20,270 +Dilutive impact of stock options +— +148 +238 +Dilutive impact of restricted stock +— +40 +78 +Dilutive impact of warrants +— +326 +777 +(c) Weighted average shares outstanding for diluted net income per share +21,222 +21,290 +21,363 +Stock options excluded due to the exercise +price being greater than the stock price +399 +75 +28 +Basic net income (loss) per share (a ¸ b) +$ +(20.68 +) +$ +0.73 +$ +2.00 +Diluted net income (loss) per share (a ¸ c) +$ +(20.68 +) +$ +0.71 +$ +1.90 +In addition, below are the shares (in thousands) relating to stock option, warrants and restricted +stock that were not included in diluted shares for the year ended December 31, 2008 due to the fact +that the Company had a loss for this period. The Company had net income for the years ended +December 31, 2007 and 2006 and all such shares were included as described above. +2008 +Stock options +161 +Warrants +328 +Restricted Stock +129 +59 +Table of Contents +5. INCOME TAXES +Below is an analysis of deferred income taxes as of December 31, 2008 and 2007. +December 31, +2 008 +2007 +(In thousands) +Deferred tax asset: +Federal net operating loss carryforwards +$ +68,432 +$ +58,397 +State net operating loss carryforwards +45,939 +36,345 +Statutory depletion carryforward +4,561 +4,184 +Alternative minimum tax credit carryforward +375 +375 +Asset retirement obligations +13,102 +11,274 +Oil and gas properties +58,061 +— +Other +2,241 +3,572 +Valuation allowance +(174,062 +) +(36,345 +) +Total deferred tax asset +18,649 +77,802 +Deferred tax liability: +Oil and gas properties +— +(109,530 +) +Other +(18,649 +) +(462 +) +Total deferred tax liability +(18,649 +) +(109,992 +) +Net deferred tax liability +$ +— +$ +(32,190 +) +SFAS 109 provides for the weighing of positive and negative evidence in determining whether it is +more likely than not that a deferred tax asset is recoverable. As a result of the impairment of +oil and gas properties in the fourth quarter of 2008, the Company incurred losses on an aggregate +basis for the three-year period ended December 31, 2008, the Company established a full valuation +allowance in the amount of $128 million on the tax benefit associated with the federal and state +net operating loss carryforwards as of December 31, 2008. +If not utilized, the Company’s federal net operating loss carryforwards will expire in 2013 through +2023. The Company’s state net operating loss carryforwards will expire in 2009 through 2023. The +Company has very limited state taxable income as primarily all of its revenue is generated in +federal waters and is not subject to state income taxes. Accordingly, the Company has established +a full valuation allowance on the tax benefit associated with these state net operating loss +carryforwards as the Company does not anticipate generating taxable state income in the states in +which these carryforwards apply. +Callon adopted FIN 48 effective January 1, 2007. The Company had no significant unrecognized tax +benefits at the date of adoption or at December 31, 2008. Accordingly, the Company does not have +any interest or penalties related to uncertain tax positions. However, if interest or penalties +were to be incurred related to uncertain tax positions, such amounts would be recognized in income +tax expense. Tax periods for years 2004 through 2008 remain open to examination by the federal and +state taxing jurisdictions to which the Company is subject. +Below is a reconciliation of the reported amount of income tax expense attributable to continuing +operations for the year to the amount of income tax expense that would result from applying +domestic federal statutory tax rates to pretax income from continuing operations. +60 +Table of Contents +Years Ended December 31, +2008 +2007 +2006 +Income tax expense computed at the statutory +federal income tax rate +(35 +)% +35 +% +35 +% +Change in valuation allowance +27 +% +— +— +Other +— +2 +% +— +Effective income tax rate +(8 +)% +37 +% +35 +% +6. OTHER COMPREHENSIVE INCOME +The Company’s other comprehensive income (loss) of $18 million, $(12) million and $9 million for +the years ended December 31, 2008, 2007 and 2006, respectively, relates to the change in fair value +of its derivatives. Other comprehensive income (loss) was net of income tax expense (benefit) of +$9.4 million, $(6.5) million and $4.7 million for the years ended December 31, 2008, 2007 and 2006, +respectively. +7. LONG-TERM DEBT +Long-term debt consisted of the following at: +December 31, +2008 +2007 +(In thousands) +Senior Secured Credit Facility (matures +September 25, 2012) +$ +— +$ +— +9.75% Senior Notes (due December 2010) net of discount +194,420 +192,012 +Senior Revolving Credit Facility (due 2014) +— +200,000 +Callon Entrada Credit Facility — non-recourse +78,435 +— +Total long-term debt +272,855 +392,012 +Less current portion +— +— +Long-term portion +$ +272,855 +$ +392,012 +Senior Secured Credit Facility . On September 25, 2008, the Company completed a $250 million second +amended and restated senior secured revolving credit agreement, which matures on September 25, +2012, with the Union Bank of California (“UBOC”) as administrative agent and issuing lender. The +borrowing base, which will be reviewed and redetermined semi-annually, was $70 million at December +31, 2008. Borrowings under the credit agreement are secured by mortgages covering the Company’s +major fields excluding Entrada. As of December 31, 2008, there were no borrowings under the +agreement; however Callon had a letter of credit outstanding in the amount of $15 million to secure +the drilling rig, Ocean Victory, for the development of Entrada. As a result, $55 million was +available for future borrowings under the credit agreement as of December 31, 2008. See Note 18. +The credit facility bears interest at 0% to 0.50% above a defined base rate depending on +utilization of the borrowing base or, at the option of the Company, LIBOR plus 1.375% to 2.0% based +on utilization of the borrowing base. Under the senior secured revolving credit facility, a +commitment fee of 0.25% or 0.375% per annum, depending on the amount of the unused portion of the +borrowing base, is payable quarterly. The interest rate on the senior secured credit facility +during 2008 was 5.75%. +Senior Revolving Credit Facility (due 2014) . On April 18, 2007, Callon closed the Entrada +acquisition contemporaneous with a seven-year $200 million senior revolving credit facility +arranged by Merrill Lynch Capital Corporation, which is secured by a lien on the Entrada +properties. Borrowings outstanding under the facility bore interest at a rate of LIBOR plus 7%. +The Company borrowed the full commitment amount under the facility at closing to cover the required +$150 million payment to BP Exploration and Production Company (“BP”) and expenses and fees related +to the transaction and the balance was used to pay down +the Company’s UBOC senior secured credit facility. Callon’s UBOC senior secured credit facility +was amended to allow for this transaction. +61 +Table of Contents +On April 8, 2008, Callon extinguished the $200 million senior revolving credit facility. The +retirement was made with cash on hand, a $16 million draw under the UBOC credit facility and +proceeds from the sale of a 50% working interest in Callon’s Entrada Field to CIECO Energy (US) +Limited (“CIECO”). Due to the early extinguishment of this credit facility, Callon incurred +expenses of $11.9 million, consisting of $6.3 million in pre-payment penalties plus a non-cash +charge of $5.6 million related to the amortization expense associated with the deferred financing +costs related to the credit facility. These amounts are included in “Loss on early extinguishment +of debt” in the accompanying Consolidated Statements of Operations. See Note 15. +Callon Entrada Credit Agreement (Non-Recourse). A wholly-owned subsidiary of Callon, Callon +Entrada, entered into a credit agreement with CIECO in April 2008, +pursuant to which Callon Entrada may borrow up to $150 million, plus interest expense incurred of +up to $12 million, to finance the development of the Entrada project. The Callon Entrada credit +facility is secured by the Entrada Field and related assets. The agreement bears interest at +six-month LIBOR (as in effect on the first day of each interest period) plus 375 basis points and +is subject to customary representations, warranties, covenants and events of default. As of +December 31, 2008, $78.4 million of principal and $2.7 million of accrued interest was outstanding +under this facility. See Note 15. +Callon +and its subsidiaries (other than Callon Entrada) did not guarantee and are not otherwise +obligated to repay the principal, accrued interest or any other amount which may become outstanding +under the Callon Entrada credit facility. However, Callon has entered into a customary +indemnification agreement pursuant to which it agrees to indemnify the lenders under the Callon +Entrada credit facility against Callon Entrada’s misappropriation of funds, non-performance of +certain covenants and similar matters. In addition, Callon also guaranteed the obligations of +Callon Entrada to fund its proportionate share of any operating costs related to the Entrada +project that Callon Entrada may, from time to time, expressly approve under the Entrada joint +operating agreement. Callon also has guaranteed Callon Entrada’s payment of all amounts to plug +and abandon wells and related facilities for a breach of law, rule or regulation (including +environmental laws) and for any losses attributable to gross negligence of Callon Entrada. The +Company has not classified any of this facility as current and has not included any amounts due in +the five year maturities as it believes, based on the advice of counsel, that the Callon Entrada +credit agreement does not obligate Callon or any of its subsidiaries (other than Callon Entrada) to +pay principal, accrued interest or other amounts which may be owed under such credit agreement. +In late November 2008, Callon Entrada and CIECO decided to abandon the Entrada project. Prior to +abandonment of the project, CIECO failed to fund two loan requests totaling $40 million under our +non-recourse credit agreement with them. The Company continues to discuss with CIECO its failure to fund the +$40 million in loan requests. Because these discussions are in early stages, no assurances can be +made regarding the outcome of these discussions. The Company does not believe that we have waived any of our +rights under our agreements with CIECO. +9.75% Senior Notes (due 2010). In December 2003, the Company borrowed $185 million pursuant to a +senior unsecured credit facility. The loans under the credit facility have a stated interest rate +of 9.75% and a seven-year maturity. In conjunction with the senior unsecured notes, the Company +issued detachable warrants to purchase 2.775 million shares of its common stock at an exercise +price of $10 per share and an expiration date of December 2010. The warrants were valued at $10.6 +million and were treated as a discount on the debt. +62 +Table of Contents +This senior unsecured debt matures December 8, 2010 and has an effective interest rate of 11.4%. The +Company recorded the issuance of these new securities at a fair value of $171 million. Deferred +costs of $14 million associated with the notes are being amortized over the life of the notes. +During March 2004, Callon borrowed an additional $15 million under its 9.75% senior unsecured +credit facility bringing the total outstanding under the facility to $200 million. The net proceeds +of approximately $14 million were primarily used to retire the remaining $10 million of 12% senior +loans due March 31, 2005 plus a 1% call premium of $100,000. The Company recorded the issuance of +these additional new securities at a fair value of $14 million. Deferred costs of $1 million +associated with the notes are being amortized over the life of the notes. See Note 15. +In March 2004, the $200 million in aggregate principal amount of loans outstanding under the 9.75% +senior unsecured credit facility were exchanged for 9.75% Senior Notes due 2010, Series A, (“Series +A notes”), issued pursuant to a senior indenture between Callon and American Stock Transfer & Trust +Company dated March 15, 2004. On August 12, 2004, the Company completed an offer to exchange its +9.75% Senior Notes due 2010, Series B, that have been registered under the Securities Act of 1933, +for all outstanding Series A notes. +As of December 31, 2008, 2.410 million of the 2.775 million detachable warrants issued with the +9.75% Senior Notes due 2010 were exercised. +Certain of the Company’s subsidiaries guarantee the Company’s obligations under the $200 million +9.75% Senior Notes due 2010. The subsidiary guarantors are 100% owned, all of the guarantees are +full and unconditional and joint and several, the parent company has no independent assets or +operations and any subsidiaries of the parent company other than the subsidiary guarantors are +minor. +Capital Lease . In December 2001, the Company entered into a 10-year gas processing agreement +associated with a production facility on Callon’s Mobile Block 952 Field with Hanover Compression +Limited Partnership, which was being accounted for as a capital lease. In May 2007, the Company +sold the Mobile Block 952 Field and retired the remainder of the capital lease. +Restrictive Covenants . The Indenture governing our 9.75% senior notes due 2010 and the Company’s +senior secured revolving credit facility contains various covenants including restrictions on +additional indebtedness and payment of cash dividends. In addition, Callon’s senior secured +revolving credit facility contains covenants for maintenance of certain financial ratios. The +Company was in compliance with these covenants at December 31, 2008. +8. DERIVATIVES +The following table summarizes derivative expense for the periods presented (in thousands): +Years Ended December 31, +2008 +2007 +2006 +Amortization of derivative contract premiums +$ +— +$ +— +$ +150 +Change in fair value and settlements of ineffective +derivative contracts +498 +— +— +$ +498 +$ +— +$ +150 +63 +Table of Contents +The change in fair value and settlements of ineffective derivative contracts in 2008 related to +contracts that were deemed ineffective as a result of a shortfall in production volumes due to +downtime resulting from damages caused by Hurricanes Gustav and Ike. For the year ended December +31, 2008, cash settlements on effective cash flow hedges resulted in a reduction in oil and gas +sales of $9.4 million. Cash settlements on effective cash flow hedges for the years ended December +31, 2007 and 2006 resulted in an increase in oil and gas sales of $8.1 million and $8.9 million, +respectively. +Listed in the table below are the outstanding derivative contracts, which are collars, as of +December 31, 2008: +Collars +Average +Average +Volumes per +Quantity +Floor +Ceiling +Product +Month +Type +Price +Price +Period +Oil +30,000 +Bbls +$ +110.00 +$ +175.75 +01/09-12/09 +Natural Gas +100,000 +MMBtu +$ +11.00 +$ +20.00 +01/09-03/09 +9. FAIR VALUE MEASUREMENTS +Effective January 1, 2008, the Company adopted SFAS 157, “Fair Value Measurements.” SFAS 157 defines fair value, establishes a framework for +measuring fair value and requires enhanced disclosures about fair value measurements. SFAS 157 +establishes a fair value hierarchy which consists of three broad levels that prioritize the inputs +to valuation techniques used to measure fair value. +• +Level 1 valuations consist of unadjusted quoted prices in active markets for +identical assets and liabilities and have the highest priority. +• +Level 2 valuations rely on quoted market information for the calculation of +fair market value. +• +Level 3 valuations are internal estimates and have the lowest priority. +Per SFAS 157, the Company has classified its derivatives into these levels depending upon the data +relied on to determine the fair values of the derivative instruments. The fair values of collars +and natural gas basis swaps are estimated using internal discounted cash flow calculations based +upon forward commodity price curves or quotes obtained from counterparties to the agreements and +are designated as Level 3. The following table summarizes the valuation of our assets and +liabilities measured at fair value on a recurring basis at December 31, 2008 (in thousands): +64 +Table of Contents +Fair Value Measurements Using +Quoted +Significant +Prices in +Other +Significant +Active +Observable +Unobservable +Assets +Markets +Inputs +Inputs +(Liabilities) +(Level 1) +(Level 2) +(Level 3) +At Fair Value +Derivative assets +$ +— +$ +— +$ +21,780 +$ +21,780 +Derivative liabilities +— +— +— +— +Total +$ +— +$ +— +$ +21,780 +$ +21,780 +The table below presents a reconciliation for assets and liabilities measured at fair value on a +recurring basis using significant unobservable inputs (Level 3) during the period ended December +31, 2008. The fair values of Level 3 derivative instruments are estimated using proprietary +valuation models that utilize both market observable and unobservable parameters. Level 3 +instruments presented in the table consist of net derivatives valued using pricing models +incorporating assumptions that, in management’s judgment, reflect the assumptions a marketplace +participant would have used at December 31, 2008 (in thousands): +Derivatives +Balance at January 1, 2008 +$ +(5,205 +) +Total gains or losses (realized or unrealized): +Included in earnings +— +Included in other comprehensive income +17,076 +Purchases, issuances and settlements +9,909 +Balance at December 31, 2008 +$ +21,780 +Change in unrealized gains (losses) included in +earnings relating to derivatives still held as of +December 31, 2008 +$ +— +The Company also adopted SFAS 159, “The +Fair Value Option for Financial Assets and Financial Liabilities,” on January 1, 2008, which +permits entities to choose to measure various financial instruments and certain other items at fair +value. The adoption of SFAS 159 did not have an impact on the Company’s financial statements. +10. COMMITMENTS AND CONTINGENCIES +From time to time, the Company, as part of the Consolidation and other capital transactions, +entered into registration rights agreements whereby certain parties to the transactions are +entitled to require the Company to register common stock of the Company owned by them with the SEC +for sale to the public in firm commitment public offerings and generally to include shares owned by +them, at no cost, in registration statements filed by the Company. Costs of the offering will not +include broker’s discounts and commissions, which will be paid by the respective sellers of the +common stock. +The Company is involved in various claims and lawsuits incidental to its business. In the opinion +of management, the ultimate liability hereunder, if any, will not have a material adverse effect on +the financial position or results of operations of the Company. +In November 2008, the decision was made to abandon the Entrada Project. See Notes 7 and 15 for +more details related to commitments and contingencies. +65 +Table of Contents +The Company’s Medusa deepwater property is eligible for royalty suspensions pursuant to the Deep +Water Royalty Relief Act. In addition, the Company has several shallow water, deep natural gas +properties and prospects that are eligible for royalty suspensions. However, the federal offshore +leases covering these properties contain “price threshold” provisions for oil and gas prices. +Under these “price threshold” provisions, if the average monthly NYMEX sales price for oil or gas during a fiscal year exceeds the price threshold for oil or gas, +respectively, then royalties on the associated production must be paid to the Minerals Management +Service (MMS) at the rate stipulated in the lease. The price thresholds are adjusted annually by +the implicit price deflator for the GDP. The determination of whether or not royalties are due as +a result of the average NYMEX price exceeding the price threshold is made during the first quarter +of the succeeding year. Any royalty payments due must be made shortly after this determination is +made. If a royalty payment is due for all production during a year as a result of exceeding the +price threshold, the lessee is required to make monthly royalty payments during the succeeding +fiscal year for the succeeding year’s production. If at the end of any year the average NYMEX +price is below the price threshold, the lessee can apply for a refund for any associated royalties +paid during that year and the lessee will not be required to pay royalties monthly during the +succeeding year for the succeeding year’s production. +The Company was required to make monthly royalty payments for 2008 deepwater oil and gas production +and will be required to make monthly royalty payments for 2009. With regard to the shallow water, +deep natural gas royalty relief, the Company was not required to make royalty payments for 2008 and +will not be required to make royalty payments for 2009. +In the year succeeding the year in which any of the Company’s properties became subject to +royalties as the result of the average NYMEX price exceeding the price threshold, the portion of +reserves attributable to potential future royalties would not be included in the year-end reserve +report. However, if the average NYMEX prices were below the price thresholds in subsequent years, +our reserves would be increased to reflect reserves previously attributed to future royalties. As +a result, reported oil and gas reserves could materially increase or decrease, depending on the +relation of price thresholds versus the average NYMEX prices. The reduction in revenues resulting +from an obligation to pay these royalties and subsequent reduction of proved reserves could have a +material adverse effect on the Company’s results of operations and financial condition. The +Company’s reserve report as of December 31, 2008 excluded oil and gas reserves for Medusa that are +subject to MMS royalties as a result of the average 2008 NYMEX prices for oil and gas exceeding the +deepwater price thresholds. With regard to the shallow water, deep natural gas properties, there +was no reduction in reserves for potential future royalties as of December 31, 2008 as a result of +the average 2008 NYMEX price for gas being below the price threshold. +The Company’s activities are subject to federal, state and local laws and regulations governing +environmental quality and pollution control. Although no assurances can be made, the Company +believes that, absent the occurrence of an extraordinary event, compliance with existing federal, +state and local laws, rules and regulations governing the release of materials into the environment +or otherwise relating to the protection of the environment will not have a material effect upon the +capital expenditures, earnings or the competitive position of the Company with respect to its +existing assets and operations. The Company cannot predict what effect additional regulation or +legislation, enforcement polices hereunder, and claims for damages to property, employees, other +persons and the environment resulting from the Company’s +operations could have on its activities. +66 +Table of Contents +11. ASSET RETIREMENT OBLIGATIONS +The +following table summarizes the activity for the Company’s asset +retirement obligations (in thousands): +Years Ended December 31, +2008 +2007 +Asset retirement obligations at beginning of period +$ +36,837 +$ +41,179 +Accretion expense +4,172 +3,985 +Liabilities incurred +2,851 +6,368 +Liabilities settled +(6,586 +) +(19,519 +) +Revisions to estimate +4,920 +4,824 +Asset retirement obligation at end of period +42,194 +36,837 +Less: current retirement obligations +(9,151 +) +(9,810 +) +Long-term retirement obligations +$ +33,043 +$ +27,027 +Assets, +primarily short-term U.S. Government securities, of approximately $4.8 million at December +31, 2008, were recorded as restricted investments. These assets are held in abandonment trusts +dedicated to pay future abandonment costs for several of the Company’s oil and gas properties. +67 +Table of Contents +12. OIL AND GAS PROPERTIES +The following table discloses certain financial data relating to the Company’s oil and gas +activities, all of which are located in the United States. +Years Ended December 31, +2008 +2007 +2006 +(In thousands) +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance +$ +1,349,904 +$ +1,096,907 +$ +937,698 +Property acquisition costs +6,126 +154,193 +4,053 +Exploration costs +2,578 +35,959 +73,659 +Development costs +223,090 +62,845 +81,497 +End of period balance +$ +1,581,698 +$ +1,349,904 +$ +1,096,907 +Unevaluated Properties (excluded from +amortization)- +Beginning of period balance +$ +70,176 +$ +54,802 +$ +49,065 +Additions +6,409 +21,525 +19,103 +Capitalized interest +6,496 +7,152 +6,477 +Transfers to evaluated +(50,252 +) +(13,303 +) +(19,843 +) +End of period balance +$ +32,829 +$ +70,176 +$ +54,802 +Accumulated depreciation, depletion +and amortization- +Beginning of period balance +$ +738,374 +$ +604,682 +$ +539,399 +Ceiling test and provision charged to expense +549,552 +72,762 +65,283 +Sale of mineral interests +167,349 +60,930 +— +End of period balance +$ +1,455,275 +$ +738,374 +$ +604,682 +Unevaluated property costs, primarily lease acquisition costs incurred at federal and state lease +sales, unevaluated drilling costs, seismic, capitalized interest and general and administrative +costs being excluded from the amortizable evaluated property base, consisted of $11.3 million +incurred in 2008, $10.3 million incurred in 2007, $5.8 million incurred in 2006 and $5.4 million +incurred in 2005 and prior. These costs are directly related to the acquisition and evaluation of +unproved properties and major development projects. The excluded costs and related reserves are +included in the amortization base as the properties are evaluated and proved reserves are +established or impairment is determined. The Company expects that the majority of these costs will +be evaluated over the next three to five years. +Depletion per unit-of-production (thousand cubic feet of gas equivalent) amounted to $5.57, $3.89 +and $3.14 for the years ended December 31, 2008, 2007, and 2006, respectively. +Under the full-cost accounting rules of the SEC, the Company reviews the carrying value of its +proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and gas +properties, net of accumulated depreciation, depletion and amortization and deferred income taxes, +may not exceed the present value of estimated future net cash flows from proved oil and gas +reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of +related tax effects (the full-cost ceiling amount). These rules generally require pricing future +oil and gas production at the unescalated market price for oil and gas at the end of each fiscal +quarter and require a write-down if the “ceiling” is exceeded. However, if prices recover +sufficiently subsequent to the balance sheet date before the release of the financial statements +then use of subsequent pricing is allowed and no write-down would be required if such pricing was +used. Given the volatility of oil and gas prices, it is reasonably possible that the Company’s +estimate of discounted future net cash flows from proved oil and gas reserves could change in the +near term. If oil and gas prices decline significantly, even if only for a short period of time, +it is possible that write-downs of oil and gas properties could occur in the future. For the year +ended December 31, 2008, the Company recorded a $485.5 million impairment of oil and gas properties +as a result of the ceiling test calculation. +13. EMPLOYEE BENEFIT PLANS +The Company has adopted a series of incentive compensation plans designed to align the interest of +the executives and employees with those of its stockholders. The following is a brief description +of each plan: +Savings and Protection Plan +The Savings and Protection Plan (“401-K Plan”) provides employees with the +option to defer receipt of a portion of their compensation and the Company may, at +its discretion, match a portion of the employee’s deferral with cash and Company +Common Stock. The Company may also elect, at its discretion, to contribute a +non-matching amount in cash and Company +68 +Table of Contents +Common Stock to employees. The amounts held under the 401-K Plan are invested in various +funds maintained by a third party in accordance with the directions of each +employee. An employee is fully vested, including Company discretionary +contributions, immediately upon participation in the 401-K Plan. The total amounts +contributed by the Company, including the value of the common stock contributed, +were $747,000, $680,000 and $615,000 in the years 2008, 2007 and 2006, respectively. +1996 Stock Incentive Plan +On August 23, 1996, the Board of Directors of the Company approved and adopted +the Callon Petroleum Company 1996 Stock Incentive Plan (the “1996 Plan”). The 1996 +Plan was approved by the shareholders in 1997 and limited to a maximum of 1,200,000 +shares (as amended from the original 900,000 shares) of common stock subject to +outstanding awards. The 1996 Plan was amended again and approved on May 9, 2000 at +the Annual Meeting of Shareholders, increasing the number of shares reserved for +issuance under the 1996 plan to 2,200,000 shares. Unvested options are subject to +forfeiture upon certain termination of employment events and expire 10 years from +the date of grant. +In August 2006, the Board of Directors approved the award of 520,000 shares of +restricted stock from the 1996 Plan. Of the 520,000 shares, 20,000 shares were +granted to non-employee members of the Board of Directors and vested immediately. +The remaining 500,000 shares were issued to employees of the Company with 20% vesting +immediately and the remaining 80% vesting ratably over the next four years. The +compensation cost with respect to the 20% that vested immediately was recognized as +an expense on the grant date and the compensation cost with respect to the remaining +80% is being amortized to expense over the vesting period. +2002 Stock Incentive Plan +On February 14, 2002, the Board of Directors of the Company approved and adopted +the 2002 Stock Incentive Plan (the “2002 Plan”). Pursuant to the 2002 Plan, 350,000 +shares of common stock shall be reserved for issuance upon the exercise of options or +for grants of stock options, stock appreciation rights or units, bonus stock, or +performance shares or units. This Plan qualified as a “broadly based” plan under the +provisions of the New York Stock Exchange’s rules and regulations and therefore did +not require shareholder approval. Because the 2002 Plan is a broadly based plan, the +aggregate number of shares underlying awards granted to officers and directors cannot +exceed 50% of the total number of shares underlying the awards granted to all +employees during any three-year period. +In 2006, 17,500 shares were awarded as restricted stock with 20% vesting immediately +and the remaining 80% vesting ratably over the next four years. The compensation cost +with respect to the 20% that vested immediately was recognized as an expense on the +grant date and the compensation cost with respect to the remaining 80% is being +amortized to expense over the vesting period. +2006 Stock Incentive Plan +On March 9, 2006, the Board of Directors of the Company approved the 2006 Stock +Incentive Plan (“2006 Plan”). The 2006 Plan was approved by the shareholders at the +May 4, 2006 annual meeting. Pursuant to the 2006 Plan, 500,000 shares of common +stock shall be reserved for issuance upon exercise of stock options, restricted +stock or other stock-based awards. In +69 +Table of Contents +2006, 45,000 shares were awarded as +restricted stock that will vest ratably over the next four years. +The compensation cost with respect to this grant is being amortized to expense over +the vesting period. +In April 2008, 217,600 shares were awarded as restricted stock with cliff vesting +over the next three years and the compensation cost is being amortized over the +vesting period. In addition, 25,000 shares were awarded as restricted stock vesting +immediately and the compensation cost was recognized as an expense on the grant +date. +14. EQUITY TRANSACTIONS +The Company adopted a stockholder rights plan on March 30, 2000, designed to assure that the +Company’s stockholders receive fair and equal treatment in the event of any proposed takeover of +the Company and to guard against partial tender offers, squeeze-outs, open market accumulations, +and other abusive tactics to gain control without paying all stockholders a fair price. The rights +plan was not adopted in response to any specific takeover proposal. Under the rights plan, the +Company declared a dividend of one right (“Right”) on each share of the Company’s Common Stock. +Each Right will entitle the holder to purchase one one-thousandth of a share of a Series B +Preferred Stock, par value $0.01 per share, at an exercise price of $90 per one one-thousandth of a +share. +The Rights are not currently exercisable and will become exercisable only in the event a person or +group acquires, or engages in a tender or exchange offer to acquire, beneficial ownership of 15 +percent or more (one existing stockholder was granted an exception for up to 21 percent) of the +Company’s common stock. After the Rights become exercisable, each Right will also entitle its +holder to purchase a number of +common shares of the Company having a market value of twice the exercise price. The dividend +distribution was made to stockholders of record at the close of business on April 10, 2000. The +Rights will expire on March 30, 2010. +15. ENTRADA +On April 18, 2007, the Company completed an acquisition of BP’s 80% working interest in the Entrada +field for a purchase price of $190 million. The purchase price included $150 million payable at +closing and an additional $40 million payable after the achievement of certain production +milestones. The purchased interests included five federal offshore blocks at Garden Banks Blocks +738, 782, 785, 826 and 827, subject to certain depth limitations. The acquisition was recorded at +fair value based on the initial purchase price of $150 million. As a result of the acquisition, +Callon owned a 100% working interest in the Entrada field and became operator. +To finance the initial $150 million payment of the purchase price, Callon closed on a seven-year +$200 million senior revolving credit facility arranged by Merrill Lynch Capital Corporation +contemporaneous with the closing of the acquisition. The facility was secured by a lien on the +Entrada properties. The Company borrowed the full commitment amount under the facility at closing +to cover the required $150 million payment to BP and expenses and fees related to the transaction +and the balance was used to pay down our UBOC senior secured revolving credit facility. The Company’s UBOC +senior secured credit facility was amended to allow for this transaction. +70 +Table of Contents +In August 2007, Callon entered into a production handling agreement (“PHA”) with ConocoPhillips and +Devon Energy Corporation. The PHA provides for production from the Entrada field to be processed +through the Magnolia production platform, which is owned by ConocoPhillips and Devon. On February +25, 2009 a letter was sent to ConocoPhillips to terminate the PHA. There are no costs associated +with the termination. +On April 8, 2008, Callon completed the sale of a 50% working interest in the Entrada Field to CIECO +effective January 1, 2008. At closing, CIECO paid Callon $155 million and reimbursed Callon $12.6 +million for 50% of Entrada capital expenditures incurred prior to the closing date. In addition, +CIECO agreed to fund half of a $40 million future contingent payment owed by Callon to BP if the +production milestone was achieved. Callon retained a 50% working interest and is operator of the +field. The Company did not recognize a gain or loss on this transaction. +Simultaneously with the closing of the CIECO transaction, the Company used the proceeds from the +sale, cash on hand and a draw of $16 million from the UBOC credit facility, to extinguish the $200 +million senior revolving credit facility, which was secured by a lien on the Entrada +properties. Due to the early extinguishment of the $200 million senior revolving credit facility +on April 8, 2008, Callon incurred expenses of $11.9 million consisting of $6.3 million in cash +pre-payment penalties plus a non-cash charge of $5.6 million related to the amortization expense +associated with the deferred financing costs related to the credit facility. +As part of the purchase price, CIECO agreed to loan a wholly-owned subsidiary of Callon, Callon +Entrada, the first $150 million of Callon Entrada’s costs to develop the Entrada project plus up to +$12 million of additional loans to pay accrued interest thereon, which loans were non-recourse to +Callon Entrada, were not guaranteed by Callon or any of its other subsidiaries, and were to be +repaid solely out of the proceeds of the sale of production from the Entrada project. The Callon +Entrada credit facility is secured by Callon’s remaining 50% interest in the Entrada field, which +was conveyed to Callon Entrada as a capital contribution in connection with the closing of the +Callon Entrada credit facility. +In late November 2008, Callon Entrada and CIECO decided to abandon the Entrada project. Under the +terms of our agreements with CIECO, Callon Entrada is responsible for its 50% share of the costs to +plug and abandon the Entrada project, which we estimate to be +$46 million, $23 million net to Callon Entrada. +In addition, prior to abandonment of the project, CIECO failed to fund two loan requests totaling +$40 million under our non-recourse credit agreement with them. CIECO also refused to fund its +working interest share for the settlement payment to terminate a +drilling contract. Callon Entrada has +paid its share of the drilling contract. We continue to discuss with CIECO its failure to fund +the $40 million in loan requests and its share of the drilling +contract. Because these discussions are in early stages, no assurances can +be made regarding the outcome of these discussions. We do not believe that we have waived any of +our rights under our agreements with CIECO regarding the loan requests or the drilling contract +settlement. +71 +Table of Contents +16. SUPPLEMENTAL OIL AND GAS RESERVE DATA (UNAUDITED) +The Company’s proved oil and gas reserves at December 31, 2008, 2007 and 2006 have been estimated +by Huddleston & Co., Inc., the Company’s independent petroleum engineers. The reserves were +prepared in accordance with guidelines established by the SEC. Accordingly, the following reserve +estimates are based upon existing economic and operating conditions. +There are numerous uncertainties inherent in establishing quantities of proved reserves. The +following reserve data represents estimates only and should not be construed as being exact. In +addition, the standardized measure of discounted future net cash flows should not be construed as +the current market value of the Company’s oil and gas properties or the cost that would be incurred +to obtain equivalent reserves. See Note 10 regarding the provisions for royalty relief and the +effect on reserves. +Estimated Reserves +Changes in the estimated net quantities of crude oil and natural gas reserves, all of which are +located onshore and offshore in the continental United States, are as follows: +72 +Table of Contents +Reserve Quantities +Years Ended December 31, +2008 +2007 +2006 +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period +24,531 +13,265 +18,428 +Revisions to previous estimates +(9,026 +) +(1,152 +) +(3,733 +) +Change in ownership +— +144 +— +Purchase of reserves in place +— +13,658 +— +Sale of reserves in place +(8,536 +) +(356 +) +— +Extensions and discoveries +— +35 +204 +Production +(942 +) +(1,063 +) +(1,634 +) +End of period +6,027 +24,531 +13,265 +Natural Gas (MMcf): +Beginning of period +116,454 +66,037 +78,021 +Revisions to previous estimates +(49,526 +) +(3,022 +) +(15,557 +) +Change in ownership +— +192 +— +Purchase of reserves in place +— +68,068 +— +Sale of reserves in place +(42,542 +) +(3,690 +) +— +Extensions and discoveries +105 +1,209 +14,550 +Production +(5,840 +) +(12,340 +) +(10,977 +) +End of period +18,651 +116,454 +66,037 +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period +4,723 +5,159 +7,323 +End of period +4,663 +4,723 +5,159 +Natural Gas (MMcf): +Beginning of period +22,340 +36,750 +30,982 +End of period +13,463 +22,340 +36,750 +73 +Table of Contents +Standardized Measure +The following tables present the Company’s standardized measure of discounted future net cash flows +and changes therein relating to proved oil and gas reserves and were computed using reserve +valuations based on regulations prescribed by the SEC. These regulations provide that the oil and +gas price structure utilized to project future net cash flows reflect period-end prices +(approximately $6.36 per Mcf for natural gas and $36.80 per Bbl for oil for the 2008 disclosures, +$7.59 per Mcf and $90.92 per Bbl for 2007 disclosures, and $5.78 per Mcf and $54.07 per Bbl for +2006 disclosures) at each date presented with no escalation. Future production and development +costs are based on current costs without escalation. The resulting net future cash flows have been +discounted to their present values based on a 10% annual discount factor. +Standardized Measure +Years Ended December 31, +2008 +2007 +2006 +(In thousands) +Future cash inflows +$ +340,485 +$ +3,113,759 +$ +1,101,182 +Future costs - +Production +(192,819 +) +(390,669 +) +(243,740 +) +Development and net abandonment +(34,111 +) +(405,186 +) +(81,700 +) +Future net inflows before income taxes +113,555 +2,317,904 +775,742 +Future income taxes +(565 +) +(699,967 +) +(119,685 +) +Future net cash flows +112,990 +1,617,937 +656,057 +10% discount factor +(26,685 +) +(483,948 +) +(185,266 +) +Standardized measure of discounted +future net cash flows +$ +86,305 +$ +1,133,989 +$ +470,791 +Changes in Standardized Measure +Years Ended December 31, +2008 +2007 +2006 +(In thousands) +Standardized measure — beginning of period +$ +1,133,989 +$ +470,791 +$ +837,552 +Sales and transfers, net of production costs +(122,104 +) +(142,973 +) +(153,387 +) +Net change in sales and transfer prices, +net of production costs +(111,140 +) +411,525 +(347,193 +) +Net change due to purchases and sales of in +place reserves +(558,652 +) +795,595 +— +Extensions, discoveries, and improved +recovery, net of future production and +development costs incurred +162,566 +(201,750 +) +122,862 +Changes in future development cost +33,652 +— +— +Revisions of quantity estimates +(786,001 +) +(66,735 +) +(155,342 +) +Accretion of discount +159,147 +53,474 +108,871 +Net change in income taxes +457,483 +(393,530 +) +187,209 +Changes in production rates, timing and other +(282,635 +) +207,592 +(129,781 +) +Aggregate change +(1,047,684 +) +663,198 +(366,761 +) +Standardized measure — end of period +$ +86,305 +$ +1,133,989 +$ +470,791 +At year-end 2006, a downward revision was made by the Company’s independent petroleum engineers to +Entrada’s estimated net proved reserves as of December 31, 2006 due to new performance data from +analogous deepwater reservoirs. +The Company ended the year 2008 with estimated net proved reserves of 54.8 billion cubic feet of +natural gas equivalent (“Bcfe”). This reduction from 2007 year-end estimated net proved reserves +of 263.6 Bcfe is primarily due to the sale to CIECO of a 50% interest in the Entrada field and the +abandonment of the Entrada project. +74 +Table of Contents +17. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) +First +Second +Third +Fourth +Quarter +Quarter +Quarter +Quarter +(In thousands, except per share data) +2008 +Total revenues +$ +44,960 +$ +48,029 +$ +32,783 +$ +15,540 +Income (loss) from operations +21,069 +24,046 +13,640 +(500,438 +) (a) +Net income (loss) +7,632 +5,153 +5,856 +(457,534 +) (a) +Net income (loss) per common share-basic +$ +0.37 +$ +0.25 +$ +0.27 +$ +(21.19 +) (a) +Net income (loss) per common share-diluted +0.35 +0.23 +0.27 +(21.19 +) (a) +First +Second +Third +Fourth +Quarter +Quarter +Quarter +Quarter +(In thousands, except per share data) +2007 +Total revenues +$ +45,484 +$ +43,474 +$ +37,869 +$ +43,941 +Income from operations +13,705 +12,828 +13,090 +16,727 +Net income +5,803 +2,581 +2,268 +4,542 +Net income per common share-basic +$ +0.28 +$ +0.12 +$ +0.11 +$ +0.22 +Net income per common share-diluted +0.27 +0.12 +0.11 +0.21 +(a) +Loss resulting from impairment of oil and gas properties in the amount of $485.5 million and +establishing a full valuation allowance on the tax benefit in the amount of +$128.1 million associated with net operating loss carryforwards as of December 31, +2008. +18. SUBSEQUENT EVENTS +Subsequent to December 31, 2008, the Company entered into the first amendment of the +Second Amended and Restated Credit Agreement dated September 25, 2008, which states that a default under the Entrada non-recourse loan would not +constitute a default under the Company’s senior secured revolving credit facility. +The amendment set the borrowing base at $48 million and implemented a Monthly Commitment Reduction +(MCR) commencing on June 1, 2009 in the amount of $4.33 million per month. The borrowing +base and MCR are both subject to re-determination August 1, 2009 and quarterly thereafter. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON +ACCOUNTING AND FINANCIAL DISCLOSURE +There have been no disagreements with the independent auditors on any matters of accounting +principles or practices, financial statement disclosure, or auditing scope or procedures. +ITEM 9.A CONTROLS AND PROCEDURES +The term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the +Securities Exchange Act of 1934, or the Exchange Act. This term refers to the controls and +procedures of a company that are designed to ensure that information required to be disclosed by a +company in the reports that it files or submits under the Exchange Act is recorded, processed, +summarized and reported within the time periods specified by the Securities and Exchange +Commission. Our management, including our Chief Executive Officer and Chief Financial Officer, has +evaluated the effectiveness of our disclosure controls and procedures as of the end of the period +covered by this annual report. Based upon that evaluation, our Chief Executive Officer and Chief +Financial Officer have concluded that our +disclosure controls and procedures were effective as of the end of the period covered by this +annual report. There were no changes to our internal control over financial reporting during our +last fiscal quarter that have materially affected, or are reasonable likely to materially affect, +our internal control over financial reporting. +75 +Table of Contents +Management’s Report On Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over +financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the +supervision and with the participation of our management, including our principal executive and +financial officers, we conducted an evaluation of the effectiveness of our internal control over +financial reporting as of December 31, 2008 based on the frame work in the Internal +Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our evaluation under the framework in Internal Control-Integrated Framework, +our management concluded that our internal control over financial reporting was effective as of +December 31, 2008. +Ernst & Young LLP, our independent registered public accounting firm, has issued an attestation +report on the Company’s internal control over financial reporting as of December 31, 2008. +76 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited Callon Petroleum Company’s internal control over financial reporting as of December +31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the +Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Callon +Petroleum Company’s management is responsible for maintaining effective internal control over +financial reporting and for its assessment of the effectiveness of internal control over financial +reporting included in the accompanying Management’s Report on Internal Control over Financial +Reporting. Our responsibility is to express an opinion on the Company’s internal control over +financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight +Board (United States). Those standards require that we plan and perform the audit to obtain +reasonable assurance about whether effective internal control over financial reporting was +maintained in all material respects. Our audit included obtaining an understanding of internal +control over financial reporting, assessing the risk that a material weakness exists, testing and +evaluating the design and operating effectiveness of internal control based on the assessed risk, +and performing such other procedures as we considered necessary in the circumstances. We believe +that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable +assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A +company’s internal control over financial reporting includes those policies and procedures that (1) +pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the +transactions and dispositions of the assets of the company; (2) provide reasonable assurance that +transactions are recorded as necessary to permit preparation of financial statements in accordance +with generally accepted accounting principles, and that receipts and expenditures of the company +are being made only in accordance with authorizations of management and directors of the company; +and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the +financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or +detect misstatements. Also, projections of any evaluation of effectiveness to future periods are +subject to the risk that controls may become inadequate because of changes in conditions, or that +the degree of compliance with the policies or procedures may deteriorate. +In our opinion, Callon Petroleum Company maintained, in all material respects, effective internal +control over financial reporting as of December 31, 2008, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight +Board (United States), the consolidated balance sheets of Callon Petroleum Company as of December +31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity and +cash flows for each of the three years in the period ended December 31, 2008 and our report dated +March 19, 2009, expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 19, 2009 +77 +Table of Contents +ITEM 9.B OTHER INFORMATION +We have disclosed all information required to be disclosed in a current report on Form 8-K during +the fourth quarter of the year ended December 31, 2008 in previously filed reports on Form 8-K. +78 +Table of Contents +PART III. +ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. +For information concerning Item 10, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on April 30, 2009 which will be filed +with the Securities and Exchange Commission and is incorporated herein by reference. +The Company has adopted a code of ethics that applies to the Company’s chief executive officer, +chief financial officer and chief accounting officer. The full text of such code of ethics has +been posted on the Company’s website at www.callon.com, and is available free of charge in print to +any shareholder who requests it. Request for copies should be addressed to the Secretary at 200 +North Canal Street, Natchez, Mississippi 39120. +ITEM 11. EXECUTIVE COMPENSATION. +For information concerning Item 11, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on April 30, 2009 which will be filed +with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED +STOCKHOLDER MATTERS. +For information concerning the security ownership of certain beneficial owners and management, see +the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of +Stockholders +to be held on April 30, 2009 which will be filed with the Securities and Exchange +Commission and is incorporated herein by reference. +79 +Table of Contents +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on April 30, 2009 which will be filed +with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES. +For information concerning Item 14, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on April 30, 2009 which will be filed +with the Securities and Exchange Commission and is incorporated herein by reference. +PART IV. +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K +(a) 1. The following is an index to the financial statements and financial statement schedules +that are filed as part of this Form 10-K on pages 47 through 76. +Report of Independent Registered Public Accounting Firm +Consolidated Balance Sheets as of the Years Ended December 31, 2008 and 2007 +Consolidated Statements of Operations for the Three Years in the Period Ended +December 31, 2008 +Consolidated Statements of Stockholders’ Equity for the Three Years in the Period Ended +December 31, 2008 +Consolidated Statements of Cash Flows for the Three Years in the Period Ended +December 31, 2008 +Notes to Consolidated Financial Statements +(a) 2. Schedules other than those listed above are omitted because they are not required, not +applicable or the required information is included in the financial statements or notes thereto. +80 +Table of Contents +(a) 3. Exhibits: +2. +Plan of acquisition, reorganization, arrangement, liquidation or succession* +3. +Articles of Incorporation and Bylaws +3.1 +Certificate of Incorporation of the Company, as amended (incorporated by +reference to Exhibit 3.1 of the Company’s Annual Report on Form 10-K for the year +ended December 31, 2003, File No. 001-14039) +3.2 +Bylaws of the Company (incorporated by reference from Exhibit 3.2 of the +Company’s Registration Statement on Form S-4, filed August 4, 1994, Reg. No. +33-82408) +3.3 +Certificate of Amendment to Certificate of Incorporation of the Company +(incorporated by reference to Exhibit 3.3 of the Company’s Annual Report on Form +10-K for the year ended December 31, 2003, File No. 001-14039) +4. +Instruments defining the rights of security holders, including indentures +4.1 +Specimen Common Stock Certificate (incorporated by reference from Exhibit +4.1 of the Company’s Registration Statement on Form S-4, filed August 4, 1994, Reg. +No. 33-82408) +4.2 +Rights Agreement between Callon Petroleum Company and American Stock Transfer +& Trust Company, Rights Agent, dated March 30, 2000 (incorporated by reference from +Exhibit 99.1 of the Company’s Registration Statement on Form 8-A, filed April 6, 2000, +File No. 001-14039) +4.3 +Form of Warrants dated December 8, 2003 and December 29, 2003 entitling lenders under +the Company’s $185 million amended and restated senior unsecured credit agreement dated +December 23, 2003 to purchase common stock from the Company (incorporated by reference +to Exhibit 4.14 of the Company’s Annual Report on Form 10-K for the year ended +December 31, 2003, File No. 001-14039) +4.4 +Indenture for the Company’s 9.75% Senior Notes due 2010, dated March 15, 2004 between +Callon Petroleum Company and American Stock Transfer and Trust Company (incorporated by +reference to Exhibit 4.16 of the Company’s Quarterly Report on Form 10-Q for the period +ended March 31, 2004, File No. 001-14039) +9. +Voting trust agreement +None. +10. Material contracts +10.1 +Registration Rights Agreement dated September 16, 1994 between the Company and +NOCO Enterprises, L. P. (incorporated by reference from Exhibit 10.2 of the Company’s +Registration Statement on Form 8-B filed October 3, 1994) +81 +Table of Contents +10.2 +Counterpart to Registration Rights Agreement by and between the Company, +Ganger Rolf ASA and Bonheur ASA. (incorporated by reference from Exhibit 10.2 of the +Company’s Report on Form 10-K for the fiscal year ended December 31, 2000, File No. +001-14039) +10.3 +Registration Rights Agreement dated September 16, 1994 between the Company and +Callon Stockholders (incorporated by reference from Exhibit 10.3 of the Company’s +Registration Statement on Form 8-B filed October 3, 1994) +10.4 +Callon Petroleum Company 1994 Stock Incentive Plan (incorporated by reference +from Exhibit 10.5 of the Company’s Registration Statement on Form 8-B filed October 3, +1994 +10.5 +Callon Petroleum Company 1996 Stock Incentive Plan as amended on May 9, 2000 +(incorporated by reference from Appendix I of the Company’s Definitive Proxy Statement +of Schedule 14A filed March 28, 2000) +10.6 +Conveyance of Overriding Royalty Interest from the Company to Duke Capital +Partners, LLC, dated June 29, 2001 (incorporated by reference to Exhibit 10.03 of the +Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2001, File No. +001-14039) +10.7 +Callon Petroleum Company 2002 Stock Incentive Plan (incorporated by reference +to Exhibit 10.13 of the Company’s Annual Report on Form 10-K for the year ended +December 31, 2001, File No. 001-14039) +10.8 +Medusa Spar Agreement dated as of August 8, 2003, among Callon Petroleum +Operating Company, Murphy Exploration & Production Company-USA and Oceaneering +International, Inc. (incorporated by reference to Exhibit 10.19 of the Company’s +Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +10.9 +Purchase and Sale Agreement executed on March 8, 2007 by and between Callon +Petroleum Operating Company and BP Exploration and Production Company (incorporated by +reference to Exhibit 2.1 of the Company’s Report on Form 8-K filed on March 9, 2007). +10.10 +Deepwater Production Handling and Operating Services Agreement for Garden +Banks Blocks 738, 782, 785, 826 and 827 Production Handling at the Garden Banks Block +783 Magnolia TLP, dated as of August 31, 2007, by and between ConocoPhillips Company +and Devon Energy Production Company, L.P. and Callon Petroleum Operating Company +(incorporated by reference from Exhibit 10.1 of the Company’s Report on Form 10-Q +filed on November 6, 2007). +10.11 +Purchase and Sale Agreement between Callon Petroleum Company and Callon +Petroleum Operating Company as Seller, and Indigo Minerals LLC, as Buyer (incorporated +by reference from Exhibit 2.1 of the Company’s Report on Form 8-K filed on December +13, 2007). +10.12 +Purchase and Sale Agreement by and between Callon Petroleum Operating Company +and CIECO Energy (US) Limited (incorporated by reference from Exhibit 1.1 of the +Company’s Report on Form 8-K filed on February 13, 2008). +10.13 +Supplemental Indenture dated April 4, 2008 (incorporated by reference to +Exhibit 10.1 of the Company’s Report on Form 8-K filed on April 9, 2008) +82 +Table of Contents +10.14 +Credit Agreement between Callon Entrada and CIECO Energy (Entrada) LLC dated +April 4, 2008 (incorporated by reference to Exhibit 10.3 of the Company’s Report on +Form 8-K filed on April 9, 2008) +10.15 +Indemnity Agreement dated April 4, 2008 (incorporated by reference to Exhibit +10.4 of the Company’s Report on Form 8-K filed on April 9, 2008) +10.16 +Non-Recourse Guaranty dated April 4, 2008 (incorporated by reference to +Exhibit 10.5 of the Company’s Report on Form 8-K filed on April 9, 2008) +10.17 +Severance Compensation Agreement dated April 18, 2008 by and between Fred L. +Callon and Callon Petroleum Company (incorporated by reference to Exhibit 10.1 of the +Company’s Report on Form 8-K filed on April 23, 2008) +10.18 +Form of Severance Compensation Agreement dated April 18, 2008 by and between +Callon Petroleum Company and its executive officers (incorporated by reference to +Exhibit 10.2 of the Company’s Report on Form 8-K filed on April 23, 2008) +10.19 +Second Amended and Restated Credit Agreement dated as of September 25, 2008, +by and among Callon Petroleum Company, the “Lenders” described therein, Regions Bank, +as Syndication Agent, Capital One, N.A., as Documentation Agent, and Union Bank of +California, N.A., as Administrative Agent (incorporated by reference to Exhibit 10.1 +of the Company’s Report on Form 8-K filed on October 1, 2008) +10.20 +Amendment No. 1 to Severance Compensation Agreement executed on +December 31, 2008 by and between Fred L. Callon and Callon +Petroleum Company (incorporated by reference from Exhibit 10.1 of +the Company’s Report on Form 8-K filed on January 5, 2009). +10.21 +Form of Amendment No.1 to Severance Compensation Agreement by and +between Callon Petroleum Company and its executive officers +(incorporated by reference from Exhibit 10.2 of the Company’s +Report on Form 8-K filed on January 5, 2009). +10.22 +Amendment No. 3 to the Callon Petroleum Company 1996 Stock +Incentive Plan (incorporated by reference from Exhibit 10.1 of the +Company’s Report on Form 8-K filed on January 5, 2009). +10.23 +Amendment No. 1 to the Callon Petroleum Company 2002 Stock +Incentive Plan (incorporated by reference from Exhibit 10.2 of the +Company’s Report on Form 8-K filed on January 5, 2009). +10.24 +Callon Petroleum Company Amended and Restated 2006 Stock Incentive +Plan (incorporated by reference from Exhibit 10.3 of the Company’s +Report on Form 8-K filed on January 5, 2009). +10.25 +Amendment No. 1 dated as of March 19, 2009 to the Second Amended +and Restated Credit Agreement dated September 25, 2008 is among +Callon Petroleum, the Lenders and Union Bank of California, N.A., +as Administrative Agent and as Issuing Lender. +11. +Statement re computation of per share earnings* +12. +Statements re computation of ratios* +13. +Annual Report to security holders, Form 10-Q or quarterly reports* +14. +Code of Ethics +14.1 +Code of Ethics for Chief Executive Officers and Senior Financial Officers +(incorporated by reference to Exhibit 14.1 of the Company’s Annual Report +on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +16. +Letter re change in certifying accountant* +18. +Letter re change in accounting principles* +21. +Subsidiaries of the Company +21.1 +Subsidiaries of the Company (incorporated by reference from Exhibit 21.1 of +the Company’s Registration Statement on Form 8-B filed October 3, 1994) +22. +Published report regarding matters submitted to vote of security holders* +23. +Consents of experts and counsel +83 +Table of Contents +23.1 +Consent of Ernst & Young LLP +23.3 +Consent of Huddleston & Co., Inc. +24. +Power of attorney* +31. +Rule 13a-14(a) Certifications +31.1 +Certification of Chief Executive Officer pursuant to Rule 13(a)-14(a) +31.2 +Certification of Chief Financial Officer pursuant to Rule 13(a)-14(a) +32. +Section 1350 Certifications +32.1 +Certification of Chief Executive Officer pursuant to Rule 13(a)-14(b) +32.2 +Certification of Chief Financial Officer pursuant to Rule 13(a)-14(b) +99. +Additional Exhibits* +* +Inapplicable to this filing. +84 +Table of Contents +SIGNATURES +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed +below by the following persons on behalf of the registrant and in the capacities and on the dates +indicated. +CALLON PETROLEUM COMPANY +Date: March 19, 2009 +/s/Fred L. Callon +Fred L. Callon (principal executive officer, director) +Date: March 19, 2009 +/s/B. F. Weatherly +B. F. Weatherly (principal financial officer, director) +Date: March 19, 2009 +/s/Rodger W. Smith +Rodger W. Smith (principal accounting officer) +Date: March 19, 2009 +/s/Richard L. Flury +Richard Flury (director) +Date: March 19, 2009 +/s/John C. Wallace +John C. Wallace (director) +85 +Table of Contents +Date: March 19, 2009 +/s/Richard O. Wilson +Richard O. Wilson (director) +Date: March 19, 2009 +/s/Larry D. McVay +Larry McVay (director) +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the +registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto +duly authorized. +CALLON PETROLEUM COMPANY +Date: March 19, 2009 +By: /s/B. F. Weatherly +B. F. Weatherly, Executive Vice-President and +Chief Financial Officer +86 \ No newline at end of file diff --git a/raw/filings/0000928022/2008/0000950134-09-005716/filing_metadata.csv b/raw/filings/0000928022/2008/0000950134-09-005716/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..faf82d15c27a92566cac626e851e6145c0acb7f9 --- /dev/null +++ b/raw/filings/0000928022/2008/0000950134-09-005716/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000928022,CPE,Callon Petroleum Co,10-K,2009-03-20,2008-12-31,2009-03-19T22:15:08.000Z,0000950134-09-005716,d66826e10vk.htm,FORM 10-K,841856,0,0,https://www.sec.gov/Archives/edgar/data/928022/000095013409005716/d66826e10vk.htm,https://www.sec.gov/Archives/edgar/data/928022/000095013409005716/,2008,2008,1 diff --git a/raw/filings/0000928022/2008/0000950134-09-005716/item1.txt b/raw/filings/0000928022/2008/0000950134-09-005716/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..0beb83fd4f99eddf87f6f0e48851cb8be0b93608 --- /dev/null +++ b/raw/filings/0000928022/2008/0000950134-09-005716/item1.txt @@ -0,0 +1,3869 @@ +Item 1.B. Unresolved Staff Comments +None. +25 +Table of Contents +ITEM 3. LEGAL PROCEEDINGS +We are a defendant in various legal proceedings and claims, which arise in the ordinary course of +our business. We do not believe the ultimate resolution of any such actions will have a material +affect on our financial position or results of operations. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +There were no matters submitted to a vote of security holders during the fourth quarter of 2008. +26 +Table of Contents +PART II. +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS +Our common stock trades on the New York Stock Exchange under the symbol “CPE”. The following table +sets forth the high and low sale prices per share as reported for the periods indicated. +Quarter Ended +High +Low +2007: +First quarter +$ +15.00 +$ +12.54 +Second quarter +15.19 +13.26 +Third quarter +15.68 +11.50 +Fourth quarter +17.21 +13.33 +2008: +First quarter +$ +19.22 +$ +13.42 +Second quarter +28.93 +17.63 +Third quarter +28.00 +16.18 +Fourth quarter +18.06 +1.02 +As of March 10, 2009 there were approximately 3,560 common stockholders of record. +We have never paid dividends on our common stock and intend to retain our cash flow from operations +for the future operation and development of our business. In addition, our primary credit facility +and the terms of our outstanding subordinated debt prohibit the payment of cash dividends on our +common stock. +Equity Compensation Plan Information. The following table summarizes information regarding +the number of shares of our common stock that are available for issuance under all of our existing +equity compensation plans as of December 31, 2008. +Number of securities +remaining available +Number of +Weighted- +for future issuance +securities +average +under equity +to be issued upon +exercise price of +compensation plan +exercise +outstanding +(excluding securities +of outstanding +options, warrants +reflected in column +options +and rights +(a)) +Plan Category +(a) +(b) +(c) +Equity +compensation plans +approved by +security holders +422,792 +$ +10.81 +351,479 +Equity +compensation plans +not approved by +security holders +90,483 +7.73 +42,466 +Total +513,275 +$ +10.27 +393,945 +27 +Table of Contents +Performance Graph +The following graph compares the yearly percentage change for the five years ended December 31, +2008, in the cumulative total shareholder return on the Company’s Common Stock against the +cumulative total return for the (i) Hemscott Industry and Market Index of SIC Group 123 (the +“Hemscott Group Index”) consisting of independent oil and gas drilling and exploration companies +and (ii) the New York Stock Exchange Market Index. The comparison of total return on an investment +for each of the periods assumes that $100 was invested on December 31, 2003 in the Company, the +Hemscott Group Index and the New York Stock Exchange Market Index, and that all dividends were +reinvested. +COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN +AMONG CALLON PETROLEUM COMPANY, +NYSE MARKET INDEX AND HEMSCOTT GROUP INDEX +ASSUMES $100 INVESTED ON DEC. 31, 2003 +ASSUMES DIVIDEND REINVESTED +FISCAL YEAR ENDING DEC. 31, 2008 +2003 +2004 +2005 +2006 +2007 +2008 +Callon Petroleum Company +$ +100 +$ +139 +$ +170 +$ +145 +$ +159 +$ +25 +Hemscott Group Index +$ +100 +$ +141 +$ +222 +$ +263 +$ +413 +$ +185 +NYSE Market Index +$ +100 +$ +113 +$ +122 +$ +143 +$ +151 +$ +95 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth, as of the dates and for the periods indicated, selected financial +information about us. The financial information for each of the five years in the period ended +December 31, 2008 has been derived from our audited Consolidated Financial Statements for such +periods. The information should be read in conjunction with “Management’s Discussion and Analysis +of Financial Condition and Results of Operations” and the Consolidated Financial Statements and +Notes thereto. The following information is not necessarily indicative of our future results. +28 +Table of Contents +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(In thousands, except per share amounts) +Years Ended December 31, +2008 +2007 +2006 +2005 +2004 +Statement of Operations Data: +Operating revenues: +Oil and gas sales +$ +141,312 +$ +170,768 +$ +182,268 +$ +141,290 +$ +119,802 +Operating expenses: +Lease operating expenses +19,208 +27,795 +28,881 +24,377 +22,308 +Depreciation, depletion and +amortization +64,054 +72,762 +65,283 +44,946 +47,453 +General and administrative +9,565 +9,876 +8,591 +8,085 +8,758 +Accretion expense +4,172 +3,985 +4,960 +3,549 +3,400 +Derivative expense +498 +— +150 +6,028 +1,371 +Impairment of oil and gas properties +485,498 +— +— +— +— +Total operating expenses +582,995 +114,418 +107,865 +86,985 +83,290 +Income (loss) from operations +(441,683 +) +56,350 +74,403 +54,305 +36,512 +Other (income) expenses: +Interest expense +26,705 +34,329 +16,480 +16,660 +20,137 +Other (income) +(1,379 +) +(1,172 +) +(1,869 +) +(998 +) +(357 +) +Loss on early extinguishment of debt +11,871 +— +— +— +3,004 +Total other (income) expenses +37,197 +33,157 +14,611 +15,662 +22,784 +Income (loss) before income taxes +(478,880 +) +23,193 +59,792 +38,643 +13,728 +Income tax expense (benefit) +(39,725 +) +8,506 +20,707 +13,209 +(6,697 +) +Income (loss) before equity in earnings of +Medusa Spar LLC +(439,155 +) +14,687 +39,085 +25,434 +20,425 +Equity in earnings of Medusa Spar +LLC, net of tax +262 +507 +1,475 +1,342 +1,076 +Net income (loss) +(438,893 +) +15,194 +40,560 +26,776 +21,501 +Preferred stock dividends +— +— +— +318 +1,272 +Net income (loss) available to common +shares +$ +(438,893 +) +$ +15,194 +$ +40,560 +$ +26,458 +$ +20,229 +Net income (loss) per common share: +Basic +$ +(20.68 +) +$ +0.73 +$ +2.00 +$ +1.43 +$ +1.28 +Diluted +$ +(20.68 +) +$ +0.71 +$ +1.90 +$ +1.28 +$ +1.22 +Shares used in computing net income (loss) +per common share: +Basic +21,222 +20,776 +20,270 +18,453 +15,796 +Diluted +21,222 +21,290 +21,363 +20,883 +17,678 +29 +Table of Contents +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(In thousands, except per share amounts) +Years Ended December 31, +2008 +2007 +2006 +2005 +2004 +Balance Sheet Data (end of period): +Oil and gas properties, net +$ +159,252 +$ +681,706 +$ +547,027 +$ +447,364 +$ +406,690 +Total assets +$ +266,090 +$ +792,482 +$ +625,527 +$ +533,776 +$ +457,523 +Long-term debt, less current portion +$ +272,855 +$ +392,012 +$ +225,521 +$ +188,813 +$ +192,351 +Stockholders’ equity +$ +(129,804 +) +$ +287,075 +$ +281,363 +$ +228,048 +$ +198,312 +We follow the full-cost method of accounting for oil and gas properties. Under this method of +accounting, our net capitalized costs to acquire, explore and develop oil and gas properties may +not exceed the sum of (1) the estimated future net revenues from proved reserves at current prices +discounted at 10% and (2) the lower of cost or market of unevaluated properties, net of tax (the +full-cost ceiling amount). If these capitalized costs exceed the full-cost ceiling amount, the +excess is charged to expense. For the year ended December 31, 2008, the Company recorded a $485.5 +million impairment of oil and gas properties as a result of the ceiling test. See Note 12 to the +Consolidated Financial Statements. +30 +Table of Contents +ITEM 7 . MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND +RESULTS OF OPERATIONS +The following discussion is intended to assist in an understanding of our financial condition and +results of operations. Our consolidated financial statements and notes thereto contain detailed +information that should be referred to in conjunction with the following discussion. See Item 8 +“Financial Statements and Supplementary Data.” +General +We have been engaged in the exploration, development, acquisition and production of oil and gas +properties since 1950. In the past several years, our activities have been focused in the shelf and +deepwater areas of the Gulf of Mexico. Production from wells in this area is characterized by high +initial production rates and steep decline curves. Accordingly, we are required to make material +expenditures to explore for and discover reserves to replace those produced. +Disruptions in Capital Markets. The capital markets are experiencing significant disruptions, +and many financial institutions have liquidity concerns, prompting government intervention to +mitigate pressure on the credit markets. Our primary exposure to the current credit market crisis +includes our senior secured revolving credit facility, senior notes and counterparty nonperformance +risks. +Our senior secured revolving credit facility was committed in the amount of $70 million as of December 31, 2008. Subsequent to December 31, 2008, our +borrowing base redetermination was completed and reduced to $48 million due to lower commodity prices. In addition, a Monthly Commitment Reduction (“MCR”) will be implemented commencing June 1, 2009 in the amount of $4.33 million per month. If not extended, the credit facility matures in September 25, 2012. +Should current credit market tightening be prolonged for several years, future extensions of our +credit facility may contain terms that are less favorable than those of our current credit +facility. The amounts which may be outstanding under our credit facility are limited by a +borrowing base, which is established by our lenders and based on the value of our proved reserves +using prices, costs and other assumptions determined by our lenders. Continued disruptions in the +capital markets could cause our lenders to be more restrictive in calculating our borrowing base. See +Note 18 to the Consolidated Financial Statements. +We have outstanding $200 million of senior notes due 2010. Continued disruptions in the capital +markets could make it more difficult or expensive to refinance those notes when they come due. +Current market conditions also elevate the concern over counterparty risks related to our commodity +derivative contracts and trade credit. At December 31, 2008, our open commodity derivative +instruments were in a net receivable position with a fair value of $21.8 million. We have all of +our commodity derivative instruments with a major financial +institution. Should the +financial counterparty not perform, we may not realize the benefit of some of our derivative +instruments under lower commodity prices and we could incur a loss. +We sell our production to a variety of purchasers. Some of these parties may experience liquidity +problems. Credit enhancements have been obtained from some parties in the way of parental +guarantees or letters of credit; however, we do not have all of our trade credit enhanced through +guarantees or credit support. +Reduced Prices for Oil and Gas Production . The United States and world economies are currently in +a recession which could last through 2009 and perhaps longer. Both oil and gas prices have +undergone significant decline during the second half of 2008 and into 2009 as a result of the +reduced economic activity brought on by the recession. Continued lower commodity prices will reduce +our cash flows from operations. To mitigate the impact of lower commodity prices on our cash flows, +we have entered into crude oil and natural gas commodity contracts for 2009. See Note 8 to our Consolidated Financial +Statements. Depending on the length of the current recession, commodity prices may stay depressed +or decline further, thereby causing a prolonged downturn, which would further reduce our cash flows +from operations. This could cause us to alter our business plans including reducing or delaying +our exploration and development program spending and other cost reduction initiatives. +31 +Table of Contents +Abandonment of the Entrada Project +In late November 2008, we and our joint working interest owner, CIECO, decided to abandon the +Entrada project. Under the terms of our agreements with CIECO, Callon Entrada is responsible for +its share of the costs to plug and abandon the Entrada project, which we estimate to be $46 +million, $23 million net to Callon Entrada. In addition, prior to abandonment of the project, CIECO failed to +fund two loan requests totaling $40 million under our non-recourse credit agreement with them. +CIECO also failed to fund its working interest share of a settlement +payment to terminate a drilling contract +for the Entrada project. Callon has paid its share of the settlement payment. +We continue to discuss with CIECO its failure to fund $40 million in loan requests and its share of +a settlement payment to terminate a drilling contract. Because these discussions are in the early +stages, no assurances can be made regarding the outcome of these discussions. We do not believe +that we have waived any of our rights under the agreements with CIECO regarding the loan requests +or the drilling contract settlement. +The CIECO Non-Recourse Credit Agreement +Principal and interest outstanding under the credit agreement with CIECO is non-recourse to Callon +Entrada and is not guaranteed by Callon Petroleum or any of its subsidiaries. The principal and +interest under the non-recourse credit agreement is secured by a lien on substantially all of +Callon Entrada’s assets. Included in these assets are the Entrada leases and equipment purchased +for the development project. At December 31, 2008 there was no value included on the balance sheet +for these assets. +CIECO has not declared Callon Entrada to be in default under the non-recourse credit agreement. +The lenders under our senior secured revolving credit facility have +amended the Second Amended and Restated Credit Agreement dated +September 25, 2008 to state that a default under the +Callon Entrada non-recourse credit facility will not be a default under their facility. In +addition, this amendment eliminates a possible cross default with regard +to our $200 million senior notes due +2010. Accordingly, we do not believe that a default under the CIECO agreement will have a material +negative impact on our financial position, results of operations and +cash flows. See Note 18 to the Consolidated Financial Statements. +Other Events in 2008 +In addition, the following events impacted our business in 2008: +Asset +Impairments — As required under the full-cost +accounting rules of the SEC, we assessed the recoverability +of our oil and gas properties. Due to the depressed economic environment, coupled with a severe +decrease in commodity prices during the fourth quarter of 2008 and the abandonment of the Entrada +project, we determined that our oil and gas properties were impaired. For 2008, total pre-tax +(non-cash) asset impairment charges were $485.5 million. See Critical Accounting Policies - +Impairment of Proved Oil and Gas Properties and Other Investments, and Impairment of Unproved Oil +and Gas Properties. +Deferred Tax Asset Valuation Allowance — As a result of incurring losses on an aggregate basis for +the three-year period ended December 31, 2008, we established a full valuation allowance in the +amount of $128 million on the tax benefit associated with the federal and state net operating loss +carryforwards as of December 31, 2008. See Critical Accounting Policies — Income Taxes. +Hurricanes Gustav and Ike — In August and September, Hurricanes Gustav and Ike moved through the +Gulf of Mexico. Inspection of our facilities and equipment indicated there was no major damage from +the hurricanes, although damage to third-party processing and pipeline facilities has slowed +reinstatement of production from our Gulf of Mexico assets. Temporary shut-ins of production +reduced volumes on average 12.8 million cubic feet of natural gas equivalent (“MMcfe”) per day +during third quarter 2008 and 18.0 MMcfe per day during fourth quarter 2008. +32 +Table of Contents +2009 OUTLOOK +We expect the mid-point of our 2009 crude oil and gas production to be slightly above our 2008 +results. The expected year-over-year change in production is impacted by several factors including: +• +the amount of development capital expenditures; +• +allocation of capital expenditures to acquire producing properties; and +• +natural field decline in the deepwater Gulf of Mexico and Gulf Coast areas of our US +operations. +Factors potentially impacting our expected production profile include: +• +our reduced level of capital expenditures, as discussed below; +• +potential hurricane-related volume curtailments in the Gulf of Mexico and Gulf Coast +areas as occurred with Hurricanes Gustav and Ike; and +• +the timeliness of restoration of pipeline and facilities after an inclement weather +event necessary to increase our Gulf of Mexico production. +2009 Budget —Due to the uncertain economic and commodity price environment, we have designed a +flexible capital spending program that will be responsive to conditions that develop during +2009. Our preliminary base capital program, including plugging and abandonment, for 2009 is $75 +million, which is relatively flat with 2008 budget, excluding the Entrada project, of $71 +million. However, depending on commodity prices and other economic conditions we experience in +2009, this base capital program may be adjusted up or down. +We expect that the 2009 budget will be funded primarily from cash flows from operations, cash on +hand, and borrowings under our senior secured revolving credit facility and/or other financing. We +will evaluate the level of capital spending throughout the year based on drilling results, +commodity prices, cash flows from operations and property acquisitions and divestitures. +Inflation has not had a material impact on us and is not expected to have a material impact on us +in the future. +Summary of Significant Accounting Policies +Property and Equipment. We follow the full-cost method of accounting for oil and gas properties +whereby all costs incurred in connection with the acquisition, exploration and development of oil +and gas reserves, including certain overhead costs, are capitalized into the “full-cost pool.” The +amounts we capitalize into the full-cost pool are depleted (charged against earnings) using the +unit-of-production method. The full-cost method of accounting for our proved oil and gas +properties requires that we make estimates based on assumptions as to future events that could +change. These estimates are described below. +Depreciation, Depletion and Amortization (DD&A) of Oil and Gas Properties . We calculate depletion +by using the net capitalized costs in our full-cost pool plus estimated future development costs +(combined, the depletable base) and our estimated net proved reserve quantities. Capitalized +costs added to the full-cost pool include the following: +33 +Table of Contents +• +the cost of drilling and equipping productive wells, dry hole costs, acquisition costs +of properties with proved reserves, delay rentals and other costs related to exploration +and development of our oil and gas properties; +• +our payroll and general and administrative costs and costs related to fringe benefits +paid to employees directly engaged in the acquisition, exploration and/or development of +oil and gas properties as well as other directly identifiable general and administrative +costs associated with such activities. Such capitalized costs do not include any costs +related to our production of oil and gas or our general corporate overhead; +• +costs associated with properties that do not have proved reserves classified as +unevaluated property costs and are excluded from the depletable base. These unevaluated +property costs are added to the depletable base at such time as wells are completed on the +properties, the properties are sold or we determine these costs have been impaired. Our +determination that a property has or has not been impaired (which is discussed below) +requires that we make assumptions about future events; +• +estimated costs to dismantle, abandon and restore properties that are capitalized to the +full-cost pool when the related liabilities are incurred under SFAS 143; and +• +our estimates of future costs to develop proved properties are added to the full-cost +pool for purposes of the DD&A computation. We use assumptions based on the latest +geologic, engineering, regulatory and cost data available to us to estimate these amounts. +However, the estimates we make are subjective and may change over time. Our estimates of +future development costs are periodically updated as additional information becomes +available. +Capitalized costs included in the full-cost pool plus estimated future development costs are +depleted and charged against earnings using the unit-of-production method. Under this method, we +estimate the proved reserves quantities at the beginning of each accounting period. For each Mcfe +produced during the period, we record a depletion charge equal to the amount included in the +depletable base (net of accumulated depreciation, depletion and amortization) divided by our +estimated net proved reserve quantities. +Because we use estimates and assumptions to calculate proved reserves (as discussed below) and the +amounts included in the depletable base, our depletion rates may materially change if actual +results differ from these estimates. +Ceiling Test . Under the full-cost accounting rules of the SEC, we review the carrying value of our +proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and gas +properties, net of accumulated depreciation, depletion and amortization and deferred income taxes, +may not exceed the present value of estimated future net cash flows from proved oil and gas +reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of +related tax effects (the full-cost ceiling amount). These rules generally require pricing future oil and gas production at the unescalated market price for +oil and gas at the end of each fiscal quarter and require a write-down if the “ceiling” is +exceeded. However, if prices recover sufficiently subsequent to the balance sheet date before the +release of the financial statements then use of the subsequent pricing is allowed and no write-down +would be required. Given the volatility of oil and gas prices, it is reasonably possible that our +estimate of discounted future net cash flows from proved oil and gas reserves could change in the +near term. If oil and gas prices decline significantly, even if only for a short period of time, +it is possible that write-downs of oil and gas properties could occur in the future. See Note 12 +to our Consolidated Financial Statements. +Estimating Reserves and Present Value of Estimated Future Net Cash Flows . The estimates of +quantities of proved oil and gas reserves and the discounted present value of estimated future net +cash flows from such reserves at the end of each quarter are based on numerous assumptions, which +are likely to change over time. These assumptions include: +34 +Table of Contents +• +the prices at which we can sell our oil and gas production in the future. Oil and gas +prices are volatile, but we are required to assume that they will not change from the +prices in effect at the end of the quarter. In general, higher oil and gas prices will +increase quantities of proved reserves and the present value of estimated future net cash +flows from such reserves, while lower prices will decrease these amounts. Because our +properties have relatively short productive lives, changes in prices will affect the +present value of estimated future net cash flows more than the estimated quantities of oil +and gas reserves; +• +the costs to develop and produce our reserves and the costs to dismantle our production +facilities when reserves are depleted. These costs are likely to change over time, but we +are required to assume that costs in effect at the end of the quarter will not change. +Increases in costs will reduce estimated oil and gas quantities and the present value of +estimated future net cash flows, while decreases in costs will increase such amounts. +Because our properties have relatively short productive lives, changes in costs will affect +the present value of estimated future net cash flows more than the estimated quantities of +oil and gas reserves; and +• +the potential royalties payable to the Mineral Management Service. See Note 10 of our +consolidated financial statements for a more detailed discussion. +In addition, the process of estimating proved oil and gas reserves requires that our independent +and internal reserve engineers exercise judgment based on available geological, geophysical and +technical information. We have described the risks associated with reserve estimation and the +volatility of oil and gas prices under “Risk Factors”. +Sales of oil and gas properties are +accounted for as adjustments to the net full cost pool with no gain or loss recognized, unless the +adjustment would significantly alter the relationship between capitalized costs and proved reserves. +Unproved Properties . Costs associated with properties that do not have proved reserves, including +capitalized interest, are excluded from the depletable base. These unproved properties are +included in the line item “Unevaluated properties excluded from amortization.” Unproved property +costs are transferred to the depletable base when wells are completed on the properties or the +properties are sold. In addition, we are required to determine whether our unproved properties are +impaired and, if so, include the costs of such properties in the depletable base. We determine +whether an unproved property should be impaired by periodically reviewing our exploration program +on a property by property basis. This determination may require the exercise of substantial +judgment by our management. +Asset Retirement Obligations. We account for asset retirement obligations in accordance with +Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” +(“SFAS 143”), which essentially requires entities to record the fair value of a liability for +obligations associated with the retirement of tangible long-lived assets and the associated asset +retirement costs. Interest is accreted on the present value of the asset retirement obligation and +reported as accretion expense within operating expenses in the Consolidated Statements of +Operations. See Note 11 to our Consolidated Financial Statements. +Derivatives. We periodically use derivative financial instruments to manage oil and gas price risk +on a limited amount of our future production and do not use these instruments for trading purposes. +Settlement of derivative contracts are generally based on the difference between the contract +price or prices specified in the derivative instrument and a NYMEX price or other cash or futures +index price. Such derivatives are accounted for under Statement of Financial Accounting Standards +No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended. +Our derivative contracts that are accounted for as cash flow hedges under SFAS 133 are recorded at +fair market value and the changes in fair value are recorded through other comprehensive income +(loss), net of tax, in stockholders’ equity. The cash settlements on these contracts are recorded +as an increase or decrease in oil and gas sales. The changes in fair value related to ineffective +derivative contracts are recognized as +derivative expense (income). The cash settlement on these contracts is also recorded within +derivative expense (income). See Note 8 to our Consolidated Financial Statements. +35 +Table of Contents +Our derivative contracts are carried at fair value on our consolidated balance sheet under the +caption “Fair Market Value of Derivatives”. The oil and gas derivative contracts are settled based +upon reported prices on NYMEX. The estimated fair value of these contracts is based upon closing +exchange prices on NYMEX and in the case of collars and floors, the time value of options. See +Note 9, “Fair Value Measurements” to our Consolidated Financial Statements. +Fair Value Measurements. Effective January 1, 2008, we adopted Statement of Financial Accounting +Standard No. 157, (“SFAS 157”), Fair Value Measurements. SFAS 157 defines fair value, establishes +a framework for measuring fair value and requires enhanced disclosures about fair value +measurements. We also adopted Statement of Financial Accounting Standard No. 159 “The Fair Value +Option for Financial Assets and Liabilities (“SFAS 159”), which permits entities to choose to +measure various financial instruments and certain other items at fair value. See Note 9 to our +Consolidated Financial Statements. +Income Taxes. We account for income taxes in accordance with Statement of Financial Accounting +Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”). Provisions for income taxes include +deferred taxes resulting primarily from temporary differences due to different reporting methods +for oil and gas properties for financial reporting purposes and income tax purposes. SFAS 109 +provides for the recognition of a deferred tax asset for net operating loss carryforwards, +statutory depletion carryforward and tax credit carryforwards, net of a valuation allowance. The +valuation allowance is provided for that portion of the asset for which it is deemed more likely +than not will not be realized. +We adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 “Accounting for +Uncertainty in Income Taxes” (“FIN 48”), effective January 1, 2007. FIN 48 clarifies the +accounting for income taxes by prescribing the minimum recognition threshold a tax position is +required to meet before being recognized in the financial statements. FIN 48 also provides +guidance on derecognition, measurement, classification, interest and penalties, and disclosure. +See Note 5 to our Consolidated Financial Statements. +Share-Based Compensation. Effective January 1, 2006, we adopted Statement of Financial Accounting +Standard No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”) utilizing the modified +prospective transition method. Prior to the adoption of SFAS 123R, we accounted for stock option +grants in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued +to Employees” (the intrinsic value method) and, accordingly, recognized no compensation expense for +stock option grants. +Under the modified prospective transition method, SFAS 123R applies to new awards, unvested awards +as of January 1, 2006 and awards that were outstanding on January 1, 2006 that are subsequently +modified, repurchased or cancelled. Under the modified prospective transition method, compensation +cost recognized in 2006 includes compensation cost for all share-based payments granted prior to, +but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in +accordance with the original provisions of Statement of Financial Accounting Standard No. 123 +“Accounting for Stock-Based Compensation,” (“SFAS 123”) and compensation cost for all share-based +payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in +accordance with the provisions of SFAS 123R. Prior periods were not restated to reflect the impact +of adopting the new standard. SFAS 123R also requires the cash flows from tax benefits resulting +from tax deductions in excess of compensation cost recognized for stock options exercised (excess +tax benefits) to be classified as financing cash flows. As a result of most of our stock-based +compensation being in the form of restricted stock, the impact of the adoption of SFAS 123R on +income +before taxes, net income and basic and diluted earnings per share for the year ended December 31, +2006 was immaterial. See Note 3 to our Consolidated Financial Statements. +36 +Table of Contents +New Accounting Standards +In December 2007, the FASB issued Statement of Financial Accounting Standard No. 141 (R) as +amended, “Business Combinations”, (“SFAS 141R”). The objective of SFAS 141R is to improve the +relevance, representational faithfulness, and comparability of the information that a reporting +entity provides in its financial reports about a business combination and its effects. To +accomplish that, SFAS 141R establishes principles and requirements for how the acquirer (a) +recognizes and measures in its financial statements the identifiable assets acquired, the +liabilities assumed, and any noncontrolling interest in the acquiree, (b) recognizes and measures +the goodwill acquired in the business combination or a gain from a bargain purchase, and (c) +determines what information to disclose to enable users of the financial statements to evaluate the +nature and financial effects of the business combination. SFAS 141R is effective for business +combinations with an acquisition date on or after the beginning of annual reporting period +beginning on or after December 15, 2008. We do not have an acquisition planned at this time and +can not evaluate the impact SFAS 141R will have on future financial +statements. +In December 2007, the FASB issued Statement of Financial Accounting Standard No. 160 as amended, +“Noncontrolling Interest in Consolidated Financial Statement”, (“SFAS 160”). The objective of SFAS +160 is to improve the relevance, comparability, and transparency of the financial information that +a reporting entity provides in its consolidated financial statements by establishing accounting +and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation +of a subsidiary. SFAS 160 is effective for first fiscal year and interim periods within the fiscal +year, beginning on or after December 15, 2008. We do not have a noncontrolling interest in a +subsidiary at this time and can not evaluate the impact SFAS 160 will have on future financial +statements. +In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, “Disclosures +about Derivative Instruments and Hedging Activities” – an amendment of SFAS Statement No. 133 +(“SFAS 161”). SFAS 161 changes the disclosure requirements for derivative instruments and hedging +activities. Under SFAS 161, entities are required to provide enhanced disclosures about (a) how +and why an entity uses derivative instruments, (b) how derivative instruments and related hedged +items are accounted for under Statement 133 and its related interpretations, and (c) how derivative +instruments and related hedged items affect an entity’s financial position, financial performance, +and cash flows. The new disclosure standard is effective for financial statements issued for +fiscal years and interim periods beginning after November 15, 2008, with early application +encouraged. The Statement encourages, but does not require, comparative disclosures for earlier +periods at initial adoption. We are currently evaluating the impact that SFAS 161 will have on its +financial statements. +In +December 2008 the SEC unanimously approved amendments to revise its +oil and gas reserves estimation and disclosure requirements. The +amendments, among other things: +• +allows the use of new technologies to determine proved +reserves; +• +permits the optional disclosure of probable and possible +reserves; +• +modifies the prices used to estimate reserves for SEC disclosure +purposes to a 12-month average price instead of a period-end price; +and +• +requires that if a third party is primarily responsible for +preparing or auditing the reserve estimates, the company make +disclosures relating to the independence and qualifications of the +third party, including filing as an exhibit any report received from +the third party. +The +revised rules are effective January 1, 2010. The new requirements do +not have an impact on our 2008 financial statements. +Liquidity and Capital Resources +Historically, our primary sources of capital have been cash flows from operations, borrowings from +financial institutions and the sale of debt and equity securities. Net cash and cash equivalents +decreased by $36 million during 2008 to $17 million. Cash provided from operating activities +during 2008 totaled $93 million, a decrease of 15% from $109 million in 2007. +On September 25, 2008, we closed on a four-year second amended and restated senior secured +revolving credit facility with Union Bank of California, N.A +as administrative agent and issuing lender. The borrowing base which is +reviewed and redetermined semi-annually was $70 million at December 31, 2008. There were no +borrowings under the credit facility at December 31, 2008; however we had a letter of credit +outstanding in the amount of $15 million to secure payments under a drilling contract for the Ocean +Victory with Diamond Offshore for the +37 +Table of Contents +development of Entrada. +Subsequent to December 31, 2008, we entered into the first amendment of the Second Amended and +Restated Credit Agreement dated September 25, 2008, which states that a default under the Entrada +non-recourse loan would not constitute a default under our senior secured revolving credit +facility. The amendment set the borrowing base at $48 million and implemented a Monthly Commitment +Reduction (MCR) commencing on June 1, 2009 in the amount of $4.33 million per month. The borrowing +base and MCR are both subject to re-determination August 1, 2009 and quarterly thereafter. The amendment is not expected to have a material impact on our financial +condition, operations or cash flows. See Notes 7, 15 and 18 to our Consolidated Financial +Statements. +In April 2008, we entered into a non-recourse credit agreement with CIECO pursuant to which we +could borrow up to $150 million, plus interest expense incurred of up to $12 million, to finance +the development of the Entrada project. This credit facility is secured by the Entrada Field and +related assets. During the year we borrowed $78.4 million under the facility and as of December +31, 2008, CIECO had failed to fund $40 million of loan request which were due in October and +November of 2008. We are in discussions with CIECO with regard to the loan requests. Because +these discussions are in early stages, no assurances can be made regarding the outcome of these +discussions. We do not believe that we have waived any of our rights under our agreements with +CIECO. The Company has not classified any of this facility as current and has not included any +amounts due in the five year maturities as it believes, based on the advice of counsel, that the +Callon Entrada credit agreement does not obligate Callon or any of its subsidiaries (other than +Callon Entrada) to pay principal, accrued interest or other amounts which may be owed under such +credit agreement. +In December 2003 and March 2004, we closed on our 9.75% senior notes due 2010 in the aggregate +principal amount of $200 million. The net proceeds from these notes and the public offering of +3,450,000 shares of common stock in the second quarter of 2004 were used to restructure our debt +that was maturing in 2004 and 2005. See Note 7 to the Consolidated Financial Statements for a more +detailed discussion of long-term debt. +The indenture governing our 9.75% senior notes due 2010 and our senior secured revolving credit +facility contain various covenants including restrictions on additional indebtedness and payment of +cash dividends. In addition, our senior secured revolving credit facility contains covenants for +maintenance of certain financial ratios. We were in compliance with these covenants at December +31, 2008. +Our current planned capital expenditures for 2009, total $65 million and include capitalized +interest and general and administrative expenses. The current portion of our asset retirement +obligation will require an additional $10 million resulting in capital expenditures of $75 million +for 2009. The current capital expenditure plans for 2009 include: +• +the acquisition of proved producing properties in the Gulf Coast Region; +• +lease and seismic acquisition; and +• +capitalized interest and overhead. +We believe that our operating cash flow and our credit facilities will be adequate to meet our +capital, debt repayment, and operating requirements for 2009. We fund our day-to-day operating +expenses and capital expenditures from operating cash flow, supplemented as needed by borrowings +under our credit facilities. +The following table describes our outstanding contractual obligations as of December 31, 2008 (in +thousands): +38 +Table of Contents +Payments due by Period +More +Contractual +Less Than +One-Three +Three-Five +Than-Five +Obligations +Total +One Year +Years +Years +Years +Senior Secured Credit Facility +$ +— +$ +— +$ +— +$ +— +$ +— +9.75% Senior Notes +200,000 +— +200,000 +— +— +Callon Entrada Credit Facility (1) +78,435 +— +— +— +78,435 +Throughput Commitments: +Medusa Oil Pipeline +214 +51 +101 +35 +27 +$ +278,649 +$ +51 +$ +200,101 +$ +35 +$ +78,462 +(1) The Callon Entrada Credit Facility is a direct obligation of Callon Entrada Company, an +indirect, wholly-owned subsidiary of Callon Petroleum. The Callon Entrada Credit Facility is +secured by a lien on the assets of Callon Entrada, which generally are comprised of the Entrada +Field and related equipment. Neither Callon Petroleum nor any other subsidiary of Callon Petroleum +guaranteed or otherwise agreed to pay the principal or interest payments due on the Callon Entrada +Credit Facility, so such facility is effectively non-recourse to Callon Petroleum and its other +subsidiaries. +Off-Balance Sheet Arrangements +We have a 10% ownership interest in Medusa Spar LLC (“LLC”), which is a limited liability company +that owns a 75% undivided ownership interest in the deepwater spar production facilities at our +Medusa Field in the Gulf of Mexico. In December 2003, we contributed a 15% undivided ownership interest in +the production facility to the LLC in return for approximately $25 million in cash and a 10% +ownership interest in the LLC. The LLC earns a tariff based upon production volume throughput from +the Medusa area. We are obligated to process our share of production from the Medusa Field and any +future discoveries in the area through the spar production +facilities. This arrangement allowed us +to defer the cost of the spar production facility over the life of the Medusa Field. Our cash +proceeds were used to reduce the balance outstanding under our senior secured credit facility. The +LLC used the cash proceeds from $83.7 million of non-recourse financing and a cash contribution by +one of the LLC owners to acquire its 75% interest in the spar. In the second quarter at 2008, the +non-recourse financing was extinguished. The balance of Medusa Spar LLC is owned by Oceaneering +International, Inc. and Murphy. We are accounting for our 10% ownership interest in the LLC under +the equity method. +39 +Table of Contents +Results of Operations +The following table sets forth certain operating information with respect to our oil and gas +operations for each of the three years in the period ended December 31, 2008. +December 31, +2008 +2007 +2006 +Production: +Oil (MBbls) +942 +1,063 +1,634 +Gas (MMcf) +5,839 +12,340 +10,977 +Total production (MMcfe) +11,494 +18,718 +20,780 +Average daily production (MMcfe) +31.4 +51.3 +56.9 +Average sales price: +Oil (per Bbl) (a) +$ +88.07 +$ +67.63 +$ +57.33 +Gas (per Mcf) +$ +9.99 +$ +8.01 +$ +8.07 +Total (per Mcfe) +$ +12.29 +$ +9.12 +$ +8.77 +Oil and gas revenues (in thousands): +Oil revenue +$ +82,963 +$ +71,891 +$ +93,665 +Gas revenue +58,349 +98,877 +88,603 +Total +$ +141,312 +$ +170,768 +$ +182,268 +Lease operating expenses (in thousands) +$ +19,208 +$ +27,795 +$ +28,881 +Additional per Mcfe data: +Sales price +$ +12.29 +$ +9.12 +$ +8.77 +Lease operating expenses +1.67 +1.48 +1.39 +Operating margin +$ +10.62 +$ +7.64 +$ +7.38 +Depletion +$ +5.57 +$ +3.89 +$ +3.14 +General and administrative (net of management fees) +$ +.83 +$ +.53 +$ +.41 +(a) Below is a reconciliation of the average NYMEX price to the average realized sales price per +barrel of oil: +Average NYMEX oil price +$ +99.67 +$ +72.33 +$ +66.22 +Basis differential and quality adjustments +(1.15 +) +(4.08 +) +(7.03 +) +Transportation +(1.15 +) +(1.15 +) +(1.25 +) +Hedging +(9.30 +) +0.53 +(0.61 +) +Average realized oil price +$ +88.07 +$ +67.63 +$ +57.33 +Comparison of Results of Operations for the Years Ended December 31, 2008 and 2007 +Oil and Gas Revenues +Total oil and gas revenues decreased 17% from $170.8 million in 2007 to $141.3 million in 2008 +primarily due to lower gas production. Total production on an equivalent basis for 2008 decreased +by 39% versus 2007. +Gas production during 2008 totaled 5.8 Bcf and generated $58.3 million in revenues compared to 12.3 +Bcf and $98.9 million in revenues during the same period in 2007. Average gas prices realized for +2008 were $9.99 per Mcf compared to $8.01 per Mcf during the same period in 2007. The 53% decrease +in 2008 production was primarily due to the sale of our Mobile Bay Field on Blocks 952, 953, and +955, effective May 1, 2007, a lower number of producing wells, downtime resulting from Hurricanes +Gustav and Ike and normal and expected declines in production from our older properties. Three of +our gas wells were shut-in due to early water production, two of which are now scheduled for +plugging and abandonment, and the third was sold for the plugging and abandonment liability. In +addition, our High Island Block A-540 well was shut in during the second quarter of 2008, due to a +plugged flowline, and management has determined it to be uneconomic to repair. +40 +Table of Contents +Oil production during 2008 totaled 942,000 barrels and generated $83.0 million in revenues compared +to 1,063,000 barrels and $71.9 million in revenues for the same period in 2007. Average oil prices +realized in 2008 were $88.07 per barrel compared to $67.63 per barrel in 2007. The 11% decrease in +2008 production was primarily due to downtime resulting from Hurricanes Gustav and Ike and normal +and expected declines in producing wells. In addition, our High Island Block A-540 well was shut +in during the second quarter of +2008, due to a plugged flowline, and management has determined it to be uneconomic to repair. See +the Results of Operations table for a reconciliation of the realized oil prices to average NYMEX. +Lease Operating Expenses +Lease operating expenses for 2008 decreased by 31% to $19.2 million compared to $27.8 million for +the same period in 2007. The decrease was primarily due to the sale of the Mobile Bay Field on +Blocks 952, 953 and 955 effective May 1, 2007, a lower number of producing wells and downtime in +the third and fourth quarters of 2008 caused by Hurricanes Gustav and Ike resulting in lower +throughput charges. Three of our gas wells were shut-in due to early water production, two of +which are now scheduled for plugging and abandonment, and the third was sold for the plugging and +abandonment liability. In addition, our High Island Block A-540 well was shut in during the second +quarter of 2008, due to a plugged flowline, and management has determined it to be uneconomic to +repair. +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization for 2008 and 2007 totaled $64.1 million and $72.8 million, +respectively. The 12% decrease was due to lower production volumes which were partially offset by +a higher depletion rate. The 43% increase in the depletion rate from 2007 to 2008 was higher +Entrada development costs in addition to the abandonment of operations. +Impairment of Oil and Gas Properties +During the fourth quarter of 2008, capitalized costs of oil and gas properties, net of accumulated +amortization and deferred taxes relating to oil and gas properties exceeded the sum of (1) the +estimated future net revenues from proved reserves at current prices discounted at 10% and (2) the +lower of cost or market of unevaluated properties, net of tax effects. As a result, the excess in +the amount of $485.5 million was expensed as an impairment of oil and gas properties for the year +ended December 31, 2008. See Note 12 to the Consolidated Financial Statements. +Accretion Expense +Accretion expense for 2008 and 2007 of $4.2 million and $4.0 million, respectively, represents +accretion of our asset retirement obligations. See Note 11 to the Consolidated Financial +Statements. +General and Administrative +General and administrative expenses for 2008, net of amounts capitalized, were $9.6 million +compared to $9.9 million in 2007, or a 3% decrease. +41 +Table of Contents +Interest Expense +Interest expense decreased to $26.7 million in 2008 compared to $34.3 million in 2007. This +decrease was due to the retirement of the $200 million senior revolving credit facility associated +with the Entrada acquisition. See Notes 7 and 15 to the Consolidated Financial Statement for more +details. +Loss on Early Extinguishment of Debt +Due to the early extinguishment of the $200 million senior revolving credit facility on April 8, +2008, we incurred expenses of $11.9 million consisting of $6.3 million in cash pre-payment +penalties plus a non-cash charge of $5.6 million related to the amortization expense associated +with the deferred financing costs related to the senior revolving credit facility. See Notes 7 and +15 to the Consolidated Financial Statements for more details. +Income Taxes +For 2008, we recorded an income tax benefit of $39.7 million compared to an income tax expense of +$8.5 million in 2007. The income tax benefit in 2008 was primarily the result of expensing the +impairment of oil and gas properties in the amount of $485.5 million. We evaluated our deferred +income tax asset in light of our reserve quantity estimates, our long-term outlook for oil and gas +prices and our expected level of future revenues and expenses and based upon this evaluation, we +believe it is more likely than not, that we will not realize the recorded deferred income tax +asset. As a result, we have established a valuation allowance in the amount of $128 million, the +amount of the deferred income tax asset. See Note 5 to the Consolidated Financial Statements. +Comparison of Results of Operations for the Years Ended December 31, 2007 and 2006 +Oil and Gas Revenues +Total oil and gas revenues decreased 6% from $182.3 million in 2006 to $170.8 million in 2007 +primarily due to lower oil production. Total production on an equivalent basis for 2007 decreased +by 10% versus 2006. +Gas production during 2007 totaled 12.3 Bcf and generated $98.9 million in revenues compared to +11.0 Bcf and $88.6 million in revenues during the same period in 2006. Average gas prices realized +for 2007 were $8.01 per Mcf compared to $8.07 per Mcf during the same period in 2006. The 12% +increase in 2007 production was primarily attributable to new discoveries brought on line. The +increase was partially offset by the sale of the Mobile Bay 952,953,955 Field in the second quarter +of 2007, early water production from East Cameron Block 90, High Island Block 73 and North Padre +Island Block 913 and normal and expected declines in production from our High Island Block 119 and +Mobile Bay area fields and older properties. In addition, remedial work with wireline and coil +tubing was performed to correct mechanical problems on the A-1 well at Medusa in the fourth quarter +of 2006 that resulted in production being restored at a lower rate. +Oil production during 2007 totaled 1,063,000 barrels and generated $71.9 million in revenues +compared to 1,634,000 barrels and $93.7 million in revenues for the same period in 2006. Average +oil prices realized in 2007 were $67.63 per barrel compared to $57.33 per barrel in 2006. The 35% +decrease in production was primarily due to the A-1 well at Medusa having mechanical problems which +required remedial work in +the +42 +Table of Contents +fourth quarter of 2006 and resulted in production being restored at a +lower rate. In addition, the #1 well at Habanero became uneconomic as expected in the third +quarter of 2007 and was sidetracked and completed as planned in an updip location in the reservoir. +Production from the sidetrack well commenced in October 2007. See the Results of Operations table +for a reconciliation of the realized oil prices to average NYMEX. +Lease Operating Expenses +Lease operating expenses for 2007 decreased by 4% to $27.8 million compared to $28.9 million for +the same period in 2006. The decrease was primarily due to the sale of the Mobile Bay 952, 953, +955 Field effective May, 2007, lower throughput charges at Habanero and the shut-in of our South +Marsh Island 261 Field, which is scheduled to be plugged and abandoned. The decrease was partially +offset by additional operating costs associated with or new discoveries. +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization for 2007 and 2006 were $72.8 million and $65.3 million, +respectively. The 11% increase was due to higher depletion rate resulting from higher costs +associated with our exploration and development activities in the Gulf of Mexico. +Accretion Expense +Accretion expense for 2007 and 2006 of $4.0 million and $5.0 million, respectively, represents +accretion of our asset retirement obligations. See Note 11 to the Consolidated Financial +Statements. +General and Administrative +General and administrative expenses for 2007, net of amounts capitalized, were $9.9 million +compared to $8.6 million in 2006. The 15% increase was a result of additions to our technical +staff and higher compensation costs. +Interest Expense +Interest expense increased to $34.3 million in 2007 compared to $16.5 million in 2006. This +increase was due to the new debt associated with the Entrada acquisition. See Notes 7 and 15 to +the Consolidated Financial Statements for more details. +Income Taxes +For 2007, income tax expense was $8.5 million compared to $20.7 million in 2006. The 59% decrease +was primarily due to a decrease in income before income taxes arising mainly out of the reduced oil +production and increased interest expense during the year. +43 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS +Commodity Price Risk +The Company’s revenues are derived from the sale of its crude oil and natural gas production. The +prices for oil and gas remain extremely volatile and sometimes experience large fluctuations as a +result of relatively small changes in supply, weather conditions, economic conditions and +government actions. From time to time, the Company enters into derivative financial instruments to +manage oil and gas price risk. +The Company may utilize fixed price “swaps”, which reduce the Company’s exposure to decreases in +commodity prices and limit the benefit the Company might otherwise have received from any increases +in commodity prices. +The Company may utilize price “collars” to reduce the risk of changes in oil and gas prices. Under +these arrangements, no payments are due by either party as long as the market price is above the +floor price and below the ceiling price set in the collar. If the price falls below the floor, the +counter-party to the collar pays the difference to the Company, and if the price rises above the +ceiling, the counter-party receives the difference from the Company. +Callon may purchase “puts” which reduce the Company’s exposure to decreases in oil and gas prices +while allowing realization of the full benefit from any increases in oil and gas prices. If the +price falls below the floor, the counter-party pays the difference to the Company. +The Company enters into these various agreements from time to time to reduce the effects of +volatile oil and gas prices and does not enter into derivative transactions for speculative +purposes. However, certain of the Company’s derivative positions may not be designated as hedges +for accounting purposes. See Note 8 to the Consolidated Financial Statements for a description of +the Company’s hedged position at December 31, 2008. +Based on projected annual sales volumes for 2009 (excluding incremental production from 2008 +exploratory drilling), a 10% decline in the prices Callon receives for its crude oil and natural +gas production would have an approximate $4.5 million impact on our revenues. +44 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +Report +of Independent Registered Public Accounting Firm +46 +Consolidated Balance Sheets as of December 31, 2008 +and 2007 +47 +Consolidated Statements of Operations for Each of the Three Years +in the Period Ended December 31, 2008 +48 +Consolidated Statements of Stockholders’ Equity +for Each of the Three Years in the Period Ended December 31, +2008 +49 +Consolidated Statements of Cash Flows for Each of the Three Years +in the Period Ended December 31, 2008 +50 +Notes +to Consolidated Financial Statements +51 +45 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited the accompanying consolidated balance sheets of Callon Petroleum Company as of +December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ +equity and cash flows for each of the three years in the period ended December 31, 2008. These +financial statements are the responsibility of the Company’s management. Our responsibility is to +express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting +Oversight Board (United States). Those standards require that we plan and perform the audit to +obtain reasonable assurance about whether the financial statements are free of material +misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and +disclosures in the financial statements. An audit also includes assessing the accounting +principles used and significant estimates made by management, as well as evaluating the overall +financial statement presentation. We believe that our audits provide a reasonable basis for our +opinion. +In our opinion, the financial statements referred to above present fairly, in all material +respects, the consolidated financial position of Callon Petroleum Company as of December 31, 2008 +and 2007, and the consolidated results of its operations and its cash flows for each of the three +years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting +principles. +As discussed in Note 2 to the financial statements, in 2007 the Company changed its method of +accounting for income taxes. +We also have audited, in accordance with the standards of the Public Company Accounting +Oversight Board (United States), Callon Petroleum Company’s internal control over financial +reporting as of December 31, 2008, based on criteria established in Internal Control—Integrated +Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our +report dated March 19, 2009, expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 19, 2009 +46 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(In thousands, except share data) +December +31, +2008 +2007 +ASSETS +Current assets: +Cash and cash equivalents +$ +17,126 +$ +53,250 +Accounts receivable +44,290 +22,073 +Restricted investments +— +100 +Fair market value of derivatives +21,780 +— +Other current assets +1,103 +6,592 +Total current assets +84,299 +82,015 +Oil and gas properties, full-cost accounting method: +Evaluated properties +1,581,698 +1,349,904 +Less accumulated depreciation, depletion and amortization +(1,455,275 +) +(738,374 +) +126,423 +611,530 +Unevaluated properties excluded from amortization +32,829 +70,176 +Total oil and gas properties +159,252 +681,706 +Other property and equipment, net +2,536 +1,986 +Restricted investments +4,759 +4,525 +Investment in Medusa Spar LLC +12,577 +12,673 +Other assets, net +2,667 +9,577 +Total assets +$ +266,090 +$ +792,482 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable and accrued liabilities +$ +76,516 +$ +37,698 +Asset retirement obligations +9,151 +9,810 +Fair market value of derivatives +— +5,205 +Total current liabilities +85,667 +52,713 +9.75% Senior Notes +194,420 +192,012 +Callon Entrada Credit Facility (non-recourse) +78,435 +— +Senior Revolving Credit Facility +— +200,000 +Total long-term debt +272,855 +392,012 +Asset retirement obligations +33,043 +27,027 +Deferred tax liability +— +32,190 +Other long-term liabilities +4,329 +1,465 +Total liabilities +395,894 +505,407 +Stockholders’ equity: +Preferred Stock, $.01 par value; 2,500,000 shares authorized; +— +— +Common Stock, $.01 par value; 30,000,000 shares +authorized; 21,621,142 shares and 20,891,145 shares issued +outstanding at December 31, 2008 and 2007, respectively +216 +209 +Capital in excess of par value +227,803 +223,336 +Other comprehensive income (loss) +14,157 +(3,383 +) +Retained (deficit) earnings +(371,980 +) +66,913 +Total stockholders’ equity +(129,804 +) +287,075 +Total liabilities and stockholders’ equity +$ +266,090 +$ +792,482 +The accompanying notes are an integral part of these financial statements. +47 +Table of Contents +Callon Petroleum Company +Consolidated Statements of Operations +(In thousands, except per share amounts) +Year Ended December 31, +2008 +2007 +2006 +Operating revenues: +Oil sales +$ +82,963 +$ +71,891 +$ +93,665 +Gas sales +58,349 +98,877 +88,603 +Total operating revenues +141,312 +170,768 +182,268 +Operating expenses: +Lease operating expenses +19,208 +27,795 +28,881 +Depreciation, depletion and amortization +64,054 +72,762 +65,283 +General and administrative +9,565 +9,876 +8,591 +Accretion expense +4,172 +3,985 +4,960 +Derivative expense +498 +— +150 +Impairment of oil and gas properties +485,498 +— +— +Total operating expenses +582,995 +114,418 +107,865 +Income (loss) from operations +(441,683 +) +56,350 +74,403 +Other (income) expenses: +Interest expense +26,705 +34,329 +16,480 +Loss on early extinguishment of debt +11,871 +— +— +Other income +(1,379 +) +(1,172 +) +(1,869 +) +Total other (income) expenses +37,197 +33,157 +14,611 +Income (loss) before income taxes +(478,880 +) +23,193 +59,792 +Income tax (benefit) expense +(39,725 +) +8,506 +20,707 +Income (loss) before equity in earnings of Medusa Spar LLC +(439,155 +) +14,687 +39,085 +Equity in earnings of Medusa Spar LLC, net of tax +262 +507 +1,475 +Net income (loss) available to common shares +$ +(438,893 +) +$ +15,194 +$ +40,560 +Net income (loss) per common share: +Basic +$ +(20.68 +) +$ +0.73 +$ +2.00 +Diluted +$ +(20.68 +) +$ +0.71 +$ +1.90 +Shares used in computing net income (loss) per share +amounts: +Basic +21,222 +20,776 +20,270 +Diluted +21,222 +21,290 +21,363 +The accompanying notes are an integral part of these financial statements. +48 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(In thousands) +Unearned +Accumulated +Total +Restricted +Capital in +Other +Retained +Stock- +Preferred +Common +Stock +Excess of +Comprehensive +Earnings +holders’ +Stock +Stock +Compensation +Par Value +Income (Loss) +(Deficit) +Equity +Balances, December 31, 2005 +$ +— +$ +194 +$ +(3,334 +) +$ +220,360 +$ +(331 +) +$ +11,159 +$ +228,048 +Comprehensive income: +Net income +— +— +— +— +— +40,560 +Other comprehensive income +— +— +— +— +8,983 +— +Total comprehensive income +49,543 +Shares issued pursuant to employee +benefit and option plan +— +2 +— +(441 +) +— +— +(439 +) +Tax benefits related to stock +compensation plans +— +— +— +1,356 +— +— +1,356 +Adoption of 123R +3,334 +(3,334 +) +— +— +Restricted stock +— +1 +— +2,854 +— +— +2,855 +Warrants +— +10 +— +(10 +) +— +— +— +Balances, December 31, 2006 +— +207 +— +220,785 +8,652 +51,719 +281,363 +Comprehensive income: +Net income +— +— +— +— +— +15,194 +Other comprehensive loss +— +— +— +— +(12,035 +) +— +Total comprehensive income +3,159 +Tax benefits related to stock +compensation plans +— +— +— +163 +— +— +163 +Restricted stock +— +2 +— +2,388 +— +— +2,390 +Balances, December 31, 2007 +— +209 +— +223,336 +(3,383 +) +66,913 +287,075 +Comprehensive income (loss): +Net loss +— +— +— +— +— +(438,893 +) +Other comprehensive income +— +— +— +— +17,540 +— +Total comprehensive loss +(421,353 +) +Shares issued pursuant to employee +benefit and option plan +— +1 +— +(1,153 +) +— +— +(1,152 +) +Tax benefits related to stock +compensation plans +— +— +— +2,050 +— +— +2,050 +Restricted stock +— +1 +— +3,575 +— +— +3,576 +Warrants +— +5 +— +(5 +) +— +— +— +Balances, December 31, 2008 +$ +— +$ +216 +$ +— +$ +227,803 +$ +14,157 +$ +(371,980 +) +$ +(129,804 +) +The accompanying notes are an integral part of these financial statements. +49 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In thousands) +Years Ended December 31, +2008 +2007 +2006 +Cash flows from operating activities: +Net income (loss) +$ +(438,893 +) +$ +15,194 +$ +40,560 +Adjustments to reconcile net income (loss) to +cash provided by operating activities: +Depreciation, depletion and amortization +64,862 +73,677 +65,929 +Impairment of oil and gas properties +485,498 +— +— +Accretion expense +4,172 +3,985 +4,960 +Amortization of deferred financing costs +4,185 +3,009 +2,221 +Non-cash loss on early extinguishment of debt +5,598 +— +— +Equity in earnings of Medusa Spar, LLC +(262 +) +(507 +) +(1,475 +) +Non-cash derivative expense +— +— +150 +Deferred income tax (benefit) expense +(39,725 +) +8,506 +20,707 +Non-cash charge related to compensation plans +1,550 +849 +1,420 +Excess tax benefits from share-based payment arrangements +(2,050 +) +(163 +) +(1,449 +) +Changes in current assets and liabilities: +Accounts receivable +(22,215 +) +6,658 +(2,107 +) +Other current assets +5,489 +(619 +) +(3,975 +) +Current liabilities +22,987 +(2,057 +) +11,311 +Change in gas balancing receivable +630 +(938 +) +(311 +) +Change in gas balancing payable +156 +889 +133 +Change in other long-term liabilities +2,708 +(10 +) +(2 +) +Change in other assets, net +(1,458 +) +810 +(2,588 +) +Cash provided by operating activities +93,232 +109,283 +135,484 +Cash flows from investing activities: +Capital expenditures +(176,536 +) +(127,409 +) +(167,979 +) +Entrada acquisition +— +(150,000 +) +— +Proceeds from sale of mineral interests +167,349 +60,931 +— +Distribution from Medusa Spar, LLC +498 +687 +1,078 +Cash used by investing activities +(8,689 +) +(215,791 +) +(166,901 +) +Cash flows from financing activities: +Change in accrued liabilities to be refinanced +— +— +(5,000 +) +Increases in debt +94,435 +229,000 +88,000 +Payments on debt +(216,000 +) +(64,000 +) +(53,000 +) +Deferred financing costs +— +(6,429 +) +— +Equity issued related to employee stock plans +(1,152 +) +— +(438 +) +Excess tax benefits from share-based payment arrangements +2,050 +163 +1,449 +Capital leases +— +(872 +) +(263 +) +Cash (used) provided by financing activities +(120,667 +) +157,862 +30,748 +Net (decrease) increase in cash and cash equivalents +(36,124 +) +51,354 +(669 +) +Cash and cash equivalents: +Balance, beginning of period +53,250 +1,896 +2,565 +Balance, end of period +$ +17,126 +$ +53,250 +$ +1,896 +The accompanying notes are an integral part of these financial statements. +50 +Table of Contents +CALLON PETROLEUM COMPANY +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +General +Callon Petroleum Company (“the Company” or “Callon”) was organized under the laws of the state of +Delaware in March 1994 to serve as the surviving entity in the consolidation and combination of +several related entities (referred to herein collectively as the “Constituent Entities”). The +combination of the businesses and properties of the Constituent Entities with the Company was +completed on September 16, 1994 (“Consolidation”). +As a result of the Consolidation, all of the businesses and properties of the Constituent Entities +are owned (directly or indirectly) by the Company. Certain registration rights were granted to the +stockholders of certain of the Constituent Entities. See Note 10. +The Company and its predecessors have been engaged in the acquisition, development and exploration +of crude oil and natural gas since 1950. The Company’s properties are geographically concentrated +in the Gulf Coast Region. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Principles of Consolidation and Reporting +The Consolidated Financial Statements include the accounts of the Company, and its subsidiary, +Callon Petroleum Operating Company (“CPOC”). CPOC also has subsidiaries, namely Callon Offshore +Production, Inc., Callon Entrada Company (“Callon Entrada”) and Mississippi Marketing, Inc. All intercompany accounts +and transactions have been eliminated. Certain prior year amounts have been reclassified to +conform to presentation in the current year. +Use of Estimates +The preparation of financial statements in conformity with U.S. generally accepted accounting +principles requires management to make estimates and assumptions that affect the reported amounts +of assets and liabilities and disclosure of contingent assets and liabilities at the date of the +financial statements and the reported amounts of revenues and expenses during the reporting period. +Actual results could differ from those estimates. +Asset Retirement Obligations +The Company accounts for asset retirement obligations in accordance with Statement of Financial +Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”), which +essentially requires entities to record the fair value of a liability for obligations associated +with the retirement of tangible long-lived assets and the associated asset retirement costs. +Interest is accreted on the present value of the asset retirement obligation and reported as +accretion expense within operating expenses in the consolidated statements of operations. See Note +11. +51 +Table of Contents +Oil and Gas Properties +The Company follows the full-cost method of accounting for oil and gas properties whereby all costs +incurred in connection with the acquisition, exploration and development of oil and gas reserves, +including certain overhead costs, are capitalized. Such amounts include the cost of drilling and +equipping productive wells, dry hole costs, lease acquisition costs, delay rentals, interest +capitalized on unevaluated leases, other costs related to exploration and development activities, +and site restoration, dismantlement and abandonment costs capitalized under SFAS 143. General and +administrative costs capitalized include salaries and related fringe benefits paid to employees +directly engaged in the acquisition, exploration and/or development of oil and gas properties as +well as other directly identifiable general and administrative costs associated with such +activities. Such capitalized costs ($12.6 million in 2008, $10.8 million in 2007 and $9.6 million +in 2006) do not include any costs related to production or general corporate overhead. Costs +associated with unevaluated properties, including capitalized interest on such costs, are excluded +from amortization. Unevaluated property costs are transferred to evaluated property costs at such +time as wells are completed on the properties or management determines that these costs have been +impaired. +Costs of oil and gas properties, including future development costs, which have proved reserves and +properties which have been determined to be worthless, are depleted using the unit-of-production +method based on proved reserves. If the total capitalized costs of oil and gas properties, net of +accumulated amortization and deferred taxes relating to oil and gas properties, exceed the sum of +(1) the estimated future net revenues from proved reserves at current prices discounted at 10% and +(2) the lower of cost or market of unevaluated properties, net of tax effects (the full-cost +ceiling amount), then such excess is charged to expense during the period in which the excess +occurs. See Note 12. +Upon the acquisition or discovery of oil and gas properties, management estimates the future net +costs to be incurred to dismantle, abandon and restore the property using available geological, +engineering and regulatory data. Such cost estimates are periodically updated for changes in +conditions and requirements. In accordance with SFAS 143, such costs are capitalized to the +full-cost pool when the related liabilities are incurred. In accordance with SEC Staff Accounting +Bulletin No. 106, assets recorded in connection with the recognition of an asset retirement +obligation pursuant to SFAS 143 are included as part of the costs subject to the full-cost ceiling +limitation. The future cash outflows associated with settling the recorded asset retirement +obligations are excluded from the computation of the present value of estimated future net revenues +used in determining the full-cost ceiling amount. +Sales of oil and gas properties are +accounted for as adjustments to the net full cost pool with no gain or loss recognized, unless the +adjustment would significantly alter the relationship between capitalized costs and proved reserves. +Property and Equipment +Depreciation of other property and equipment is provided using the straight-line method over +estimated lives of three to 20 years. Depreciation expense of $437,000, $457,000 and $351,000 +relating to other property and equipment was included in general and administrative expenses in the +Company’s consolidated statements of operations for the years ended December 31, 2008, 2007 and +2006, respectively. The accumulated depreciation on other property and equipment was $11.6 million +and $11.2 million as of December 31, 2008 and 2007, respectively. +52 +Table of Contents +Investment in Medusa Spar LLC +The Company has a 10% ownership interest in Medusa Spar, LLC (“LLC”), which is a limited liability +company that owns a 75% undivided ownership interest in the deepwater spar production facilities on +Callon’s Medusa Field in the Gulf of Mexico. In December 2003, the Company contributed a 15% +undivided ownership interest in the production facility to the LLC in return for approximately $25 +million in cash and a 10% ownership interest in the LLC. The LLC earns a tariff based upon +production volume throughput from the Medusa area. Callon is obligated to process its share of +production from the Medusa Field and any future discoveries in the area through the spar production +facilities. This arrangement allowed Callon to defer the cost of the spar production facility over +the life of the Medusa Field. The Company’s cash proceeds were used to reduce the balance +outstanding under its senior secured credit facility. The LLC used the cash proceeds from $83.7 +million of non-recourse financing and a cash contribution by one of the LLC owners to acquire its +75% interest in the spar. During the second quarter of 2008, the non-recourse financing was +extinguished. The balance of Medusa Spar LLC is owned by Oceaneering International, Inc. +(NYSE:OII) and Murphy Oil Corporation (NYSE:MUR). The Company is accounting for its 10% ownership +interest in the LLC under the equity method. +Natural Gas Imbalances +The Company follows the entitlement method of accounting for its proportionate share of gas +production on a well-by-well basis, recording a receivable to the extent that a well is in an +“undertake” position and recording a liability to the extent that a well is in an “overtake” +position. Gas balancing receivables were $1.0 million and $1.7 million as of December 31, 2008 and +2007, respectively. Gas balancing payables were $1.5 million and $1.3 million as of December 31, +2008 and 2007, respectively. +Derivatives +The Company periodically uses derivative financial instruments to manage oil and gas price risk on +a limited amount of its future production and does not use these instruments for trading purposes. +Settlement of derivative contracts is generally based on the difference between the contract price +or prices specified in the derivative instrument and a New York +Mercantile Exchange (NYMEX) price or other cash or futures index +price. Such derivatives are accounted for under Statement of Financial Accounting Standards No. +133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended. +The Company’s derivative contracts that are accounted for as cash flow hedges under SFAS 133 are +recorded at fair market value and the changes in fair value are recorded through other +comprehensive income (loss), net of tax, in stockholders’ equity. The cash settlements on these +contracts are recorded as an increase or decrease in oil and gas sales. The changes in fair value +related to ineffective derivative contracts are recognized as derivative expense (income). The +cash settlement on these contracts is also recorded within derivative expense (income). See Note +8. +Callon’s derivative contracts are carried at fair value on the Company’s consolidated balance sheet +under the caption “Fair Market Value of Derivatives”. The oil and gas derivative contracts are +settled based upon reported prices on NYMEX. The estimated fair value of these contracts is based +upon closing exchange prices on NYMEX and in the case of collars and floors, the time value of +options. See Note 9, “Fair Value Measurements.” +53 +Table of Contents +Income Taxes +The Company accounts for income taxes in accordance with Statement of Financial Accounting +Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”). Provisions for income taxes include +deferred taxes resulting primarily from temporary differences due to different reporting methods +for oil and gas properties for financial reporting purposes and income tax purposes. SFAS 109 +provides for the recognition of a deferred tax asset for net operating loss carryforwards, +statutory depletion carryforward and tax credit carryforwards, net of a valuation allowance. The +valuation allowance is provided for that portion of the asset for which it is deemed more likely +than not will not be realized. +Callon adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 “Accounting for +Uncertainty in Income Taxes” (“FIN 48”), effective January 1, 2007. FIN 48 clarifies the +accounting for income taxes by prescribing the minimum recognition threshold a tax position is +required to meet before being recognized in the financial statements. FIN 48 also provides +guidance on derecognition, measurement, classification, interest and penalties, and disclosure. +See Note 5. +Earnings per Share +The Company accounts for earnings per share (“EPS”) in accordance with Statement of Financial +Accounting Standards No. 128, “Earnings Per Share” (“SFAS 128”). SFAS 128 requires all entities +with publicly held common stock or potential common stock must disclose EPS — basic and diluted. +Basic EPS is computed by dividing reported earnings available to common stockholders by weighted +average shares outstanding. Diluted EPS reflects the potential dilution that could occur if +securities or other contracts to issue common stock were exercised or converted into common stock +or resulted in the issuance of common stock that then shared in the earnings of the entity. The +earnings component of EPS is limited to earnings applicable to common shares or earnings after +deduction of preferred stock dividends if incurred. If discontinued operations, extraordinary +items, and /or the cumulative effect of a change in accounting principles are reported, EPS +information is required for each of the following: (a) income from continuing operations, (b) +income before extraordinary items, (c) the cumulative effect of the change in accounting principle, +net of tax, and (d) net income. See note 4. +Stock-Based Compensation +Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standard No. 123 +(revised 2004), “Share-Based Payment,” (“SFAS 123R”) utilizing the modified prospective transition +method. Prior to the adoption of SFAS 123R, the Company accounted for stock option grants in +accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to +Employees” (the intrinsic value method) and, accordingly, recognized no compensation expense for +stock option grants. +Under the modified prospective transition method, SFAS 123R applies to new awards, unvested awards +as of January 1, 2006 and awards that were outstanding on January 1, 2006 that are subsequently +modified, repurchased or cancelled. Under the modified prospective transition method, compensation +cost recognized in 2008, 2007 and 2006 includes compensation cost for all share-based payments +granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value +estimated in accordance with the original provisions of Statement of Financial Accounting Standard +No. 123 “Accounting for Stock-Based Compensation,” (“SFAS 123”) and compensation cost for all +share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value +estimated in accordance with the provisions of SFAS 123R. Prior periods were not restated to +reflect the impact of adopting the new standard. +SFAS 123R requires the cash flows from tax benefits resulting from tax deductions in excess of +compensation cost recognized for stock options exercised (excess tax benefits) to be classified as +financing cash flows. The +$2.1 million, $163,000 and $1.4 million of excess tax benefits classified as a financing cash +inflow for the years ended December 31, 2008, 2007 and 2006, respectively would have been +classified as an operating cash +54 +Table of Contents +flow had the Company not adopted SFAS 123R. There were no stock +option exercises in the year ended December 31, 2007 and no cash proceeds from the exercise of +stock options for the years ended December 31, 2008 and 2006 due to the fact that all options were +exercised through net-share settlements. As a result of most of the Company’s stock-based +compensation being in the form of restricted stock, the impact of the adoption of SFAS 123R on +income before taxes, net income and basic and diluted earnings per share for the year ended +December 31, 2006 was not significant. See Note 3. +Accounts Receivable +Accounts receivable consists primarily of accrued oil and gas production receivables. The balance +in the reserve for doubtful accounts netted within accounts receivable was $65,000 at both December +31, 2008 and 2007. There were no provisions to expense in the three-year period ended December 31, +2008. +Major Customers +The Company’s production is generally sold on month-to-month contracts at prevailing prices. The +following table identifies customers to whom it sold a significant percentage of its total oil and +gas production during each of the years ended: +December 31, +2008 +2007 +2006 +Shell Trading Company +33 +% +25 +% +41 +% +Louis Dreyfus Energy Services +16 +% +20 +% +25 +% +StatoilHydro +— +13 +% +— +Plains Marketing, L.P. +23 +% +10 +% +11 +% +Because alternative purchasers of oil and gas are readily available, the Company believes that the +loss of any of these purchasers would not result in a material adverse effect on its ability to +market future oil and gas production. +Statements of Cash Flows +The Company considers all highly liquid investments with an original maturity of three months or +less to be cash equivalents. +The Company paid no federal income taxes for the three years in the period ended December 31, 2008. +During the years ended December 31, 2008, 2007 and 2006, the Company made cash payments for +interest of $27.0 million, $37.6 million and $20.5 million, respectively. +Fair Value of Financial Instruments +Fair value of cash and cash equivalents, accounts receivable and accounts payable, approximated +book value at December 31, 2008 and 2007. The fair value of the senior revolving credit facility +approximated book value at December 31, 2008. The senior secured +revolving credit facility and capital lease +had no balance outstanding at December 31, 2008 and the fair value approximated book value at +December 31, 2008. The Company’s 9.75% Senior Notes due 2010 had an estimated fair market value of +52% and 94% of face value at December 31, 2008 and 2007, respectively. +55 +Table of Contents +Fair Value Measurements +Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standard No. 157, +(“SFAS 157”), Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for +measuring fair value and requires enhanced disclosures about fair value measurements. The adoption +of SFAS 157 did not have a significant impact on the Company’s financial statements. The Company +also adopted Statement of Financial Accounting Standard No. 159 “The Fair Value Option for +Financial Assets and Liabilities (“SFAS 159”) on January 1, 2008, which permits entities to choose +to measure various financial instruments and certain other items at fair value. The Adoption of +SFAS 159 did not have an impact on the Company’s financial statements. See Note 9. +Accounting Pronouncements +In December 2007, the FASB issued Statement of Financial Accounting Standard No. 141 (R) as +amended, “Business Combinations”, (“SFAS 141R”). The objective of SFAS 141R is to improve the +relevance, representational faithfulness, and comparability of the information that a reporting +entity provides in its financial reports about a business combination and its effects. To +accomplish that, SFAS 141R establishes principles and requirements for how the acquirer (a) +recognizes and measures in its financial statements the identifiable assets acquired, the +liabilities assumed, and any noncontrolling interest in the acquiree, (b) recognizes and measures +the goodwill acquired in the business combination or a gain from a bargain purchase, and (c) +determines what information to disclose to enable users of the financial statements to evaluate the +nature and financial effects of the business combination. SFAS 141R is effective for business +combinations with an acquisition date on or after the beginning of annual reporting period +beginning on or after December 15, 2008. The Company does not have an acquisition planned at this +time and can not evaluate the impact SFAS 141R will have on future +financial statements. +In December 2007, the FASB issued Statement of Financial Accounting Standard No. 160 as amended, +“Noncontrolling Interest in Consolidated Financial Statement”, (“SFAS 160”). The objective of SFAS +160 is to improve the relevance, comparability, and transparency of the financial information that +a reporting entitiy provides in its consolidated financial statements by establishing accounting +and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation +of a subsidiary. SFAS 160 is effective for first fiscal year and interim periods within the fiscal +year, beginning on or after December 15, 2008. The Company doe not have a noncontrolling interest +in a subsidiary at this time and can not evaluate the impact SFAS 160 will have on future financial +statements. +In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, “Disclosures +about Derivative Instruments and Hedging Activities” — an amendment of SFAS Statement No. 133 +(“SFAS 161”). SFAS 161 changes the disclosure requirements for derivative instruments and hedging +activities. Under SFAS 161, entities are required to provide enhanced disclosures about (a) how +and why an entity uses derivative instruments, (b) how derivative instruments and related hedged +items are accounted for under Statement 133 and its related interpretations, and (c) how derivative +instruments and related hedged items affect an entity’s financial position, financial performance, +and cash flows. The new disclosure standard is effective for financial statements issued for +fiscal years and interim periods beginning after November 15, 2008, with early application +encouraged. The Statement encourages, but does not require, comparative disclosures for earlier +periods at initial adoption. Callon is currently evaluating the impact that SFAS 161 will have on +its financial statements. +In +December 2008 the SEC unanimously approved amendments to revise its +oil and gas reserves estimation and disclosure requirements. The +amendments, among other things: +• +allows the use of new technologies to determine proved +reserves; +• +permits the optional disclosure of probable and possible +reserves; +• +modifies the prices used to estimate reserves for SEC disclosure +purposes to a 12-month average price instead of a period-end price; +and +• +requires that if a third party is primarily responsible for +preparing or auditing the reserve estimates, the company make +disclosures relating to the independence and qualifications of the +third party, including filing as an exhibit any report received from +the third party. +The revised rules are effective January 1, 2010. The new requirements do +not have an impact on the Company’s 2008 financial statements. +3. STOCK-BASED COMPENSATION +The Company has various stock plans (“Plans”) under which employees of the Company and its +subsidiaries and non-employee members of the Board of Directors of the Company have been or may be +granted certain stock-based compensation. For further discussion of the Plans, refer to Note 13. +56 +Table of Contents +For the year ended December 31, 2008, the Company recorded stock-based compensation expense of $4.5 +million, of which $2.5 million was included in general and administrative expenses and $2.0 million +was capitalized to oil and gas properties. For the year ended December 31, 2007, the Company +recorded stock-based compensation expense of $2.9 million, of which $1.4 million was included in +general and administrative expenses and $1.5 million was capitalized to oil and gas properties. +For the year ended December 31, 2006, the Company recorded stock-based compensation expense of $3.5 +million, of which $1.8 million was included in general and administrative expenses and $1.7 million +was capitalized to oil and gas properties. Shares available for future stock option or restricted +stock grants to employees and directors under existing plans were 393,945 at December 31, 2008. +Stock Options +The Company uses the Black-Scholes option pricing model to estimate the fair value of stock option +awards with the following weighted-average assumptions for the +indicated periods. There were no stock options issued during 2008. +Years Ended +December 31, +2007 +2006 +Dividend yield +— +— +Expected volatility +36.2 +% +38.9 +% +Risk-free interest rate +4.7 +% +4.6 +% +Expected life of option (in years) +5 +5 +Weighted-average grant-date fair value +$ +5.64 +$ +7.72 +Forfeiture rate +2.0 +% +7.5 +% +The assumptions above are based on multiple factors, including historical exercise patterns of +employees with respect to exercise and post-vesting employment termination behaviors, expected +future exercising patterns and the historical volatility of the Company’s stock price. +The following table represents stock option activity for the three years ended December 31, 2008: +2008 +2007 +2006 +Wtd Avg +Wtd Avg +Wtd Avg +Shares +Ex Price +Shares +Ex Price +Shares +Ex Price +Outstanding, beginning of year +755,225 +$ +10.00 +740,225 +$ +9.93 +1,205,558 +$ +10.11 +Granted (at market) +— +— +30,000 +14.27 +15,000 +18.69 +Exercised +(238,950 +) +9.34 +— +— +(480,333 +) +10.66 +Forfeited +(3,000 +) +15.97 +— +— +— +— +Expired +— +— +(15,000 +) +15.31 +— +— +Outstanding, end of year +513,275 +$ +10.27 +755,225 +$ +10.00 +740,225 +$ +9.93 +Exercisable, end of year +488,075 +$ +9.91 +710,225 +$ +9.57 +695,225 +$ +9.44 +Weighted-average remaining +Contract life: +Outstanding options at +end of period +2.92 yrs. +3.39 yrs. +4.06 yrs. +Outstanding +exercisable at +end of period +2.68 yrs. +3.08 yrs. +3.76 yrs. +As of December 31, 2008, the aggregate intrinsic value of options outstanding and options +exercisable was zero. As of December 31, 2007 and 2006, the aggregate intrinsic value of options +outstanding was $5.0 million and $3.9 million and the aggregate intrinsic value of options +exercisable was $4.9 million and $3.9 million, respectively. Total intrinsic value of options +exercised was $4.1 million for both the years ended December 31, +2008 and 2006. At December 31, 2008, there was $116,000 of unrecognized compensation cost related +to unvested stock options, which is expected to be recognized over a weighted-average period of +two years. +57 +Table of Contents +Restricted Stock +The Plans allow for the issuance of restricted stock awards. The unearned stock-based compensation +related to these awards is being amortized to compensation expense on a straight-line basis over +the requisite service period for the entire award. The compensation expense for these awards was +determined based on the market price of our stock at the date of grant applied to the total numbers +of shares that were anticipated to fully vest. As of December 31, 2008, there was $6.9 million of +unrecognized compensation cost associated with these awards, which is expected to be recognized +over a weighted average period of 1.8 years. +The following table represents unvested restricted stock activity for the year ended December 31, +2008: +Weighted-Average +Number of +Grant-Date +Shares +Fair Value +Outstanding shares at beginning of period +487,450 +$ +15.17 +Granted +242,600 +20.73 +Vested +(206,950 +) +16.05 +Forfeited +(13,800 +) +16.08 +Outstanding shares at end of period +509,300 +$ +17.43 +For the years ended December 31, 2008, 2007 and 2006 the Company recognized non-cash compensation +expense associated with the restricted stock awards of $4.3 million, $2.7 million and $3.4 million, +respectively. +4. NET INCOME PER SHARE +Basic net income per common share was computed by dividing net income by the weighted average +number of shares of common stock outstanding during the year. Diluted net income per common share +was determined on a weighted average basis using common shares issued and outstanding adjusted for +the effect of stock options and restricted stock considered common stock equivalents computed using +the treasury stock method. +58 +Table of Contents +A reconciliation of the basic and diluted net income per share computation is as follows (in +thousands, except per share amounts): +2008 +2007 +2006 +(a) Net income (loss) available to common shares +$ +(438,893 +) +$ +15,194 +$ +40,560 +(b) Weighted average shares outstanding +21,222 +20,776 +20,270 +Dilutive impact of stock options +— +148 +238 +Dilutive impact of restricted stock +— +40 +78 +Dilutive impact of warrants +— +326 +777 +(c) Weighted average shares outstanding for diluted net income per share +21,222 +21,290 +21,363 +Stock options excluded due to the exercise +price being greater than the stock price +399 +75 +28 +Basic net income (loss) per share (a ¸ b) +$ +(20.68 +) +$ +0.73 +$ +2.00 +Diluted net income (loss) per share (a ¸ c) +$ +(20.68 +) +$ +0.71 +$ +1.90 +In addition, below are the shares (in thousands) relating to stock option, warrants and restricted +stock that were not included in diluted shares for the year ended December 31, 2008 due to the fact +that the Company had a loss for this period. The Company had net income for the years ended +December 31, 2007 and 2006 and all such shares were included as described above. +2008 +Stock options +161 +Warrants +328 +Restricted Stock +129 +59 +Table of Contents +5. INCOME TAXES +Below is an analysis of deferred income taxes as of December 31, 2008 and 2007. +December 31, +2 008 +2007 +(In thousands) +Deferred tax asset: +Federal net operating loss carryforwards +$ +68,432 +$ +58,397 +State net operating loss carryforwards +45,939 +36,345 +Statutory depletion carryforward +4,561 +4,184 +Alternative minimum tax credit carryforward +375 +375 +Asset retirement obligations +13,102 +11,274 +Oil and gas properties +58,061 +— +Other +2,241 +3,572 +Valuation allowance +(174,062 +) +(36,345 +) +Total deferred tax asset +18,649 +77,802 +Deferred tax liability: +Oil and gas properties +— +(109,530 +) +Other +(18,649 +) +(462 +) +Total deferred tax liability +(18,649 +) +(109,992 +) +Net deferred tax liability +$ +— +$ +(32,190 +) +SFAS 109 provides for the weighing of positive and negative evidence in determining whether it is +more likely than not that a deferred tax asset is recoverable. As a result of the impairment of +oil and gas properties in the fourth quarter of 2008, the Company incurred losses on an aggregate +basis for the three-year period ended December 31, 2008, the Company established a full valuation +allowance in the amount of $128 million on the tax benefit associated with the federal and state +net operating loss carryforwards as of December 31, 2008. +If not utilized, the Company’s federal net operating loss carryforwards will expire in 2013 through +2023. The Company’s state net operating loss carryforwards will expire in 2009 through 2023. The +Company has very limited state taxable income as primarily all of its revenue is generated in +federal waters and is not subject to state income taxes. Accordingly, the Company has established +a full valuation allowance on the tax benefit associated with these state net operating loss +carryforwards as the Company does not anticipate generating taxable state income in the states in +which these carryforwards apply. +Callon adopted FIN 48 effective January 1, 2007. The Company had no significant unrecognized tax +benefits at the date of adoption or at December 31, 2008. Accordingly, the Company does not have +any interest or penalties related to uncertain tax positions. However, if interest or penalties +were to be incurred related to uncertain tax positions, such amounts would be recognized in income +tax expense. Tax periods for years 2004 through 2008 remain open to examination by the federal and +state taxing jurisdictions to which the Company is subject. +Below is a reconciliation of the reported amount of income tax expense attributable to continuing +operations for the year to the amount of income tax expense that would result from applying +domestic federal statutory tax rates to pretax income from continuing operations. +60 +Table of Contents +Years Ended December 31, +2008 +2007 +2006 +Income tax expense computed at the statutory +federal income tax rate +(35 +)% +35 +% +35 +% +Change in valuation allowance +27 +% +— +— +Other +— +2 +% +— +Effective income tax rate +(8 +)% +37 +% +35 +% +6. OTHER COMPREHENSIVE INCOME +The Company’s other comprehensive income (loss) of $18 million, $(12) million and $9 million for +the years ended December 31, 2008, 2007 and 2006, respectively, relates to the change in fair value +of its derivatives. Other comprehensive income (loss) was net of income tax expense (benefit) of +$9.4 million, $(6.5) million and $4.7 million for the years ended December 31, 2008, 2007 and 2006, +respectively. +7. LONG-TERM DEBT +Long-term debt consisted of the following at: +December 31, +2008 +2007 +(In thousands) +Senior Secured Credit Facility (matures +September 25, 2012) +$ +— +$ +— +9.75% Senior Notes (due December 2010) net of discount +194,420 +192,012 +Senior Revolving Credit Facility (due 2014) +— +200,000 +Callon Entrada Credit Facility — non-recourse +78,435 +— +Total long-term debt +272,855 +392,012 +Less current portion +— +— +Long-term portion +$ +272,855 +$ +392,012 +Senior Secured Credit Facility . On September 25, 2008, the Company completed a $250 million second +amended and restated senior secured revolving credit agreement, which matures on September 25, +2012, with the Union Bank of California (“UBOC”) as administrative agent and issuing lender. The +borrowing base, which will be reviewed and redetermined semi-annually, was $70 million at December +31, 2008. Borrowings under the credit agreement are secured by mortgages covering the Company’s +major fields excluding Entrada. As of December 31, 2008, there were no borrowings under the +agreement; however Callon had a letter of credit outstanding in the amount of $15 million to secure +the drilling rig, Ocean Victory, for the development of Entrada. As a result, $55 million was +available for future borrowings under the credit agreement as of December 31, 2008. See Note 18. +The credit facility bears interest at 0% to 0.50% above a defined base rate depending on +utilization of the borrowing base or, at the option of the Company, LIBOR plus 1.375% to 2.0% based +on utilization of the borrowing base. Under the senior secured revolving credit facility, a +commitment fee of 0.25% or 0.375% per annum, depending on the amount of the unused portion of the +borrowing base, is payable quarterly. The interest rate on the senior secured credit facility +during 2008 was 5.75%. +Senior Revolving Credit Facility (due 2014) . On April 18, 2007, Callon closed the Entrada +acquisition contemporaneous with a seven-year $200 million senior revolving credit facility +arranged by Merrill Lynch Capital Corporation, which is secured by a lien on the Entrada +properties. Borrowings outstanding under the facility bore interest at a rate of LIBOR plus 7%. +The Company borrowed the full commitment amount under the facility at closing to cover the required +$150 million payment to BP Exploration and Production Company (“BP”) and expenses and fees related +to the transaction and the balance was used to pay down +the Company’s UBOC senior secured credit facility. Callon’s UBOC senior secured credit facility +was amended to allow for this transaction. +61 +Table of Contents +On April 8, 2008, Callon extinguished the $200 million senior revolving credit facility. The +retirement was made with cash on hand, a $16 million draw under the UBOC credit facility and +proceeds from the sale of a 50% working interest in Callon’s Entrada Field to CIECO Energy (US) +Limited (“CIECO”). Due to the early extinguishment of this credit facility, Callon incurred +expenses of $11.9 million, consisting of $6.3 million in pre-payment penalties plus a non-cash +charge of $5.6 million related to the amortization expense associated with the deferred financing +costs related to the credit facility. These amounts are included in “Loss on early extinguishment +of debt” in the accompanying Consolidated Statements of Operations. See Note 15. +Callon Entrada Credit Agreement (Non-Recourse). A wholly-owned subsidiary of Callon, Callon +Entrada, entered into a credit agreement with CIECO in April 2008, +pursuant to which Callon Entrada may borrow up to $150 million, plus interest expense incurred of +up to $12 million, to finance the development of the Entrada project. The Callon Entrada credit +facility is secured by the Entrada Field and related assets. The agreement bears interest at +six-month LIBOR (as in effect on the first day of each interest period) plus 375 basis points and +is subject to customary representations, warranties, covenants and events of default. As of +December 31, 2008, $78.4 million of principal and $2.7 million of accrued interest was outstanding +under this facility. See Note 15. +Callon +and its subsidiaries (other than Callon Entrada) did not guarantee and are not otherwise +obligated to repay the principal, accrued interest or any other amount which may become outstanding +under the Callon Entrada credit facility. However, Callon has entered into a customary +indemnification agreement pursuant to which it agrees to indemnify the lenders under the Callon +Entrada credit facility against Callon Entrada’s misappropriation of funds, non-performance of +certain covenants and similar matters. In addition, Callon also guaranteed the obligations of +Callon Entrada to fund its proportionate share of any operating costs related to the Entrada +project that Callon Entrada may, from time to time, expressly approve under the Entrada joint +operating agreement. Callon also has guaranteed Callon Entrada’s payment of all amounts to plug +and abandon wells and related facilities for a breach of law, rule or regulation (including +environmental laws) and for any losses attributable to gross negligence of Callon Entrada. The +Company has not classified any of this facility as current and has not included any amounts due in +the five year maturities as it believes, based on the advice of counsel, that the Callon Entrada +credit agreement does not obligate Callon or any of its subsidiaries (other than Callon Entrada) to +pay principal, accrued interest or other amounts which may be owed under such credit agreement. +In late November 2008, Callon Entrada and CIECO decided to abandon the Entrada project. Prior to +abandonment of the project, CIECO failed to fund two loan requests totaling $40 million under our +non-recourse credit agreement with them. The Company continues to discuss with CIECO its failure to fund the +$40 million in loan requests. Because these discussions are in early stages, no assurances can be +made regarding the outcome of these discussions. The Company does not believe that we have waived any of our +rights under our agreements with CIECO. +9.75% Senior Notes (due 2010). In December 2003, the Company borrowed $185 million pursuant to a +senior unsecured credit facility. The loans under the credit facility have a stated interest rate +of 9.75% and a seven-year maturity. In conjunction with the senior unsecured notes, the Company +issued detachable warrants to purchase 2.775 million shares of its common stock at an exercise +price of $10 per share and an expiration date of December 2010. The warrants were valued at $10.6 +million and were treated as a discount on the debt. +62 +Table of Contents +This senior unsecured debt matures December 8, 2010 and has an effective interest rate of 11.4%. The +Company recorded the issuance of these new securities at a fair value of $171 million. Deferred +costs of $14 million associated with the notes are being amortized over the life of the notes. +During March 2004, Callon borrowed an additional $15 million under its 9.75% senior unsecured +credit facility bringing the total outstanding under the facility to $200 million. The net proceeds +of approximately $14 million were primarily used to retire the remaining $10 million of 12% senior +loans due March 31, 2005 plus a 1% call premium of $100,000. The Company recorded the issuance of +these additional new securities at a fair value of $14 million. Deferred costs of $1 million +associated with the notes are being amortized over the life of the notes. See Note 15. +In March 2004, the $200 million in aggregate principal amount of loans outstanding under the 9.75% +senior unsecured credit facility were exchanged for 9.75% Senior Notes due 2010, Series A, (“Series +A notes”), issued pursuant to a senior indenture between Callon and American Stock Transfer & Trust +Company dated March 15, 2004. On August 12, 2004, the Company completed an offer to exchange its +9.75% Senior Notes due 2010, Series B, that have been registered under the Securities Act of 1933, +for all outstanding Series A notes. +As of December 31, 2008, 2.410 million of the 2.775 million detachable warrants issued with the +9.75% Senior Notes due 2010 were exercised. +Certain of the Company’s subsidiaries guarantee the Company’s obligations under the $200 million +9.75% Senior Notes due 2010. The subsidiary guarantors are 100% owned, all of the guarantees are +full and unconditional and joint and several, the parent company has no independent assets or +operations and any subsidiaries of the parent company other than the subsidiary guarantors are +minor. +Capital Lease . In December 2001, the Company entered into a 10-year gas processing agreement +associated with a production facility on Callon’s Mobile Block 952 Field with Hanover Compression +Limited Partnership, which was being accounted for as a capital lease. In May 2007, the Company +sold the Mobile Block 952 Field and retired the remainder of the capital lease. +Restrictive Covenants . The Indenture governing our 9.75% senior notes due 2010 and the Company’s +senior secured revolving credit facility contains various covenants including restrictions on +additional indebtedness and payment of cash dividends. In addition, Callon’s senior secured +revolving credit facility contains covenants for maintenance of certain financial ratios. The +Company was in compliance with these covenants at December 31, 2008. +8. DERIVATIVES +The following table summarizes derivative expense for the periods presented (in thousands): +Years Ended December 31, +2008 +2007 +2006 +Amortization of derivative contract premiums +$ +— +$ +— +$ +150 +Change in fair value and settlements of ineffective +derivative contracts +498 +— +— +$ +498 +$ +— +$ +150 +63 +Table of Contents +The change in fair value and settlements of ineffective derivative contracts in 2008 related to +contracts that were deemed ineffective as a result of a shortfall in production volumes due to +downtime resulting from damages caused by Hurricanes Gustav and Ike. For the year ended December +31, 2008, cash settlements on effective cash flow hedges resulted in a reduction in oil and gas +sales of $9.4 million. Cash settlements on effective cash flow hedges for the years ended December +31, 2007 and 2006 resulted in an increase in oil and gas sales of $8.1 million and $8.9 million, +respectively. +Listed in the table below are the outstanding derivative contracts, which are collars, as of +December 31, 2008: +Collars +Average +Average +Volumes per +Quantity +Floor +Ceiling +Product +Month +Type +Price +Price +Period +Oil +30,000 +Bbls +$ +110.00 +$ +175.75 +01/09-12/09 +Natural Gas +100,000 +MMBtu +$ +11.00 +$ +20.00 +01/09-03/09 +9. FAIR VALUE MEASUREMENTS +Effective January 1, 2008, the Company adopted SFAS 157, “Fair Value Measurements.” SFAS 157 defines fair value, establishes a framework for +measuring fair value and requires enhanced disclosures about fair value measurements. SFAS 157 +establishes a fair value hierarchy which consists of three broad levels that prioritize the inputs +to valuation techniques used to measure fair value. +• +Level 1 valuations consist of unadjusted quoted prices in active markets for +identical assets and liabilities and have the highest priority. +• +Level 2 valuations rely on quoted market information for the calculation of +fair market value. +• +Level 3 valuations are internal estimates and have the lowest priority. +Per SFAS 157, the Company has classified its derivatives into these levels depending upon the data +relied on to determine the fair values of the derivative instruments. The fair values of collars +and natural gas basis swaps are estimated using internal discounted cash flow calculations based +upon forward commodity price curves or quotes obtained from counterparties to the agreements and +are designated as Level 3. The following table summarizes the valuation of our assets and +liabilities measured at fair value on a recurring basis at December 31, 2008 (in thousands): +64 +Table of Contents +Fair Value Measurements Using +Quoted +Significant +Prices in +Other +Significant +Active +Observable +Unobservable +Assets +Markets +Inputs +Inputs +(Liabilities) +(Level 1) +(Level 2) +(Level 3) +At Fair Value +Derivative assets +$ +— +$ +— +$ +21,780 +$ +21,780 +Derivative liabilities +— +— +— +— +Total +$ +— +$ +— +$ +21,780 +$ +21,780 +The table below presents a reconciliation for assets and liabilities measured at fair value on a +recurring basis using significant unobservable inputs (Level 3) during the period ended December +31, 2008. The fair values of Level 3 derivative instruments are estimated using proprietary +valuation models that utilize both market observable and unobservable parameters. Level 3 +instruments presented in the table consist of net derivatives valued using pricing models +incorporating assumptions that, in management’s judgment, reflect the assumptions a marketplace +participant would have used at December 31, 2008 (in thousands): +Derivatives +Balance at January 1, 2008 +$ +(5,205 +) +Total gains or losses (realized or unrealized): +Included in earnings +— +Included in other comprehensive income +17,076 +Purchases, issuances and settlements +9,909 +Balance at December 31, 2008 +$ +21,780 +Change in unrealized gains (losses) included in +earnings relating to derivatives still held as of +December 31, 2008 +$ +— +The Company also adopted SFAS 159, “The +Fair Value Option for Financial Assets and Financial Liabilities,” on January 1, 2008, which +permits entities to choose to measure various financial instruments and certain other items at fair +value. The adoption of SFAS 159 did not have an impact on the Company’s financial statements. +10. COMMITMENTS AND CONTINGENCIES +From time to time, the Company, as part of the Consolidation and other capital transactions, +entered into registration rights agreements whereby certain parties to the transactions are +entitled to require the Company to register common stock of the Company owned by them with the SEC +for sale to the public in firm commitment public offerings and generally to include shares owned by +them, at no cost, in registration statements filed by the Company. Costs of the offering will not +include broker’s discounts and commissions, which will be paid by the respective sellers of the +common stock. +The Company is involved in various claims and lawsuits incidental to its business. In the opinion +of management, the ultimate liability hereunder, if any, will not have a material adverse effect on +the financial position or results of operations of the Company. +In November 2008, the decision was made to abandon the Entrada Project. See Notes 7 and 15 for +more details related to commitments and contingencies. +65 +Table of Contents +The Company’s Medusa deepwater property is eligible for royalty suspensions pursuant to the Deep +Water Royalty Relief Act. In addition, the Company has several shallow water, deep natural gas +properties and prospects that are eligible for royalty suspensions. However, the federal offshore +leases covering these properties contain “price threshold” provisions for oil and gas prices. +Under these “price threshold” provisions, if the average monthly NYMEX sales price for oil or gas during a fiscal year exceeds the price threshold for oil or gas, +respectively, then royalties on the associated production must be paid to the Minerals Management +Service (MMS) at the rate stipulated in the lease. The price thresholds are adjusted annually by +the implicit price deflator for the GDP. The determination of whether or not royalties are due as +a result of the average NYMEX price exceeding the price threshold is made during the first quarter +of the succeeding year. Any royalty payments due must be made shortly after this determination is +made. If a royalty payment is due for all production during a year as a result of exceeding the +price threshold, the lessee is required to make monthly royalty payments during the succeeding +fiscal year for the succeeding year’s production. If at the end of any year the average NYMEX +price is below the price threshold, the lessee can apply for a refund for any associated royalties +paid during that year and the lessee will not be required to pay royalties monthly during the +succeeding year for the succeeding year’s production. +The Company was required to make monthly royalty payments for 2008 deepwater oil and gas production +and will be required to make monthly royalty payments for 2009. With regard to the shallow water, +deep natural gas royalty relief, the Company was not required to make royalty payments for 2008 and +will not be required to make royalty payments for 2009. +In the year succeeding the year in which any of the Company’s properties became subject to +royalties as the result of the average NYMEX price exceeding the price threshold, the portion of +reserves attributable to potential future royalties would not be included in the year-end reserve +report. However, if the average NYMEX prices were below the price thresholds in subsequent years, +our reserves would be increased to reflect reserves previously attributed to future royalties. As +a result, reported oil and gas reserves could materially increase or decrease, depending on the +relation of price thresholds versus the average NYMEX prices. The reduction in revenues resulting +from an obligation to pay these royalties and subsequent reduction of proved reserves could have a +material adverse effect on the Company’s results of operations and financial condition. The +Company’s reserve report as of December 31, 2008 excluded oil and gas reserves for Medusa that are +subject to MMS royalties as a result of the average 2008 NYMEX prices for oil and gas exceeding the +deepwater price thresholds. With regard to the shallow water, deep natural gas properties, there +was no reduction in reserves for potential future royalties as of December 31, 2008 as a result of +the average 2008 NYMEX price for gas being below the price threshold. +The Company’s activities are subject to federal, state and local laws and regulations governing +environmental quality and pollution control. Although no assurances can be made, the Company +believes that, absent the occurrence of an extraordinary event, compliance with existing federal, +state and local laws, rules and regulations governing the release of materials into the environment +or otherwise relating to the protection of the environment will not have a material effect upon the +capital expenditures, earnings or the competitive position of the Company with respect to its +existing assets and operations. The Company cannot predict what effect additional regulation or +legislation, enforcement polices hereunder, and claims for damages to property, employees, other +persons and the environment resulting from the Company’s +operations could have on its activities. +66 +Table of Contents +11. ASSET RETIREMENT OBLIGATIONS +The +following table summarizes the activity for the Company’s asset +retirement obligations (in thousands): +Years Ended December 31, +2008 +2007 +Asset retirement obligations at beginning of period +$ +36,837 +$ +41,179 +Accretion expense +4,172 +3,985 +Liabilities incurred +2,851 +6,368 +Liabilities settled +(6,586 +) +(19,519 +) +Revisions to estimate +4,920 +4,824 +Asset retirement obligation at end of period +42,194 +36,837 +Less: current retirement obligations +(9,151 +) +(9,810 +) +Long-term retirement obligations +$ +33,043 +$ +27,027 +Assets, +primarily short-term U.S. Government securities, of approximately $4.8 million at December +31, 2008, were recorded as restricted investments. These assets are held in abandonment trusts +dedicated to pay future abandonment costs for several of the Company’s oil and gas properties. +67 +Table of Contents +12. OIL AND GAS PROPERTIES +The following table discloses certain financial data relating to the Company’s oil and gas +activities, all of which are located in the United States. +Years Ended December 31, +2008 +2007 +2006 +(In thousands) +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance +$ +1,349,904 +$ +1,096,907 +$ +937,698 +Property acquisition costs +6,126 +154,193 +4,053 +Exploration costs +2,578 +35,959 +73,659 +Development costs +223,090 +62,845 +81,497 +End of period balance +$ +1,581,698 +$ +1,349,904 +$ +1,096,907 +Unevaluated Properties (excluded from +amortization)- +Beginning of period balance +$ +70,176 +$ +54,802 +$ +49,065 +Additions +6,409 +21,525 +19,103 +Capitalized interest +6,496 +7,152 +6,477 +Transfers to evaluated +(50,252 +) +(13,303 +) +(19,843 +) +End of period balance +$ +32,829 +$ +70,176 +$ +54,802 +Accumulated depreciation, depletion +and amortization- +Beginning of period balance +$ +738,374 +$ +604,682 +$ +539,399 +Ceiling test and provision charged to expense +549,552 +72,762 +65,283 +Sale of mineral interests +167,349 +60,930 +— +End of period balance +$ +1,455,275 +$ +738,374 +$ +604,682 +Unevaluated property costs, primarily lease acquisition costs incurred at federal and state lease +sales, unevaluated drilling costs, seismic, capitalized interest and general and administrative +costs being excluded from the amortizable evaluated property base, consisted of $11.3 million +incurred in 2008, $10.3 million incurred in 2007, $5.8 million incurred in 2006 and $5.4 million +incurred in 2005 and prior. These costs are directly related to the acquisition and evaluation of +unproved properties and major development projects. The excluded costs and related reserves are +included in the amortization base as the properties are evaluated and proved reserves are +established or impairment is determined. The Company expects that the majority of these costs will +be evaluated over the next three to five years. +Depletion per unit-of-production (thousand cubic feet of gas equivalent) amounted to $5.57, $3.89 +and $3.14 for the years ended December 31, 2008, 2007, and 2006, respectively. +Under the full-cost accounting rules of the SEC, the Company reviews the carrying value of its +proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and gas +properties, net of accumulated depreciation, depletion and amortization and deferred income taxes, +may not exceed the present value of estimated future net cash flows from proved oil and gas +reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of +related tax effects (the full-cost ceiling amount). These rules generally require pricing future +oil and gas production at the unescalated market price for oil and gas at the end of each fiscal +quarter and require a write-down if the “ceiling” is exceeded. However, if prices recover +sufficiently subsequent to the balance sheet date before the release of the financial statements +then use of subsequent pricing is allowed and no write-down would be required if such pricing was +used. Given the volatility of oil and gas prices, it is reasonably possible that the Company’s +estimate of discounted future net cash flows from proved oil and gas reserves could change in the +near term. If oil and gas prices decline significantly, even if only for a short period of time, +it is possible that write-downs of oil and gas properties could occur in the future. For the year +ended December 31, 2008, the Company recorded a $485.5 million impairment of oil and gas properties +as a result of the ceiling test calculation. +13. EMPLOYEE BENEFIT PLANS +The Company has adopted a series of incentive compensation plans designed to align the interest of +the executives and employees with those of its stockholders. The following is a brief description +of each plan: +Savings and Protection Plan +The Savings and Protection Plan (“401-K Plan”) provides employees with the +option to defer receipt of a portion of their compensation and the Company may, at +its discretion, match a portion of the employee’s deferral with cash and Company +Common Stock. The Company may also elect, at its discretion, to contribute a +non-matching amount in cash and Company +68 +Table of Contents +Common Stock to employees. The amounts held under the 401-K Plan are invested in various +funds maintained by a third party in accordance with the directions of each +employee. An employee is fully vested, including Company discretionary +contributions, immediately upon participation in the 401-K Plan. The total amounts +contributed by the Company, including the value of the common stock contributed, +were $747,000, $680,000 and $615,000 in the years 2008, 2007 and 2006, respectively. +1996 Stock Incentive Plan +On August 23, 1996, the Board of Directors of the Company approved and adopted +the Callon Petroleum Company 1996 Stock Incentive Plan (the “1996 Plan”). The 1996 +Plan was approved by the shareholders in 1997 and limited to a maximum of 1,200,000 +shares (as amended from the original 900,000 shares) of common stock subject to +outstanding awards. The 1996 Plan was amended again and approved on May 9, 2000 at +the Annual Meeting of Shareholders, increasing the number of shares reserved for +issuance under the 1996 plan to 2,200,000 shares. Unvested options are subject to +forfeiture upon certain termination of employment events and expire 10 years from +the date of grant. +In August 2006, the Board of Directors approved the award of 520,000 shares of +restricted stock from the 1996 Plan. Of the 520,000 shares, 20,000 shares were +granted to non-employee members of the Board of Directors and vested immediately. +The remaining 500,000 shares were issued to employees of the Company with 20% vesting +immediately and the remaining 80% vesting ratably over the next four years. The +compensation cost with respect to the 20% that vested immediately was recognized as +an expense on the grant date and the compensation cost with respect to the remaining +80% is being amortized to expense over the vesting period. +2002 Stock Incentive Plan +On February 14, 2002, the Board of Directors of the Company approved and adopted +the 2002 Stock Incentive Plan (the “2002 Plan”). Pursuant to the 2002 Plan, 350,000 +shares of common stock shall be reserved for issuance upon the exercise of options or +for grants of stock options, stock appreciation rights or units, bonus stock, or +performance shares or units. This Plan qualified as a “broadly based” plan under the +provisions of the New York Stock Exchange’s rules and regulations and therefore did +not require shareholder approval. Because the 2002 Plan is a broadly based plan, the +aggregate number of shares underlying awards granted to officers and directors cannot +exceed 50% of the total number of shares underlying the awards granted to all +employees during any three-year period. +In 2006, 17,500 shares were awarded as restricted stock with 20% vesting immediately +and the remaining 80% vesting ratably over the next four years. The compensation cost +with respect to the 20% that vested immediately was recognized as an expense on the +grant date and the compensation cost with respect to the remaining 80% is being +amortized to expense over the vesting period. +2006 Stock Incentive Plan +On March 9, 2006, the Board of Directors of the Company approved the 2006 Stock +Incentive Plan (“2006 Plan”). The 2006 Plan was approved by the shareholders at the +May 4, 2006 annual meeting. Pursuant to the 2006 Plan, 500,000 shares of common +stock shall be reserved for issuance upon exercise of stock options, restricted +stock or other stock-based awards. In +69 +Table of Contents +2006, 45,000 shares were awarded as +restricted stock that will vest ratably over the next four years. +The compensation cost with respect to this grant is being amortized to expense over +the vesting period. +In April 2008, 217,600 shares were awarded as restricted stock with cliff vesting +over the next three years and the compensation cost is being amortized over the +vesting period. In addition, 25,000 shares were awarded as restricted stock vesting +immediately and the compensation cost was recognized as an expense on the grant +date. +14. EQUITY TRANSACTIONS +The Company adopted a stockholder rights plan on March 30, 2000, designed to assure that the +Company’s stockholders receive fair and equal treatment in the event of any proposed takeover of +the Company and to guard against partial tender offers, squeeze-outs, open market accumulations, +and other abusive tactics to gain control without paying all stockholders a fair price. The rights +plan was not adopted in response to any specific takeover proposal. Under the rights plan, the +Company declared a dividend of one right (“Right”) on each share of the Company’s Common Stock. +Each Right will entitle the holder to purchase one one-thousandth of a share of a Series B +Preferred Stock, par value $0.01 per share, at an exercise price of $90 per one one-thousandth of a +share. +The Rights are not currently exercisable and will become exercisable only in the event a person or +group acquires, or engages in a tender or exchange offer to acquire, beneficial ownership of 15 +percent or more (one existing stockholder was granted an exception for up to 21 percent) of the +Company’s common stock. After the Rights become exercisable, each Right will also entitle its +holder to purchase a number of +common shares of the Company having a market value of twice the exercise price. The dividend +distribution was made to stockholders of record at the close of business on April 10, 2000. The +Rights will expire on March 30, 2010. +15. ENTRADA +On April 18, 2007, the Company completed an acquisition of BP’s 80% working interest in the Entrada +field for a purchase price of $190 million. The purchase price included $150 million payable at +closing and an additional $40 million payable after the achievement of certain production +milestones. The purchased interests included five federal offshore blocks at Garden Banks Blocks +738, 782, 785, 826 and 827, subject to certain depth limitations. The acquisition was recorded at +fair value based on the initial purchase price of $150 million. As a result of the acquisition, +Callon owned a 100% working interest in the Entrada field and became operator. +To finance the initial $150 million payment of the purchase price, Callon closed on a seven-year +$200 million senior revolving credit facility arranged by Merrill Lynch Capital Corporation +contemporaneous with the closing of the acquisition. The facility was secured by a lien on the +Entrada properties. The Company borrowed the full commitment amount under the facility at closing +to cover the required $150 million payment to BP and expenses and fees related to the transaction +and the balance was used to pay down our UBOC senior secured revolving credit facility. The Company’s UBOC +senior secured credit facility was amended to allow for this transaction. +70 +Table of Contents +In August 2007, Callon entered into a production handling agreement (“PHA”) with ConocoPhillips and +Devon Energy Corporation. The PHA provides for production from the Entrada field to be processed +through the Magnolia production platform, which is owned by ConocoPhillips and Devon. On February +25, 2009 a letter was sent to ConocoPhillips to terminate the PHA. There are no costs associated +with the termination. +On April 8, 2008, Callon completed the sale of a 50% working interest in the Entrada Field to CIECO +effective January 1, 2008. At closing, CIECO paid Callon $155 million and reimbursed Callon $12.6 +million for 50% of Entrada capital expenditures incurred prior to the closing date. In addition, +CIECO agreed to fund half of a $40 million future contingent payment owed by Callon to BP if the +production milestone was achieved. Callon retained a 50% working interest and is operator of the +field. The Company did not recognize a gain or loss on this transaction. +Simultaneously with the closing of the CIECO transaction, the Company used the proceeds from the +sale, cash on hand and a draw of $16 million from the UBOC credit facility, to extinguish the $200 +million senior revolving credit facility, which was secured by a lien on the Entrada +properties. Due to the early extinguishment of the $200 million senior revolving credit facility +on April 8, 2008, Callon incurred expenses of $11.9 million consisting of $6.3 million in cash +pre-payment penalties plus a non-cash charge of $5.6 million related to the amortization expense +associated with the deferred financing costs related to the credit facility. +As part of the purchase price, CIECO agreed to loan a wholly-owned subsidiary of Callon, Callon +Entrada, the first $150 million of Callon Entrada’s costs to develop the Entrada project plus up to +$12 million of additional loans to pay accrued interest thereon, which loans were non-recourse to +Callon Entrada, were not guaranteed by Callon or any of its other subsidiaries, and were to be +repaid solely out of the proceeds of the sale of production from the Entrada project. The Callon +Entrada credit facility is secured by Callon’s remaining 50% interest in the Entrada field, which +was conveyed to Callon Entrada as a capital contribution in connection with the closing of the +Callon Entrada credit facility. +In late November 2008, Callon Entrada and CIECO decided to abandon the Entrada project. Under the +terms of our agreements with CIECO, Callon Entrada is responsible for its 50% share of the costs to +plug and abandon the Entrada project, which we estimate to be +$46 million, $23 million net to Callon Entrada. +In addition, prior to abandonment of the project, CIECO failed to fund two loan requests totaling +$40 million under our non-recourse credit agreement with them. CIECO also refused to fund its +working interest share for the settlement payment to terminate a +drilling contract. Callon Entrada has +paid its share of the drilling contract. We continue to discuss with CIECO its failure to fund +the $40 million in loan requests and its share of the drilling +contract. Because these discussions are in early stages, no assurances can +be made regarding the outcome of these discussions. We do not believe that we have waived any of +our rights under our agreements with CIECO regarding the loan requests or the drilling contract +settlement. +71 +Table of Contents +16. SUPPLEMENTAL OIL AND GAS RESERVE DATA (UNAUDITED) +The Company’s proved oil and gas reserves at December 31, 2008, 2007 and 2006 have been estimated +by Huddleston & Co., Inc., the Company’s independent petroleum engineers. The reserves were +prepared in accordance with guidelines established by the SEC. Accordingly, the following reserve +estimates are based upon existing economic and operating conditions. +There are numerous uncertainties inherent in establishing quantities of proved reserves. The +following reserve data represents estimates only and should not be construed as being exact. In +addition, the standardized measure of discounted future net cash flows should not be construed as +the current market value of the Company’s oil and gas properties or the cost that would be incurred +to obtain equivalent reserves. See Note 10 regarding the provisions for royalty relief and the +effect on reserves. +Estimated Reserves +Changes in the estimated net quantities of crude oil and natural gas reserves, all of which are +located onshore and offshore in the continental United States, are as follows: +72 +Table of Contents +Reserve Quantities +Years Ended December 31, +2008 +2007 +2006 +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period +24,531 +13,265 +18,428 +Revisions to previous estimates +(9,026 +) +(1,152 +) +(3,733 +) +Change in ownership +— +144 +— +Purchase of reserves in place +— +13,658 +— +Sale of reserves in place +(8,536 +) +(356 +) +— +Extensions and discoveries +— +35 +204 +Production +(942 +) +(1,063 +) +(1,634 +) +End of period +6,027 +24,531 +13,265 +Natural Gas (MMcf): +Beginning of period +116,454 +66,037 +78,021 +Revisions to previous estimates +(49,526 +) +(3,022 +) +(15,557 +) +Change in ownership +— +192 +— +Purchase of reserves in place +— +68,068 +— +Sale of reserves in place +(42,542 +) +(3,690 +) +— +Extensions and discoveries +105 +1,209 +14,550 +Production +(5,840 +) +(12,340 +) +(10,977 +) +End of period +18,651 +116,454 +66,037 +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period +4,723 +5,159 +7,323 +End of period +4,663 +4,723 +5,159 +Natural Gas (MMcf): +Beginning of period +22,340 +36,750 +30,982 +End of period +13,463 +22,340 +36,750 +73 +Table of Contents +Standardized Measure +The following tables present the Company’s standardized measure of discounted future net cash flows +and changes therein relating to proved oil and gas reserves and were computed using reserve +valuations based on regulations prescribed by the SEC. These regulations provide that the oil and +gas price structure utilized to project future net cash flows reflect period-end prices +(approximately $6.36 per Mcf for natural gas and $36.80 per Bbl for oil for the 2008 disclosures, +$7.59 per Mcf and $90.92 per Bbl for 2007 disclosures, and $5.78 per Mcf and $54.07 per Bbl for +2006 disclosures) at each date presented with no escalation. Future production and development +costs are based on current costs without escalation. The resulting net future cash flows have been +discounted to their present values based on a 10% annual discount factor. +Standardized Measure +Years Ended December 31, +2008 +2007 +2006 +(In thousands) +Future cash inflows +$ +340,485 +$ +3,113,759 +$ +1,101,182 +Future costs - +Production +(192,819 +) +(390,669 +) +(243,740 +) +Development and net abandonment +(34,111 +) +(405,186 +) +(81,700 +) +Future net inflows before income taxes +113,555 +2,317,904 +775,742 +Future income taxes +(565 +) +(699,967 +) +(119,685 +) +Future net cash flows +112,990 +1,617,937 +656,057 +10% discount factor +(26,685 +) +(483,948 +) +(185,266 +) +Standardized measure of discounted +future net cash flows +$ +86,305 +$ +1,133,989 +$ +470,791 +Changes in Standardized Measure +Years Ended December 31, +2008 +2007 +2006 +(In thousands) +Standardized measure — beginning of period +$ +1,133,989 +$ +470,791 +$ +837,552 +Sales and transfers, net of production costs +(122,104 +) +(142,973 +) +(153,387 +) +Net change in sales and transfer prices, +net of production costs +(111,140 +) +411,525 +(347,193 +) +Net change due to purchases and sales of in +place reserves +(558,652 +) +795,595 +— +Extensions, discoveries, and improved +recovery, net of future production and +development costs incurred +162,566 +(201,750 +) +122,862 +Changes in future development cost +33,652 +— +— +Revisions of quantity estimates +(786,001 +) +(66,735 +) +(155,342 +) +Accretion of discount +159,147 +53,474 +108,871 +Net change in income taxes +457,483 +(393,530 +) +187,209 +Changes in production rates, timing and other +(282,635 +) +207,592 +(129,781 +) +Aggregate change +(1,047,684 +) +663,198 +(366,761 +) +Standardized measure — end of period +$ +86,305 +$ +1,133,989 +$ +470,791 +At year-end 2006, a downward revision was made by the Company’s independent petroleum engineers to +Entrada’s estimated net proved reserves as of December 31, 2006 due to new performance data from +analogous deepwater reservoirs. +The Company ended the year 2008 with estimated net proved reserves of 54.8 billion cubic feet of +natural gas equivalent (“Bcfe”). This reduction from 2007 year-end estimated net proved reserves +of 263.6 Bcfe is primarily due to the sale to CIECO of a 50% interest in the Entrada field and the +abandonment of the Entrada project. +74 +Table of Contents +17. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) +First +Second +Third +Fourth +Quarter +Quarter +Quarter +Quarter +(In thousands, except per share data) +2008 +Total revenues +$ +44,960 +$ +48,029 +$ +32,783 +$ +15,540 +Income (loss) from operations +21,069 +24,046 +13,640 +(500,438 +) (a) +Net income (loss) +7,632 +5,153 +5,856 +(457,534 +) (a) +Net income (loss) per common share-basic +$ +0.37 +$ +0.25 +$ +0.27 +$ +(21.19 +) (a) +Net income (loss) per common share-diluted +0.35 +0.23 +0.27 +(21.19 +) (a) +First +Second +Third +Fourth +Quarter +Quarter +Quarter +Quarter +(In thousands, except per share data) +2007 +Total revenues +$ +45,484 +$ +43,474 +$ +37,869 +$ +43,941 +Income from operations +13,705 +12,828 +13,090 +16,727 +Net income +5,803 +2,581 +2,268 +4,542 +Net income per common share-basic +$ +0.28 +$ +0.12 +$ +0.11 +$ +0.22 +Net income per common share-diluted +0.27 +0.12 +0.11 +0.21 +(a) +Loss resulting from impairment of oil and gas properties in the amount of $485.5 million and +establishing a full valuation allowance on the tax benefit in the amount of +$128.1 million associated with net operating loss carryforwards as of December 31, +2008. +18. SUBSEQUENT EVENTS +Subsequent to December 31, 2008, the Company entered into the first amendment of the +Second Amended and Restated Credit Agreement dated September 25, 2008, which states that a default under the Entrada non-recourse loan would not +constitute a default under the Company’s senior secured revolving credit facility. +The amendment set the borrowing base at $48 million and implemented a Monthly Commitment Reduction +(MCR) commencing on June 1, 2009 in the amount of $4.33 million per month. The borrowing +base and MCR are both subject to re-determination August 1, 2009 and quarterly thereafter. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON +ACCOUNTING AND FINANCIAL DISCLOSURE +There have been no disagreements with the independent auditors on any matters of accounting +principles or practices, financial statement disclosure, or auditing scope or procedures. +ITEM 9.A CONTROLS AND PROCEDURES +The term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the +Securities Exchange Act of 1934, or the Exchange Act. This term refers to the controls and +procedures of a company that are designed to ensure that information required to be disclosed by a +company in the reports that it files or submits under the Exchange Act is recorded, processed, +summarized and reported within the time periods specified by the Securities and Exchange +Commission. Our management, including our Chief Executive Officer and Chief Financial Officer, has +evaluated the effectiveness of our disclosure controls and procedures as of the end of the period +covered by this annual report. Based upon that evaluation, our Chief Executive Officer and Chief +Financial Officer have concluded that our +disclosure controls and procedures were effective as of the end of the period covered by this +annual report. There were no changes to our internal control over financial reporting during our +last fiscal quarter that have materially affected, or are reasonable likely to materially affect, +our internal control over financial reporting. +75 +Table of Contents +Management’s Report On Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over +financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the +supervision and with the participation of our management, including our principal executive and +financial officers, we conducted an evaluation of the effectiveness of our internal control over +financial reporting as of December 31, 2008 based on the frame work in the Internal +Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our evaluation under the framework in Internal Control-Integrated Framework, +our management concluded that our internal control over financial reporting was effective as of +December 31, 2008. +Ernst & Young LLP, our independent registered public accounting firm, has issued an attestation +report on the Company’s internal control over financial reporting as of December 31, 2008. +76 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited Callon Petroleum Company’s internal control over financial reporting as of December +31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the +Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Callon +Petroleum Company’s management is responsible for maintaining effective internal control over +financial reporting and for its assessment of the effectiveness of internal control over financial +reporting included in the accompanying Management’s Report on Internal Control over Financial +Reporting. Our responsibility is to express an opinion on the Company’s internal control over +financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight +Board (United States). Those standards require that we plan and perform the audit to obtain +reasonable assurance about whether effective internal control over financial reporting was +maintained in all material respects. Our audit included obtaining an understanding of internal +control over financial reporting, assessing the risk that a material weakness exists, testing and +evaluating the design and operating effectiveness of internal control based on the assessed risk, +and performing such other procedures as we considered necessary in the circumstances. We believe +that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable +assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A +company’s internal control over financial reporting includes those policies and procedures that (1) +pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the +transactions and dispositions of the assets of the company; (2) provide reasonable assurance that +transactions are recorded as necessary to permit preparation of financial statements in accordance +with generally accepted accounting principles, and that receipts and expenditures of the company +are being made only in accordance with authorizations of management and directors of the company; +and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the +financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or +detect misstatements. Also, projections of any evaluation of effectiveness to future periods are +subject to the risk that controls may become inadequate because of changes in conditions, or that +the degree of compliance with the policies or procedures may deteriorate. +In our opinion, Callon Petroleum Company maintained, in all material respects, effective internal +control over financial reporting as of December 31, 2008, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight +Board (United States), the consolidated balance sheets of Callon Petroleum Company as of December +31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity and +cash flows for each of the three years in the period ended December 31, 2008 and our report dated +March 19, 2009, expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 19, 2009 +77 +Table of Contents +ITEM 9.B OTHER INFORMATION +We have disclosed all information required to be disclosed in a current report on Form 8-K during +the fourth quarter of the year ended December 31, 2008 in previously filed reports on Form 8-K. +78 +Table of Contents +PART III. +ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. +For information concerning Item 10, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on April 30, 2009 which will be filed +with the Securities and Exchange Commission and is incorporated herein by reference. +The Company has adopted a code of ethics that applies to the Company’s chief executive officer, +chief financial officer and chief accounting officer. The full text of such code of ethics has +been posted on the Company’s website at www.callon.com, and is available free of charge in print to +any shareholder who requests it. Request for copies should be addressed to the Secretary at 200 +North Canal Street, Natchez, Mississippi 39120. +ITEM 11. EXECUTIVE COMPENSATION. +For information concerning Item 11, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on April 30, 2009 which will be filed +with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED +STOCKHOLDER MATTERS. +For information concerning the security ownership of certain beneficial owners and management, see +the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of +Stockholders +to be held on April 30, 2009 which will be filed with the Securities and Exchange +Commission and is incorporated herein by reference. +79 +Table of Contents +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on April 30, 2009 which will be filed +with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES. +For information concerning Item 14, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on April 30, 2009 which will be filed +with the Securities and Exchange Commission and is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000928022/2008/0000950134-09-005716/item13.txt b/raw/filings/0000928022/2008/0000950134-09-005716/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..e9a403532584b5cdc604a82d06730bda8b646934 --- /dev/null +++ b/raw/filings/0000928022/2008/0000950134-09-005716/item13.txt @@ -0,0 +1,4 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on April 30, 2009 which will be filed +with the Securities and Exchange Commission and is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000928022/2008/0000950134-09-005716/item9a.txt b/raw/filings/0000928022/2008/0000950134-09-005716/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2008/0000950134-09-005716/rp_note.txt b/raw/filings/0000928022/2008/0000950134-09-005716/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2008/0000950134-09-005716/rpt_disclosure.txt b/raw/filings/0000928022/2008/0000950134-09-005716/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..cbfbaf920f9a4314351d5f40b9ce546795d1d7e3 --- /dev/null +++ b/raw/filings/0000928022/2008/0000950134-09-005716/rpt_disclosure.txt @@ -0,0 +1,11 @@ +Certain Relationships and Related Party Transactions . Our Audit Committee charter provides +that the Company shall not enter into a related party transaction unless such transaction is +approved by the Audit Committee after a review of the transaction by the Audit Committee for +potential conflicts of interest. A transaction will be considered a “related party transaction” if +the transaction would be required to be disclosed under Item 404 of Regulation S-K. In addition, +our Code of Business Conduct and Ethics provides that an officer’s or a director’s conflict of +interest with the Company may only be waived if the Nominating and Governance Committee approves +the waiver and the full Board of Directors ratifies the waiver. The Committees have the authority +to hire legal, accounting, financial or other advisors as it may deem necessary or desirable and/or +to delegate responsibilities to executive officers of the Company in connection with discharging +their duties. As of December 31, 2008, we are not aware of any related party transactions with our \ No newline at end of file diff --git a/raw/filings/0000928022/2009/0000950123-10-024025/filing.txt b/raw/filings/0000928022/2009/0000950123-10-024025/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..a614346a9680a84dff2b1dda1c8163e31dea849a --- /dev/null +++ b/raw/filings/0000928022/2009/0000950123-10-024025/filing.txt @@ -0,0 +1,6287 @@ +10-K +1 +h71486e10vk.htm +FORM 10-K +e10vk +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF +THE SECURITIES EXCHANGE ACT OF 1934 +FOR THE FISCAL YEAR ENDED DECEMBER 31, 2009 +Commission File Number 001-14039 +CALLON PETROLEUM COMPANY +(Exact name of Registrant as specified in its charter) +Delaware +64-0844345 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer +Identification No.) +200 North Canal Street +Natchez, Mississippi 39120 +(601) 442-1601 +(Address of Principal Executive +Offices) (Zip Code) +(Registrant’s telephone number +including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of exchange on which registered +Common Stock, Par Value $.01 Per Share +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule +405 of the Securities Act. Yes o +No þ . +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or +Section 15(d) of the Act. Yes o No +þ . +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 þ No o . +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 during the preceding 12 months (or for such shorter period +that the registrant was required to submit and post such files). Yes +o No o . +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is +not contained herein, and will not be contained, to the best of Registrant’s knowledge, in +definitive proxy or information statements incorporated by reference in Part III of this Form 10-K +or any amendment to this Form 10-K. o +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 definitions of “Large accelerated +filer, accelerated filer and smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check +one): +Large accelerated filer o +Accelerated filer o +Non-accelerated filer þ +(Do not check if a smaller reporting company) +Smaller reporting Company o +Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule +12b-2). Yes o No þ . +The aggregate market value of the voting and non-voting common equity held by nonaffiliates of the +registrant was approximately $41 million as of June 30, 2009 (based on the last reported sale price +of such stock on the New York Stock Exchange on such date of $1.98). +As of March 8, 2010, there were 28,740,863 shares of the Registrant’s Common Stock, par value $.01 +per share, outstanding. +Document incorporated by reference: Portions of the definitive Proxy Statement of Callon Petroleum +Company (to be filed no later than 120 days after December 31, 2009) relating to the Annual Meeting +of Stockholders to be held on May 4, 2010, which are incorporated into Part III of this Form 10-K. +Table of Contents +Page +Item 1 and 2. +Business and Properties +3 +Item 1A. +Risk Factors +17 +Item 1B. +Unsolved Staff Comments +28 +Item 3. +Legal Proceedings +28 +Item 4. +[Reserved] +28 +Item 5. +Market for Registrant’s Common Equity, Related Stockholder +Matters and Issuer Purchases of Equity Securities +28 +Item 6. +Selected Financial Data +30 +Item 7. +Management’s Discussion and Analysis of Financial Condition and +Results of Operations +33 +Item 7A. +Quantitative and Qualitative Disclosures about Market Risks +48 +Item 8. +Financial Statements and Supplementary Data +49 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +84 +Item 9A. +Controls and Procedures +84 +Item 9A. (T) +Controls and Procedures +84 +Item 9B. +Other Information +87 +Item 10. +Directors, Executive Officers and Corporate Governance +88 +Item 11. +Executive Compensation +88 +Item 12. +Security Ownership of Certain Beneficial Owners and Management +and Related Stockholder Matters +88 +Item 13. +Certain Relationships and Related Transactions and Director Independence +88 +Item 14. +Principal Accountant Fees and Services +88 +Item 15. +Exhibits, Financial Statement Schedules +89 +EX-4.6 +EX-23.1 +EX-23.3 +EX-31.1 +EX-31.2 +EX-32.1 +EX-32.2 +EX-99.1 +2 +Table of Contents +PART I. +ITEM 1 and 2. BUSINESS and PROPERTIES +Overview +Callon Petroleum Company was incorporated under the laws of the state of Delaware in 1994 and +succeeded to the business of a publicly traded limited partnership, a joint venture with a +consortium of European investors and an independent energy company partially owned by a member of +current management. As used herein, the “Company,” “Callon,” “we,” “us,” and “our” refer to Callon +Petroleum Company and its predecessors and subsidiaries unless the context requires otherwise. +Prior to 2009, our operations were focused on exploration and production in the Gulf of Mexico. +Following the abandonment of our Entrada project in 2008, we took steps to change our operational +focus to lower risk, onshore exploration and development activities. During 2009, we took the +following actions: +• +We exchanged a new series of senior notes due 2016 and common stock for a substantial +portion of our existing $200 million of senior notes due 2010, and reduced principal from +$200 million to $154 million. +• +We filed for recoupment of deepwater royalty payments, and received a payment from the +Minerals Management Service (“MMS”) of $44.8 million in January 2010. We expect to receive +an additional payment from the MMS of approximately $7.7 million during 2010, representing +interest. +• +We began negotiating a new $100 million revolving credit facility, with a borrowing base +of $20 million, which we finalized in January 2010. +These activities were undertaken to allow us to shift our operational focus from the offshore Gulf +of Mexico to longer life, lower risk onshore properties. As part of this strategy, we employed +Steven B. Hinchman as our Chief Operating Officer. Mr. Hinchman has substantial experience in +onshore oil and gas acquisition, exploration and development activities. During 2009, we closed +two acquisitions as part of this new focus, including: +• +In September 2009, we acquired a 70% working interest in a 577-acre unit in the heart of +the Haynesville Shale play in Bossier Parish, Louisiana for $3.0 million. We plan to +drill a total of seven horizontal wells on this property, with the first two wells to be +drilled in 2010. We will be the operator of these wells. +• +On October 28, 2009, we acquired interests in properties producing from the Wolfberry +formation in Crockett, Ector, Midland and Upton Counties, Texas for total cash +consideration of $16.0 million. The acquisition included year-end proved reserves of 1.6 +million barrels of oil equivalent (“MMBoe”) 22 existing wells producing 350 barrels of oil +equivalent (“Boe”) per day and upside from a multi-year inventory of drilling +opportunities. We will operate substantially all of the production and development of +these properties. See Note 13 to our Consolidated Financial Statements. +3 +Table of Contents +Our Business Strategy +Our strategy for 2010 and going forward will be, +• +To increase reserves and production levels by using cash flows from, or monetization of, +our Gulf of Mexico properties to acquire and develop lower risk, longer life onshore oil +and gas properties; +• +To increase our reserve life by focusing on acquisition of long-life onshore properties; +• +To diversify risk by substantially increasing the number of wells we own; and +• +To strengthen our balance sheet by focusing on a reduction of our average debt per +thousand cubic feet of natural gas equivalent (“Mcfe”) of proved reserves. +Exploration and Development Activities +In 2009, capital expenditures on an accrual basis for exploration and development costs related to +oil and gas properties totaled approximately $40 million. These expenditures included: +• +$19 million for on-shore property acquisitions; +• +$2 million for development costs in the Gulf of Mexico and onshore south Louisiana; +• +$6 million for plugging and abandonment costs in the Gulf of Mexico; and +• +$3 million for capitalized interest and $10 million for capitalized general and +administration costs allocable directly to exploration and development projects. +Acquisitions and Divestitures +In September 2009, we acquired a 70% operating interest in a 577-acre Haynesville Shale Unit in +Bossier Parish, Louisiana at a cost of $3.0 million. The Unit is in the core of the play offset by +wells having demonstrated initial production rates of 20 million cubic feet of natural gas (“MMcf”) +per day. We plan to drill and complete two of seven horizontal wells in 2010. We estimate that the +typical well in this field will have gross recoverable reserves of 6.4 billion cubic feet of +natural gas (“Bcf”) per well and cost approximately $9.0 million to drill and complete. Callon +will be the operator of this project. +On October 28, 2009, we completed the acquisition of proved oil and gas property interests in +Wolfberry play located in Crockett, Ector, Midland and Upton Counties, Texas from Ambrose Energy I, +Ltd., a subsidiary of ExL Petroleum, LP for a total cash consideration of $16.0 million. The +acquisition was funded by our senior secured credit facility in the amount of $10 million, and the +remaining $6.0 million with cash on hand. The acquisition included year-end proved reserves of 1.6 +MMBoe, 22 existing wells producing 350 Boe per day and upside from a multi-year inventory of +drilling and recompletion opportunities. We will operate substantially all of the production and +development. We accounted for the acquisition in accordance with the amended guidance issued by the +Financial Accounting Standards Board (“FASB”) for business combinations which was adopted on +January 1, 2009, and recorded acquisition expenses in the fourth quarter of 2009 of $298,000. See +Note 13 to our Consolidated Financial Statements. +Oil and Gas Properties Summary +Overview. As of December 31, 2009, our estimated net proved reserves totaled 58.0 billion cubic +feet of natural gas equivalent (“Bcfe”) and included 6.5 million barrels of oil (“MMBbls”) and 19.1 +Bcf, with a pre-tax present value of $137.4 million. Pre-tax present value may be deemed to be a +non-U.S. generally accepted accounting principle (“US GAAP”) financial measure, which we reconcile +to standardized measure, the US GAAP measure, in the table below. Oil constitutes approximately +67% on an equivalent basis of our total estimated net proved reserves, and approximately 66% of our +total estimated proved reserves are proved developed reserves. +4 +Table of Contents +The following table sets forth certain information about our estimated proved reserves by our +independent petroleum reserve engineers by major field and for all other properties combined at +December 31, 2009. +Pre-tax +Discounted +Estimated Net Proved Reserves +Present +Oil +Gas +Total +Value +Operator +(MBbls) +(MMcf) +(MMcfe) +($000) +(a)(b)(c) +Gulf of Mexico Deepwater: +Mississippi Canyon 538/582 +“Medusa” +Murphy +4,412 +3,268 +29,740 +$ +89,795 +Garden Banks Block 341 +“Habanero” +Shell +725 +4,729 +9,077 +25,084 +Gulf of Mexico Shelf and Onshore: +West Cameron Block 295 +Mariner Energy +12 +1,724 +1,798 +3,402 +East Cameron Block 109 +Energy Partners LTD +18 +1,224 +1,332 +4,193 +Permian Basin +Callon +1,242 +2,117 +9,571 +17,873 +Other +Various +70 +6,041 +6,457 +(2,979 +) +Total Net Proved Reserves +6,479 +19,103 +57,975 +$ +137,368 +(a) +Represents the present value of future net cash flows before deduction of federal income +taxes, discounted at 10%, attributable to estimated net proved reserves as of December 31, +2009, as set forth in the Company’s reserve reports prepared by its independent petroleum +reserve engineers, Huddleston & Co., Inc. +(b) +Includes a reduction for estimated plugging and abandonment costs that is reflected as a +liability on our balance sheet at December 31, 2009, in accordance with accounting for asset +retirement obligations rules. See the Oil and Gas Reserve table for the standardized measure +of discounted future net cash flow in Note 18 of our consolidated financial statements. The +negative Pre-Tax Present Value of the Gulf of Mexico Shelf and Onshore Other reflects plugging +and abandonment obligations, of which most are estimated to occur within the next five years, +exceeding the future net cash flows. +(c) +We use the financial measure “Pre Tax Present Value” which is a non-US GAAP financial +measure. We believe that Pre Tax Present Value, while not a financial measure in accordance +with US GAAP, is an important financial measure used by investors and independent oil and gas +producers for evaluating the relative value of oil and natural gas properties and acquisitions +because the tax characteristics of comparable companies can differ materially. The total +standardized measure for our proved reserves as of December 31, 2009 was $135.9 million. The +standardized measure gives effect to income taxes, and is calculated in accordance with the +guidance issued by the FASB for disclosures about oil and gas producing activities.” The +$135.9 million of standardized measure of our estimated net proved reserves equals the present +value of our estimated future net revenue from proved reserves of $137.4 million, which +excludes the discounted estimated future income taxes relating to such future net revenues of +$1.5 million. +5 +Table of Contents +Onshore Oil and Gas Properties +Permian Basin +During the fourth quarter of 2009, we acquired 22 producing wells with associated proved reserves +of 1.6 MMBoe. Our primary target in the Permian Basin is the Wolfberry trend, which is a proven, +low-permeability oil play. The Wolfberry interval includes the Sprayberry, Dean, and Wolfcamp +formations. We have identified 148 drilling locations based on a 40-acre spacing development. We +commenced drilling in February 2010 and plan to drill up to 16 Wolfberry wells in 2010. +Haynesville Shale +In addition to the significant properties discussed above, we acquired a 70% working interest in a +Haynesville Shale unit located in Southern Bossier Parish, Louisiana in September 2009. We plan to +drill two horizontal wells in 2010. +Gulf of Mexico Deepwater +Medusa, Mississippi Canyon Blocks 538/582 +Our Medusa deepwater discovery was announced in September 1999, after we drilled the initial test +well in 2,235 feet of water to a total depth of 16,241 feet and encountered over 120 feet of pay in +two intervals. Subsequent sidetrack drilling from the wellbore was used to determine the extent of +the discovery, and a second well was drilled in the first quarter of 2000 to further delineate the +extent of the pay intervals. In 2001, a drilling program began which included four development +wells and one sidetrack. The program included production casing being set on six wells to provide +initial production take-points and was completed in the first half of 2002. The construction of a +floating production system, spar, at Medusa was completed during the second quarter of 2003. The +A-1 well was completed and tied into the spar and commenced production in late November 2003. The +remaining five wells were completed and commenced production in 2004. We have participated in +additional development of the Medusa field which includes the drilling and completion of two +additional wells, Mississippi Canyon 538 #4, North Medusa, and Mississippi Canyon 538 #5. We own a +15% working interest. Murphy Exploration & Production Company (“Murphy”), the operator, owns a 60% +working interest and ENI Deepwater, LLC, owns the remaining 25% working interest. +During 2009 the field produced 4.5 Bcfe net to us from eight wells which accounted for 38% of our +total production. Inception to date as of December 31, 2009, the Medusa Field had produced 43 +Bcfe, net to us. Most of the wells are still producing from their initial completion and have +14.2 Bcfe of proved developed non-producing reserves that will be accessed by recompletions in the +existing wells. Another 7.1 Bcfe of proved undeveloped reserves will be developed by side tracking +an existing well. These operations will occur as existing completions reach their economic limit +which is estimated as of December 31, 2009 to be in 2022. +In December 2003, we transferred our undivided 15% working interest in the spar production +facilities to Medusa Spar LLC (“LLC”) in exchange for cash proceeds of approximately $25 million +and a 10% ownership interest in the LLC. A detailed discussion of this transaction is included in +“Management’s Discussion and Analysis of Financial Condition and Results of Operations-Off-Balance +Sheet Arrangements.” +Habanero, Garden Banks Block 341 +During February 1999, the initial test well on our Habanero deepwater discovery encountered over +200 feet of net pay in two zones. Located in 2,015 feet of water, the well was drilled to a +measured depth of 21,158 feet. A field delineation program began in mid-year 2001, which included +three sidetracks of the discovery well. Production casing was set on this well through the last of +the sidetracks to the Habanero 52 oil and gas +6 +Table of Contents +sand and the Habanero 55 gas sand. Also, a development well was drilled in the summer of 2003 +which provides a take-point for production from the Habanero 52 oil sand. By means of a sub-sea +completion and tie-back to an existing production facility in the area operated by Shell, +production from the Habanero 52 oil sand commenced in late November 2003 and from the Habanero 55 +gas sand in January 2004. We own an 11.25% working interest in the well. The well is operated by +Shell Deepwater Development Inc., which owns a 55% working interest, with the remaining working +interest owned by Murphy. +During 2009, Habanero produced 2.2 Bcfe net to us from two wells which accounted for 19% of our +total production. Future plans include sidetracks of both the wells to drain updip and partially +fault-separated gas in the Habanero 52 sand when the existing completions reach their economic +limit, which is estimated as of December 31, 2009 to be in 2014. +Gulf of Mexico Shelf and Onshore Louisiana +We own interests in 18 wells in 12 oil and gas fields in the shelf area of the Gulf of Mexico. +These wells produced 5.0 Bcfe net to our interest in 2009. +Proved Reserves +In December 2008 the Securities and Exchange Commission (“SEC”) approved amendments to its oil and +gas reserves estimation and disclosure requirements. The amendments, among other things: +• +allow the use of reliable technologies to estimate proved reserves if those technologies +have been demonstrated to result in reliable conclusions about reserve volumes; +• +require disclosure of oil and gas proved reserves by significant geographic area; +• +permit the optional disclosure of probable and possible reserves; +• +modify the prices used to estimate reserves for SEC disclosure purposes to a 12-month +average beginning-of-the-month price instead of a period-end price; and +• +require that if a third party is primarily responsible for preparing or auditing the +reserve estimates, the company make disclosures relating to the independence and +qualifications of the third party, including filing as an exhibit any report received from +the third party. +The new requirements are effective for our year-end financial statements and our Annual Report on +Form 10-K for the year ended December 31, 2009, and as such the reserves and related information +for 2009 are presented consistent with the requirements of the new rule. The new rule does not +require prior-year reserve information to be restated, so all information related to periods prior +to 2009 is presented consistent with the prior SEC rules for the estimation of proved reserves. +Estimates of volumes of proved reserves, net to our interest, at year end are presented in Mmcf at +a pressure base of 15.025 pounds per square inch for natural gas and in MBbls for oil. Total +volumes are presented in million cubic feet of natural gas equivalent (“MMcfe”). For the +computation, one barrel is the equivalent of 6,000 cubic feet of gas. +7 +Table of Contents +The following table sets forth certain information about our estimated proved reserves. All of our +proved reserves are located in the United States. +Years Ended December 31, +2009 +2008 +2007 +Proved developed: +Oil (MBbls) +4,346 +4,663 +4,723 +Gas (MMcf) +12,301 +13,463 +22,340 +MMcfe +38,377 +41,441 +50,676 +Proved undeveloped: +Oil (MBbls) (c) +2,133 +1,364 +19,808 +Gas (MMcf) (c) +6,802 +5,189 +94,114 +MMcfe (c) +19,600 +13,375 +212,964 +Total proved: +Oil (MBbls) (c) +6,479 +6,027 +24,531 +Gas (MMcf) (c) +19,103 +18,652 +116,454 +MMcfe (c) +57,977 +54,816 +263,640 +Estimated pre-tax future net cash flows (a) +$ +216,702 +$ +113,555 +$ +2,317,905 +Pre-tax discounted present value (a) (b) +$ +137,368 +$ +86,591 +$ +1,591,472 +Standardized measure of discounted future +net cash flows(a) (b) +$ +135,921 +$ +86,305 +$ +1,133,989 +(a) +Includes a reduction for estimated plugging and abandonment costs that is reflected as +a liability on our balance sheet at December 31, 2009, in accordance with accounting for +asset retirement obligations rule. +(b) +We use the financial measure “Pre Tax Present Value” which is a non-US GAAP financial +measure. We believe that Pre Tax Present Value, while not a financial measure in +accordance with US GAAP, is an important financial measure used by investors and +independent oil and gas producers for evaluating the relative value of oil and natural gas +properties and acquisitions because the tax characteristics of comparable companies can +differ materially. The total standardized measure for our proved reserves as of December +31, 2009 was $135.9 million. The standardized measure gives effect to income taxes, and is +calculated in accordance with guidance issued by the FASB for disclosures about oil and gas +producing activities. The $135.9 million of standardized measure of our estimated net +proved reserves equals the present value of our estimated future net revenue from proved +reserves of $137.4 million, which excludes the discounted estimated future income taxes +relating to such future net revenues of $1.5 million. Year-end average pricing was $4.75 +per Mcf for natural gas and $57.40 per Bbl for oil. +(c) +The reduction in 2008 reserves as compared to 2007 year-end proved reserves of 263.6 +Bcfe was primarily associated with the sale of a 50% working interest in the Entrada Field +and the abandonment of the Entrada project. See Note 3 to our consolidated financial +statements. +8 +Table of Contents +Our estimates of proved reserves, proved developed reserves (“PDPs”), proved undeveloped reserves +(“PUDs”) at December 31, 2009, 2008 and 2007 and changes in proved reserves during the last three +years are included in Note 18 of our Consolidated Financial Statements. Also included in Note 18 +are our estimates of future net cash flows and discounted future net cash flows from proved +reserves. +Proved Undeveloped Reserves. We annually review our PUDs to ensure an appropriate plan exists for +development. Generally, reserves for our onshore properties are booked as PUDs only if we have +plans to convert the PUDs into PDPs within five years of the date they are first booked as PUDs. +We had 19.6 Bcfe of PUDs at December 31, 2009, compared with 13.4 Bcfe of PUDs at December 31, +2008. Of these 2009 PUDs, 7.1 Bcfe and 6.9 Bcfe were attributable to our offshore properties in +the Medusa and Habanero fields in the Gulf of Mexico, respectively. Our plans are to develop these +PUDs by side tracking existing wells when the zones currently being produced by the wells are +depleted. Our current reserve reports forecast that these producing zones in the Habenero field +will be depleted in 2014 and in the Medusa field in 2022, at which time we plan to develop the +PUDs. We did not convert any offshore PUDs to PDPs in 2009. +During 2009, we acquired 711 MBbls and 1.3 Bcf, or 5.6 Bcfe, of PUDs in our ExL acquisition. Our +development plan for these PUDs will begin in 2010 and are anticipated to be completed within five +years allowing the PUDs to be converted to PDPs. The remaining 0.6 Bcfe increase in PUDs from 2008 +to 2009 is associated with our deepwater property, Medusa, and is a result of including reserves +related to the Deepwater Royalty Relief Act. These PUDs were previously excluded due to prices +exceeding the MMS imposed thresholds. As a result of the court decisions, the MMS is no longer +enforcing its price thresholds. At year end 2008, we had no PUDs located onshore. See Note 12 to +our Consolidated Financial Statements. +Controls Over Reserve Estimates. Our policies and practices regarding internal controls over the +recording of reserves are structured to objectively and accurately estimate our oil and gas +reserves quantities and present values in compliance with the SEC’s regulations and US GAAP. +Compliance in reserves bookings is the responsibility of our Executive Vice President and Chief +Operating Officer, who is our principal engineer. Our principal engineer has over 30 years of +experience in the oil and gas industry, including over 25 years as a manager. Further professional +qualifications include a degree in petroleum engineering and asset evaluation and management. In +addition, the principal engineer is an over 30-year member of the Society of Petroleum Engineers. +Our controls over reserve estimates included retaining Huddleston & Co. as our independent +petroleum and geological firm. We provided information about our oil and gas properties, +including production profiles, prices and costs, to Huddleston and they prepare their own estimates +of the reserves attributable to our properties. All of the information regarding reserves in this +annual report is derived from the report of Huddleston. The report of Huddleston is included as an +Exhibit to this annual report. The principal engineer at Huddleston who is responsible for +preparing our reserve estimates has over 29 years of experience in the oil and gas industry and is +a Texas Licensed Professional Engineer. Further professional qualifications include a degree in +petroleum engineering as well as being a member of the Society of Petroleum Engineers. The +Huddleston & Co., Inc. engineer firm is a Texas Registered Engineering Firm. +The Audit Committee of our Board of Directors meets with management, including the Chief Operating +Officer to discuss matters and policies including those related to reserves. +There are numerous uncertainties inherent in estimating quantities of proved reserves, including +many factors beyond our control or the control of the reserve engineers. Reserve engineering is a +subjective process of estimating underground accumulations of oil and gas that cannot be measured +in an exact manner. The accuracy of any reserve or cash flow estimate is a function of the quality +of available data and of engineering and geological interpretation and judgment. Estimates by +different engineers often vary, sometimes significantly. In addition, physical factors, such as +the results of drilling, testing and production subsequent to the date of an +9 +Table of Contents +estimate, as well as economic factors, such as an increase or decrease in product prices that +renders production of such reserves more or less economic, may justify revision of such estimates. +Accordingly, reserve estimates could be different from the quantities of oil and gas that are +ultimately recovered. +During our last fiscal year, we have not filed any reports with other federal agencies which +contain an estimate of total proved net oil and gas reserves. +Production Volumes, Average Sales Prices and Average Production Costs +The following table sets forth certain information regarding the production volumes and average +sales prices received for and average production costs associated with the Company’s sale of oil +and natural gas for the periods indicated. +Year ended December 31, +2009 +2008 +2007 +(In thousands, except per unit data) +Production +Natural gas (Mcf) +5,740 +5,839 +12,340 +Oil (MBbl) +1,012 +942 +1,063 +Total (MMcfe) +11,809 +11,494 +18,718 +Revenues +Natural gas sales +$ +27,417 +$ +58,349 +$ +98,877 +Oil sales +73,842 +82,963 +71,891 +Total revenues +$ +101,259 +$ +141,312 +$ +170,768 +Lease Operating Expenses +Production costs +$ +16,778 +$ +17,604 +$ +24,254 +Severance/production taxes +528 +626 +1,378 +Gathering +1,141 +977 +2,162 +Total lease operating expenses +$ +18,447 +$ +19,208 +$ +27,795 +Realized prices +Natural gas ($/Mcf, including realized gains +(losses) on derivatives) +$ +4.78 +$ +9.99 +$ +8.01 +Natural gas ($/Mcf, excluding realized gains +(losses) on derivatives) +$ +4.45 +$ +10.10 +$ +7.40 +Oil ($/Bbl, including realized gains (losses) on +derivatives) +$ +73.00 +$ +88.07 +$ +67.63 +Oil ($/Bbl, excluding realized gains (losses) on +derivatives) +$ +55.84 +$ +97.37 +$ +67.10 +Operating costs per Mcfe — Total Consolidated +Production costs +$ +1.42 +$ +1.53 +$ +1.30 +Severance/production taxes +$ +0.04 +$ +0.05 +$ +0.07 +Gathering +$ +0.10 +$ +0.09 +$ +0.12 +DD&A +$ +2.83 +$ +5.57 +$ +3.89 +Interest +$ +1.62 +$ +2.09 +$ +1.83 +Total operating costs per Mcfe +$ +6.01 +$ +9.33 +$ +7.21 +10 +Table of Contents +Present Activities and Productive Wells +The following table sets forth the wells we have drilled and completed during the periods +indicated. All such wells were drilled in the continental United States primarily in federal and +state waters in the Gulf of Mexico. +Years Ended December 31, +2009 +2008 +2007 +Gross +Net +Gross +Net +Gross +Net +Development: +Oil +— +— +1 +0.15 +1 +0.25 +Gas +— +— +— +— +1 +0.12 +Non-productive +— +— +1 +0.50 +— +— +Total +— +— +2 +0.65 +2 +0.37 +Exploration: +Oil +— +— +— +— +— +— +Gas +— +— +— +— +2 +0.63 +Non-productive +— +— +2 +0.22 +3 +0.47 +Total +— +— +2 +0.22 +5 +1.10 +At December 31, 2009 we were not involved in the drilling of any wells. +The following table sets forth our productive wells as of December 31, 2009: +Wells +Gross +Net +Oil: +Working interest +32.00 +19.35 +Royalty interest +— +— +Total +32.00 +19.35 +Gas: +Working interest +19.00 +5.89 +Royalty interest +5.00 +0.13 +Total +24.00 +6.03 +A well is categorized as an oil well or a natural gas well based upon the ratio of oil to gas +reserves on a Mcfe basis. However, some of our wells produce both oil and gas. At December 31, +2009, we had no wells with multiple completions. +11 +Table of Contents +Leasehold Acreage +The following table shows our approximate developed and undeveloped (gross and net) leasehold +acreage as of December 31, 2009. +Leasehold Acreage +Developed +Undeveloped +Location +Gross +Net +Gross +Net +Louisiana +4,320 +1,964 +1,522 +973 +Texas +4,800 +3,167 +19,059 +9,136 +Federal waters +53,210 +18,387 +157,914 +99,841 +Total +62,330 +23,518 +178,495 +109,950 +Major Customers +Our production is sold generally on month-to-month contracts at prevailing prices. The following +table identifies customers to whom we sold a significant percentage of our total oil and gas +production during each of the 12-month periods ended: +December 31, +2009 +2008 +2007 +Shell Trading Company +45 +% +33 +% +25 +% +Plains Marketing, L.P. +23 +% +23 +% +10 +% +Louis Dreyfus Energy Services +15 +% +16 +% +20 +% +StatoilHydro +— +— +13 +% +Because alternative purchasers of oil and gas are readily available, we believe that the loss of +any of these purchasers would not result in a material adverse effect on our ability to market +future oil and gas production. +Title to Properties +We believe that the title to our oil and gas properties is good and defensible in accordance with +standards generally accepted in the oil and gas industry, subject to such exceptions which, in our +opinion, are not so material as to detract substantially from the use or value of such properties. +Our properties are typically subject, in one degree or another, to one or more of the following: +• +royalties and other burdens and obligations, express or implied, under oil and gas +leases; +• +overriding royalties and other burdens created by us or our predecessors in title; +• +a variety of contractual obligations (including, in some cases, development obligations) +arising under operating agreements, farmout agreements, production sales contracts and +other agreements that may affect the properties or their titles; +• +back-ins and reversionary interests existing under purchase agreements and leasehold +assignments; +• +liens that arise in the normal course of operations, such as those for unpaid taxes, +statutory liens securing obligations to unpaid suppliers and contractors and contractual +liens under operating agreements; +• +pooling, unitization and communitization agreements, declarations and orders; and +• +easements, restrictions, rights-of-way and other matters that commonly affect property. +12 +Table of Contents +To the extent that such burdens and obligations affect our rights to production revenues, they have +been taken into account in calculating our net revenue interests and in estimating the size and +value of our reserves. We believe that the burdens and obligations affecting our properties are +conventional in the industry for properties of the kind owned by us. +Corporate Offices +Our headquarters are located in Natchez, Mississippi, in approximately 51,500 square feet of owned +space. We also maintain a leased business office in Houston, Texas, and own or lease field offices +in the area of the major fields in which we operate properties or have a significant interest. +Replacement of any of our leased offices would not result in material expenditures by us as +alternative locations to our leased space are anticipated to be readily available . +Employees +We had 72 employees as of December 31, 2009, none of whom are currently represented by a union. We +believe that we have good relations with our employees. We employ seven petroleum engineers and +four petroleum geoscientists. +Regulations +General . The oil and gas industry is subject to regulation at the federal, state and local level, +and some of the laws, rules and regulations that govern our operations carry substantial penalties +for non-compliance. This regulatory burden increases our cost of doing business and, consequently, +affects our profitability. +Exploration and Production. Our operations are subject to federal, state and local regulations +that include requirements for permits to drill and to conduct other operations and for provision of +financial assurances (such as bonds and letters of credit) covering drilling and well operations. +Other activities subject to regulation are: +• +the location and spacing of wells, +• +the method of drilling and completing wells, +• +the rate and method of production, +• +the surface use and restoration of properties upon which wells are drilled and other +exploration activities, +• +the plugging and abandoning of wells, +• +the discharge of contaminants into water and the emission of contaminants into air, +• +the disposal of fluids used or other wastes obtained in connection with operations, +• +the marketing, transportation and reporting of production, and +• +the valuation and payment of royalties. +For instance, our outer continental shelf (“OCS”) leases in federal waters are administered by MMS, +and require compliance with detailed MMS regulations and orders. Lessees must obtain MMS approval +for exploration, exploitation and production plans prior to the commencement of such operations. +The MMS has promulgated regulations requiring offshore production facilities located on the OCS to +meet stringent engineering and construction specifications. The MMS also has regulations +restricting the flaring or venting of natural gas, and prohibiting the flaring of liquid +hydrocarbons and oil without prior authorization. MMS policies concerning the volume of production +that a lessee must have to maintain an offshore lease beyond its primary term also are applicable +to Callon. Similarly, the MMS has promulgated other regulations governing the plugging and +abandonment of wells located offshore and the installation and removal of production facilities. +To cover the various obligations of lessees on the OCS, the MMS generally requires that lessees +post bonds, letters of credit, or other acceptable assurances that such obligations will be met. +The cost of +13 +Table of Contents +these bonds or other surety can be substantial, and there is no assurance that bonds or other +surety can be obtained in all cases. Under some circumstances, the MMS may require any of our +operations on federal leases to be suspended or terminated. Any such suspension or termination +could materially adversely affect our financial conditions and results of operations. +Operations conducted on federal or state oil and natural gas leases must comply with numerous +regulatory restrictions, including various nondiscrimination statues, royalty and related valuation +requirements, and certain of these operations must be conducted pursuant to certain on-site +security regulations and other appropriate permits issued by the MMS or other appropriate federal +or state agencies. +Our sales of oil and natural gas are affected by the availability, terms and cost of pipeline +transportation. The price and terms for access to pipeline transportation remain subject to +extensive federal and state regulation. If these regulations change, we could face higher +transmission costs for our production and, possibly, reduced access to transmission capacity. +Various proposals and proceedings that might affect the petroleum industry are pending before +Congress, the Federal Energy Regulatory Commission, or FERC, various state legislatures, and the +courts. The industry historically has been heavily regulated and we can offer you no assurance +that the less stringent regulatory approach recently pursued by the FERC and Congress will continue +nor can we predict what effect such proposals or proceedings may have on our operations. +We do not currently anticipate that compliance with existing laws and regulations governing +exploration and production will have a significantly adverse effect upon our capital expenditures, +earnings or competitive position. +Environmental Regulation. Various federal, state and local laws and regulations concerning the +release of contaminants into the environment, including the discharge of contaminants into water +and the emission of contaminants into the air, the generation, storage, treatment, transportation +and disposal of wastes, and the protection of public health, welfare, and safety, and the +environment, including natural resources, affect our exploration, development and production +operations, including operations of our processing facilities. We must take into account the cost +of complying with environmental regulations in planning, designing, drilling, constructing, +operating and abandoning wells. Regulatory requirements relate to, among other things, the handling +and disposal of drilling and production waste products, the control of water and air pollution and +the removal, investigation, and remediation of petroleum-product contamination. In addition, our +operations may require us to obtain permits for, among other things, +• +air emissions, +• +discharges into surface waters, and +• +the construction and operations of underground injection wells or surface pits to +dispose of produced saltwater and other nonhazardous oilfield wastes. +In the event of an unauthorized discharge (e.g., to land or water), emission (e.g., to air) or +other activity, we may be liable for, among other things, penalties, costs and damages, and subject +to injunctive relief, and we could be required to cleanup or mitigate the environmental impacts of +those discharges, emissions or activities. Also, under federal, and certain state, laws, the +present and certain past owners and operators of a site, and persons that treated, disposed of or +arranged for the disposal of hazardous substances found at a site, may be liable, without regard to +fault or the legality of the original conduct, for the release of hazardous substances into the +environment. The Environmental Protection Agency, state environmental agencies and, in some cases +third parties are authorized to take actions in response to threats to human health or the +environment and to seek to recover from responsible classes of persons the costs of such actions. +We therefore could be required to remove or remediate previously disposed wastes and remediate +contamination, including contamination in surface water, soil or groundwater, caused by disposal of +that waste, irrespective +14 +Table of Contents +of whether disposal or release were authorized. We could be responsible for wastes disposed of or +released by us or prior owners or operators at properties owned or leased by us or at locations +where wastes have been taken for disposal also irrespective of whether disposal or release were +authorized. We could also be required to suspend or cease operations in contaminated areas, or to +perform remedial well plugging operations or cleanups to prevent future contamination. +Federal, and certain state, laws also impose duties and liabilities on certain “responsible +parties” related specifically to the prevention of oil spills and damages resulting from such +spills in or threatening United States waters or adjoining shorelines. A liable “responsible +party” includes the owner or operator of a facility, vessel or pipeline that is a source of an oil +discharge or that poses the substantial threat of discharge or, in the case of offshore facilities, +the lessee or permittee of the area in which a discharging facility is located. These laws assign +liability, which generally is joint and several, without regard to fault, to each liable party for +oil removal costs and a variety of public and private damages. Although defenses and limitations +exist to the liability imposed under these laws, they are limited. In the event of an oil +discharge or substantial threat of discharge, we could be liable for costs and damages. +The Environmental Protection Agency and various state agencies have limited the disposal options +for hazardous and nonhazardous wastes thereby increasing the costs of disposal. Furthermore, +certain wastes generated by our oil and natural gas operations that are currently exempt from +treatment as hazardous wastes may in the future be designated as hazardous wastes and, therefore, +be subject to considerably more rigorous and costly operating and disposal requirements. +Federal and state occupational safety and health laws require us to organize information about +hazardous materials used, released or produced in our operations. Certain portions of this +information must be provided to employees, state and local governmental authorities and local +citizens. We are also subject to the requirements and reporting set forth in federal workplace +standards. +There are federal and certain state laws that impose restrictions on activities adversely affecting +the habitat of certain plant and animal species. In the event of an unauthorized impact or taking +of a protected species or its habitat, we could be liable for penalties, costs and damages, and +subject to injunctive relief, and we could be required to mitigate those impacts. A critical +habitat or suitable habitat designation also could result in further material restrictions to land +use and may materially delay or prohibit land access for oil and natural gas development. +We have made and will continue to make expenditures to comply with environmental regulations and +requirements. These are necessary costs of doing business within the oil and gas industry. Although +we are not fully insured against all environmental risks, we maintain insurance coverage which we +believe is customary in the industry. Moreover, it is possible that other developments, such as +stricter and more comprehensive environmental laws and regulations, as well as claims for damages +to property or persons resulting from company operations, could result in substantial costs and +liabilities. We believe we are in compliance with existing environmental regulations, and that, +absent the occurrence of an extraordinary event the effect of which cannot be predicted, any +noncompliance will not have a material adverse effect on our operations or earnings. +Greenhouse Gas Legislation (“GHG”). On June 26, 2009, the U.S. House of Representatives passed the +“American Clean Energy and Security Act of 2009” which among other things, would enact a “cap and +trade” system to control GHGs. Under this cap and trade system, a cap on the amount of GHGs would +be established annually, which would be reduced annually. Each covered emission source would be +required to obtain GHG emission allowances corresponding to its annual emissions of GHGs. The +Senate has passed from committee its legislation proposing a similar cap and trade system to +regulate GHG emissions, but the +15 +Table of Contents +Senate legislation has not been voted upon by the full Senate. In the absence of a comprehensive +federal legislation on GHG emission control, the Environmental Protection Agency (“EPA”) has been +moving forward with rulemaking under the Clean Air Act (“CAA”) to regulate GHGs as pollutants under +the CAA. Should EPA regulate GHGs under the CAA, we could incur significant costs to control our +emissions and comply with regulatory requirements. In addition, EPA has adopted a mandatory GHG +emissions reporting program which imposes reporting and monitoring requirements on various +industries. We do not believe our operations will be subject to this program as currently +proposed, but there is no guarantee that EPA will not expand the program to include additional +industries. Should we be required to report GHG emissions, it could require us to incur costs to +monitor, keep records of, and report emissions of GHGs. +Because of the lack of any comprehensive legislative program addressing GHGs, there is a great deal +of uncertainty as to how and when federal regulation of GHGs might take place. In addition to +possible federal regulation, a number of states, individually and regionally, also are considering +or have implemented GHG regulatory programs. These potential regional and state initiatives may +result in so—called cap—and—trade programs, under which overall GHG emissions are limited and +GHG emissions are then allocated and sold, and possibly other regulatory requirements, that could +result in our incurring material expenses to comply, e.g., by being required to purchase or to +surrender allowances for GHGs resulting from our operations. The federal, regional and local +regulatory initiatives also could adversely affect the marketability of the oil and natural gas we +produce. The impact of such future programs cannot be predicted, but we do not expect our +operations to be affected any differently than other similarly situated domestic competitors. +Application of the Safe Drinking Water Act to Hydraulic Fracturing. The Safe Drinking Water Act +regulates, among other things, underground injection operations. Recent legislative activity has +occurred which, if successful, would impose additional regulation under the SDWA upon the use of +hydraulic fracturing fluids. The U.S. Senate and House of Representatives are considering two +companion bills entitled the “Fracturing Responsibility and Chemical Awareness Act of 2009.” If +enacted, the legislation would impose on our hydraulic fracturing operations permit and financial +assurance requirements, requirements that we adhere to construction specifications, fulfill +monitoring, reporting and recordkeeping obligations, and meet plugging and abandonment +requirements. In addition to subjecting the injection of hydraulic fracturing to the SDWA +regulatory and permitting requirements, the proposed legislation would require the disclosure of +the chemicals within the hydraulic fluids, which could make it easier for third parties opposing +hydraulic fracturing to initiate legal proceedings based on allegations that specific chemicals +used in the process could adversely affect ground water. Neither piece of legislation has been +passed. If this or similar legislation is enacted, we could incur substantial compliance costs, +and the requirements could negatively impact our ability to conduct fracturing activities on our +assets. +SDAs . In addition, eleven states have enacted surface damage statutes (“SDAs”). These laws are +designed to compensate for damage caused by mineral development. Most SDAs contain entry +notification and negotiation requirements to facilitate contact between operators and surface +owners/users. Most laws also contain bonding requirements and specific expenses for exploration and +operating activities. Costs and delays associated with SDAs could impair operational effectiveness +and increase development costs. +Other Regulations . If we conduct operations on federal, state or Indian oil and natural gas +leases, these operations must comply with numerous regulatory restrictions, including various +nondiscrimination statutes, royalty and related valuation requirements. Certain of these +operations must be conducted pursuant to certain on-site security regulations and other appropriate +permits issued by the Bureau of Land Management, Minerals Management Service or other appropriate +federal or state agencies. +16 +Table of Contents +Commitments and Contingencies +The Company’s activities are subject to federal, state and local laws and regulations governing +environmental quality and pollution control. Although no assurances can be made, the Company +believes that, absent the occurrence of an extraordinary event, compliance with existing federal, +state and local laws, rules and regulations governing the release of materials into the environment +or otherwise relating to the protection of the environment will not have a material effect upon the +capital expenditures, earnings or the competitive position of the Company with respect to its +existing assets and operations. The Company cannot predict what effect additional regulation or +legislation, enforcement polices thereunder, and claims for damages to property, employees, other +persons, and the environment resulting from the Company’s operations could have on its activities. +Availability of Reports +All of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form +8-K, and amendments to such reports as well as other filings we make pursuant to Section 13(a) and +15(d) of the Securities Exchange Act of 1934 are available free of charge on our Internet website. +The address of our Internet website is www.callon.com. Our SEC filings are available on our +website as soon as they are filed with the SEC. +Item 1A. Risk Factors +Risk Factors +We may be unable to integrate successfully the operations of recent and future acquisitions with +our operations, and we may not realize all the anticipated benefits of these acquisition. We +intend to focus on producing property acquisitions. Integration of corporate acquisitions with our +existing business and operations will be a complex, time consuming and costly process. We can +offer no assurance that we will achieve the desired profitability from any acquisitions we may +complete in the future. In addition, failure to assimilate recent and future acquisitions +successfully could adversely affect our financial condition and results of operations. +Our acquisitions may involve numerous risks, including: +• +operating a larger combined organization and adding operations; +• +difficulties in the assimilation of the assets and operations of the acquired business, +especially if the assets acquired are in a new business segment or geographic area; +• +risk that oil and natural gas reserves acquired may not be of the anticipated magnitude +or may not be developed as anticipated; +• +loss of significant key employees from the acquired business: +• +diversion of management’s attention from other business concerns; +• +failure to realize expected profitability or growth; +• +failure to realize expected synergies and cost savings; +• +coordinating geographically disparate organizations, systems and facilities; and +• +coordinating or consolidating corporate and administrative functions. +17 +Table of Contents +Further, unexpected costs and challenges may arise whenever businesses with different operations or +management are combined, and we may experience unanticipated delays in realizing the benefits of an +acquisition. If we consummate any future acquisition, our capitalization and results of operation +may change significantly, and you may not have the opportunity to evaluate the economic, financial +and other relevant information that we will consider in evaluating future acquisitions. +We may fail to fully identify problems with any properties we acquire. We acquired a portion of +our acreage position in Louisiana and Texas through acquisitions and acreage trades, and we may +acquire additional acreage in these areas or other regions in the future. Although we conduct a +review of properties we acquire which we believe is consistent with industry practices, we can give +no assurance that we have identified or will identify all existing or potential problems associated +with such properties or that we will be able to mitigate any problems we do identify. +If the United States experiences a sustained economic downturn or recession, oil and natural gas +prices may fall or remain at their current prices for an extended period of time, which may +adversely affect our results of operations. The unprecedented disruption in the United States and +international credit markets in 2008 resulted in a rapid deterioration in the worldwide economy and +tightening of the financial markets. The outlook for the economy in 2010 is uncertain. The current +global credit and economic environment has reduced worldwide demand for energy and resulted in +significantly lower oil and natural gas prices than in earlier periods. A sustained reduction in +the prices we receive for our oil and natural gas production could have a material adverse effect +on our results of operations. In addition, any worsening of domestic and global economic conditions +could adversely affect our business and results of operations. +We may not be able to obtain funding on acceptable terms or at all. Global financial markets and +economic conditions have been disrupted and volatile due to a variety of factors. As a result, the +cost of raising money in the debt and equity capital markets and the availability of funds from +those markets is unpredictable. Although we have been able to successfully raise money in the +current economic climate and refinance certain debt instruments, we may not be successful in the +future. In addition, lending counterparties under existing revolving credit facilities and debt +instruments may be unwilling or unable to meet their funding obligations. +Due to these factors, we cannot be certain that new debt or equity financing will be available on +acceptable terms. If funding is not available when needed, or is available only on unfavorable +terms, we may be unable to meet our obligations as they come due. Moreover, without adequate +funding, we may be unable to execute our growth strategy, take advantage of other business +opportunities or respond to competitive pressures, any of which could have a negative effect on our +revenues and results of operations. +Hedging transactions and receivables expose us to counterparty credit risk. Our hedging +transactions expose us to risk of financial loss if a counterparty fails to perform under a +contract. We use master agreements which allow us, in the event of default, to elect early +termination of all contracts with the defaulting counterparty. If we choose to elect early +termination, all asset and liability positions with the defaulting counterparty would be net +settled at the time of election. We also monitor the creditworthiness of our counterparty on an +ongoing basis. However, the current disruptions occurring in the financial markets could lead to +sudden changes in a counterparty’s liquidity, which could impair their ability to perform under the +terms of the hedging contract. We are unable to predict sudden changes in a counterparty’s +creditworthiness or ability to perform. Even if we do accurately predict sudden changes, our +ability to negate the risk may be limited depending upon market conditions. +18 +Table of Contents +During periods of falling commodity prices, such as in late 2008 and the first half of 2009, our +hedge receivable positions increase, which increases our exposure. If the creditworthiness of our +counterparty, which is a major financial institution, deteriorates and results in its +nonperformance, we could incur a significant loss. +Some of our customers are experiencing, or may experience in the future, severe financial problems +that have had or may have a significant impact on their creditworthiness. We cannot provide +assurance that one or more of our customers will not default on their obligations to us or that +such a default or defaults will not have a material adverse effect on our business, financial +position, future results of operations, or future cash flows. Furthermore, the bankruptcy of one or +more of our customers, or some other similar proceeding or liquidity constraint, might make it +unlikely that we would be able to collect all or a significant portion of amounts owed by the +distressed entity or entities. In addition, such events might force such customers to reduce or +curtail their future use of our products and services, which could have a material adverse effect +on our results of operations and financial condition. +The adoption of derivatives legislation or regulations related to derivative contracts could +have an adverse impact on our ability to hedge risks associated with our business. Legislation has +been proposed in Congress and by the Treasury Department to impose restrictions on certain +transactions involving derivatives, which could affect the use of derivatives in hedging +transactions. Under proposed legislation, OTC derivative dealers and other major OTC derivative +market participants could be subjected to substantial supervision and regulation. The legislation +generally would expand the power of the Commodity Futures Trading Commission, or CFTC, to regulate +derivative transactions related to energy commodities, including oil and natural gas, to mandate +clearance of derivative contracts through registered derivative clearing organizations, and to +impose conservative capital and margin requirements and strong business conduct standards on OTC +derivative transactions. The CFTC has proposed regulations that would implement speculative limits +on trading and positions in certain commodities. Although it is not possible at this time to +predict whether or when Congress may act on derivatives legislation or the CFTC may issue new +regulations, any laws or regulations that may be adopted that subject us to additional capital or +margin requirements relating to, or to additional restrictions on, our trading and commodity +positions could have an adverse effect on our ability to hedge risks associated with our business +or on the cost of our hedging activity. +Depressed oil and gas prices may adversely affect our results of operations and financial +condition . Our success is highly dependent on prices for oil and gas, which are extremely volatile. +Extended periods of low prices for oil or gas will have a material adverse effect on us. Oil and +gas markets are both seasonal and cyclical. The prices of oil and gas depend on factors we cannot +control such as weather, economic conditions, and levels of production, actions by OPEC and other +countries and government actions. Prices of oil and gas will affect the following aspects of our +business: +• +our revenues, cash flows and earnings; +• +the amount of oil and gas that we are economically able to produce; +• +our ability to attract capital to finance our operations and the cost of the capital; +• +the amount we are allowed to borrow under our senior secured credit facility; +• +the value of our oil and gas properties; and +• +the profit or loss we incur in exploring for and developing our reserves. +Our reserve information represents estimates that may turn out to be incorrect if the assumptions +upon which these estimates are based are inaccurate. Any material inaccuracies in these reserve +estimates or underlying assumptions will materially affect the quantities and present value of our +reserves. The process of estimating oil and gas reserves is complex. It requires interpretations +of available technical data and various assumptions, including assumptions relating to economic +factors. Any significant +19 +Table of Contents +in accuracies in these interpretations or assumptions could materially affect the estimated +quantities and present value of reserves shown in this annual report. +In order to prepare these estimates, we must project production rates and the timing of development +expenditures. We must also analyze available geological, geophysical, production and engineering +data, the extent, completeness, quality and reliability of which can vary. The process also +requires us to make economic assumptions, such as oil and gas prices, drilling and operating +expenses, capital expenditures, taxes and availability of funds. Therefore, estimates of oil and +gas reserves are inherently imprecise. +Actual future production, oil and gas prices, revenues, taxes, development expenditures, operating +expenses and quantities of recoverable oil and gas reserves most likely will vary from the +estimates. Any significant variance could materially affect the estimated quantities and present +value of reserves shown in this report. In addition, estimates of proved reserves may be adjusted +to reflect production history, results of exploration and development, prevailing oil and gas +prices and other factors, many of which are beyond our control. +In addition, the new reserve reporting requirements effective January 1, 2010, represent a +significant change in the types and methods of quantifying reserve, the details of which are still +being considered and refined by the SEC. These changes are the first major modifications to the +accounting-based reserve reporting requirements since 1982. The new SEC rules replace the previous +pricing mechanism of using the last day of the fiscal year by using an average price based on the +first day of the last twelve months. In addition, these new requirements permit oil and gas +companies to report not just the proved reserves, but also probable and possible reserves. While +the new rules attempt to provide users of the financial statements with a more complete picture of +the reserves of reporting companies, and recognize new technologies and knowledge about the geology +and extent of oil and natural gas fields, these changes will potentially affect the results of our +reserve estimates. Application of these new, more subjective, reserve reporting rules by +competitors may change our relative positioning in the industry as a whole. +You should not assume that the present value of future net cash flows from our proved reserves +referred to in this report is the current market value of our estimated oil and gas reserves. In +accordance with SEC requirements, we generally base the estimated discounted future net cash flows +from our proved reserves on prices and costs on the date of the estimate. Actual future prices and +costs may differ materially from those used in the present value estimate. +The discounted present value of our oil and gas reserves is prepared in accordance with guidelines +established by the SEC. A purchaser of reserves would use numerous other factors to value the +reserves. The discounted present value of reserves, therefore, does not necessarily represent the +fair market value of those reserves. +On December 31, 2009, approximately 18% of the discounted present value of our estimated net proved +reserves was PUDs. PUDs represented 34% of total proved reserves. Approximately 71% of the PUDs +were attributable to our deepwater properties. +Information about reserves constitutes forward-looking information. See “Forward-Looking +Statements” for information regarding forward-looking information. +Unless we are able to replace reserves that we have produced, our cash flows and production will +decrease over time. Our future success depends upon our ability to acquire, find and develop oil +and gas reserves that are economically recoverable. Without successful exploration or acquisition +activities, our reserves, production and revenues will decline. We cannot assure you that we will +be able to find and develop or acquire additional reserves at an acceptable cost. +20 +Table of Contents +A significant part of the value of our production and reserves is concentrated in a small number of +offshore properties, and any production problems or inaccuracies in reserve estimates related to +those properties would adversely impact our business. During 2009, approximately 75% of our daily +production came from four of our properties in the Gulf of Mexico. Moreover, one property accounted +for 38% of our production during this period. In addition, at December 31, 2009, most of our proved +reserves were located in two fields in the Gulf of Mexico, with approximately 67% of our total net +proved reserves attributable to these properties. If mechanical problems, storms or other events +curtailed a substantial portion of this production or if the actual reserves associated with any +one of these producing properties are less than our estimated reserves, our results of operations +and financial condition could be adversely affected. +Our exploration projects increase the risks inherent in our oil and gas activities. Part of our +business strategy is to replace reserves through exploration, where the risks are greater than in +acquisitions and development drilling. Although we have been successful in exploration in the +past, we cannot assure you that we will continue to increase reserves through exploration or at an +acceptable cost. Additionally, we are often uncertain as to the future costs and timing of +drilling, completing and producing wells. Our drilling operations may be curtailed, delayed or +canceled as a result of a variety of factors, including: +• +unexpected drilling conditions; +• +overpressured formations and resultant blowouts or cratering; +• +equipment failures or accidents; +• +adverse weather conditions; +• +governmental requirements; and +• +shortages or delays in the availability of drilling rigs and the delivery of +equipment. +We do not operate all of our properties, and have limited influence over the operations of some of +these properties, particularly our two deepwater properties. Our lack of control could result in +the following: +• +the operator may initiate exploration or development at a faster or slower pace than we +prefer; +• +the operator may propose to drill more wells or build more facilities on a project than +we have funds for or that we deem appropriate, which may mean that we are unable to +participate in the project or share in the revenues generated by the project even though we +paid our share of exploration costs; and +• +if an operator refuses to initiate a project, we may be unable to pursue the project. +Any of these events could materially reduce the value of our non-operated properties. +Competitive industry conditions may negatively affect our ability to conduct operations. We +compete with numerous other companies in virtually all facets of our business. Our competitors in +development, exploration, acquisitions and production include major integrated oil and gas +companies as well as numerous independents, including many that have significantly greater +resources. Therefore, competitors may be able to pay more for desirable leases and evaluate, bid +for and purchase a greater number of properties or prospects than the financial or personnel +resources of the Company permit. We also compete for the materials, equipment and services that are +necessary for the exploration, development and operation of our properties. Our ability to increase +reserves in the future will be dependent on our ability to select and acquire suitable prospects +for future exploration and development. Factors that affect our ability to compete in the +marketplace include: +21 +Table of Contents +• +our access to the capital necessary to drill wells and acquire properties; +• +our ability to acquire and analyze seismic, geological and other information relating to +a property; +• +our ability to retain the personnel necessary to properly evaluate seismic and other +information relating to a property; +• +our ability to procure materials, equipment and services required to explore, develop +and operate our properties; and +• +our ability to access pipelines, and the location of facilities used to produce and +transport oil and natural gas production. +Our competitors may use superior technology, which we may be unable to afford, or which would +require costly investment by us in order to compete. Our industry is subject to rapid and +significant advancements in technology, including the introduction of new products and services +using new technologies. As our competitors use or develop new technologies, we may be placed at a +competitive disadvantage, and competitive pressures may force us to implement new technologies at a +substantial cost. In addition, our competitors may have greater financial, technical and personnel +resources that allow them to enjoy technological advantages, and may in the future allow them to +implement new technologies before we can. We cannot be certain that we will be able to implement +technologies on a timely basis or at a cost that is acceptable to us. One or more of the +technologies that we currently use or that we may implement in the future may become obsolete, and +we may be adversely affected. +Further increasing our exposure to this risk, we may not be able to replace our reserves or +generate cash flows if we are unable to raise capital. We will be required to make substantial +capital expenditures to acquire proved producing properties, develop our existing reserves, and to +discover new oil and gas reserves. Historically, we have financed these expenditures primarily with +cash from operations, proceeds from bank borrowings and proceeds from the sale of debt and equity +securities. See “Management’s Discussion and Analysis of Financial Condition and Results of +Operations — Liquidity and Capital Resources” for a discussion of our capital budget. We cannot +assure you that we will be able to raise capital in the future. We also make offers to acquire oil +and gas properties in the ordinary course of our business. If these offers are accepted, our +capital needs may increase substantially. +Further increasing our exposure to this risk, we expect to continue using our senior secured +revolving credit facility to borrow funds to supplement our available cash. The amount we may +borrow under our senior secured revolving credit facility may not exceed a borrowing base +determined by the lenders under such facility based on their projections of our future production, +production costs, taxes, commodity prices and any other factors deemed relevant by our lenders. We +cannot control the assumptions the lenders use to calculate our borrowing base. The lenders may, +without our consent, adjust the borrowing base semiannually or in situations where we purchase or +sell assets or issue debt securities. If our borrowings under the senior secured revolving credit +facility exceed the borrowing base, the lenders may require that we repay the excess. If this +repayment request were to occur, we might have to sell assets or seek financing from other sources, +which may either be unavailable or available on terms not economically justifiable. Sales of +assets could further reduce the amount of our borrowing base. We cannot assure you that we would be +successful in selling assets or arranging substitute financing. If we were not able to repay +borrowings under our senior secured revolving credit facility to reduce the outstanding amount to +less than the borrowing base, we would be in default under our senior secured credit facility. For +a description of our senior secured revolving credit facility and its principal terms and +conditions, see “Management’s Discussion and Analysis of Financial Condition and Results of +Operations —Liquidity and Capital Resources” and Note 7 to our Consolidated Financial Statements. +22 +Table of Contents +Our decision to drill a prospect is subject to a number of factors, and we may decide to alter our +drilling schedule or not drill at all. A prospect is a property on which we have identified what +our geoscientists believe, based on available seismic and geological information, to be indications +of hydrocarbons. Our prospects are in various stages of evaluation, ranging from a prospect which +is ready to drill to a prospect that will require substantial additional seismic data processing +and interpretation. Whether we ultimately drill a prospect may depend on the following factors: +• +receipt of additional seismic data or other geophysical data or the reprocessing of +existing data; +• +material changes in oil or gas prices; +• +the costs and availability of drilling rigs; +• +the success or failure of wells drilled in similar formations or which would use the +same production facilities; +• +availability and cost of capital; +• +changes in the estimates of the costs to drill or complete wells; +• +our ability to attract other industry partners to acquire a portion of the working +interest to reduce exposure to costs and drilling risks; +• +decisions of our joint working interest owners: and +• +changes to governmental regulations. +We will continue to gather data about our prospects, and it is possible that additional information +may cause us to alter our drilling schedule or determine that a prospect should not be pursued at +all. You should understand that our plans regarding our prospects are subject to change. +Weather, unexpected subsurface conditions, and other unforeseen operating hazards may adversely +impact our ability to conduct business. There are many operating hazards in exploring for and +producing oil and gas, including: +• +our drilling operations may encounter unexpected formations or pressures, which could +cause damage to equipment or personal injury; +• +we may experience equipment failures which curtail or stop production; +• +we could experience blowouts or other damages to the productive formations that may +require a well to be re-drilled or other corrective action to be taken; +• +hurricanes, storms and other weather conditions could cause damages to our production +facilities or wells; and +• +because of these or other events, we could experience environmental hazards, including +release of oil and gas from spills, gas leaks, and ruptures. +In the event of any of the foregoing, we may be subject to interrupted production or substantial +environmental liability due to injury to persons or loss of life, damage to or destruction of +property, natural resources and equipment, pollution and other environmental damage, investigation +and remediation requirements, and fines and penalties and injunctive relief. Moreover, a +substantial portion of our operations are offshore and are subject to a variety of risks peculiar +to the marine environment such as capsizing, collisions, hurricanes and other adverse weather +conditions, which can result in substantial damage to facilities and interrupt production, as well +as more extensive governmental regulation. +We cannot assure you that we will be able to maintain adequate insurance at rates we consider +reasonable to cover our possible losses from operating hazards. The occurrence of a significant +event not fully insured or indemnified against could materially and adversely affect our financial +condition and results of operations. +23 +Table of Contents +We may not have production to offset hedges; by hedging, we may not benefit from price increases. +Part of our business strategy is to reduce our exposure to the volatility of oil and gas prices by +hedging a portion of our production. In a typical hedge transaction, we will have the right to +receive from the other parties to the hedge the excess of the fixed price specified in the hedge +over a floating price based on a market index, multiplied by the quantity hedged. If the floating +price exceeds the fixed price, we are required to pay the other parties this difference multiplied +by the quantity hedged. Additionally, we are required to pay the difference between the floating +price and the fixed price when the floating price exceeds the fixed price regardless of whether we +have sufficient production to cover the quantities specified in the hedge. Significant reductions +in production at times when the floating price exceeds the fixed price could require us to make +payments under the hedge agreements even though such payments are not offset by sales of +production. Hedging will also prevent us from receiving the full advantage of increases in oil or +gas prices above the fixed amount specified in the hedge. +We also enter into price “collars” to reduce the risk of changes in oil and gas prices. Under a +collar, no payments are due by either party so long as the market price is above a floor set in the +collar and below a ceiling. If the price falls below the floor, the counter-party to the collar +pays the difference to us and if the price is above the ceiling, we pay the counter-party the +difference. +Another type of hedging contract we have entered into is a put contract. Under a put, if the price +falls below the set floor price, the counter-party to the contract pays the difference to us. See +“Quantitative and Qualitative Disclosures About Market Risks” for a discussion of our hedging +practices. +Compliance with environmental and other government regulations could be costly and could negatively +impact production. Our operations are subject to numerous laws and regulations governing the +operation and maintenance of our facilities and the discharge of materials into the environment or +otherwise relating to environmental protection. For a discussion of the material regulations +applicable to us, see “Regulations.” These laws and regulations may: +• +require that we acquire permits before commencing drilling; +• +impose operational, emissions control and other conditions on our activities; +• +restrict the substances that can be released into the environment in connection with +drilling and production activities; +• +limit or prohibit drilling activities on protected areas such as wetlands, wilderness +areas or coral reefs; and +• +require measures to remediate or mitigate pollution and environmental impacts from +current and former operations, such as cleaning up spills or dismantling abandoned +production facilities. +Under these laws and regulations, we could be liable for costs of investigation, removal and +remediation, damages to and loss of use of natural resources, loss of profits or impairment of +earning capacity, property damages, costs of and increased public services, as well as +administrative, civil and criminal fines and penalties, and injunctive relief. We could also be +affected by more stringent laws and regulations adopted in the future, including any related +climate change and greenhouse gases. Under the common law, we could be liable for injuries to +people and property. We maintain limited insurance coverage for sudden and accidental +environmental damages. We do not believe that insurance coverage for environmental damages that +occur over time is available at a reasonable cost. Also, we do not believe that insurance coverage +for the full potential liability that could be caused by sudden and accidental environmental +damages is available at a reasonable cost. Accordingly, we may be subject to liability or we may be +required to cease production from properties in the event of environmental incidents. +24 +Table of Contents +Climate Change Legislation or regulations restricting emissions of “greenhouse gasses” could result +in increased operating costs and reduced demand for the oil and gas we produce. On December 15, +2009, the U.S. Environmental Protection Agency ( “EPA” ) officially published its findings that +emissions of carbon dioxide, methane and other “greenhouse gases” present an endangerment to public +health and the environment because emissions of such gases are, according to the EPA, contributing +to warming of the earth’s atmosphere and other climatic changes. These findings allow the EPA to +adopt and implement regulations that would restrict emissions of greenhouse gases under existing +provisions of the federal Clean Air Act. Accordingly, the EPA has proposed two sets of regulations +that would require a reduction in emissions of greenhouse gases from motor vehicles and could +trigger permit review for greenhouse gas emissions from certain stationary sources. +In addition, on October 30, 2009, the EPA published a final rule requiring the reporting of +greenhouse gas emissions from specified large greenhouse gas emission sources in the United States +beginning in 2011 for emissions occurring in 2010. +Also, on June 26, 2009, the U.S. House of Representatives passed the “American Clean Energy and +Security Act of 2009,” or “ACESA,” which would establish an economy-wide cap-and-trade program to +reduce U.S. emissions of greenhouse gases, including carbon dioxide and methane. ACESA would +require a 17% reduction in greenhouse gas emissions from 2005 levels by 2020 and just over an 80% +reduction of such emissions by 2050. Under this legislation, the EPA would issue a capped and +steadily declining number of tradable emissions allowances authorizing emissions of greenhouse +gases into the atmosphere. These reductions would be expected to cause the cost of allowances to +escalate significantly over time. The net effect of ACESA will be to impose increasing costs on +the combustion of carbon-based fuels such as oil, refined petroleum products, and natural gas. +The U.S. Senate has begun work on its own legislation for restricting domestic greenhouse gas +emissions, and the Obama Administration has indicated its support for legislation to reduce +greenhouse emissions through an emission allowance system. At the state level, more than one-third +of the states, either individually or through multi-state regional initiatives, already have begun +implementing legal measures to reduce emissions of greenhouse gases. The adoption and +implementation of any regulations imposing reporting obligations on, or limiting emissions of +greenhouse gases from, our equipment and operations could require us to incur costs to accumulate +the required data and/or reduce emissions of greenhouse gases associated with our operations or +could adversely affect demand for the oil and natural gas that we produce. +Significant physical effects of climatic change have the potential to damage our facilities, +disrupt our production activities and cause us to incur significant costs in preparing for or +responding to those effects. In an interpretative guidance on climate change disclosures, the SEC +indicates that climate change could have an effect on the severity of weather (including hurricanes +and floods), sea levels, the arability of farmland, and water availability and quality. If such +effects were to occur, our exploration and production operations have the potential to be adversely +affected. Potential adverse effects could include damages to our facilities from powerful winds or +rising waters in low-lying areas, disruption of our production activities either because of +climate-related damages to our facilities in our costs of operation potentially arising from such +climatic effects, less efficient or non-routine operating practices necessitated by climate effects +or increased costs for insurance coverages in the aftermath of such effects. Significant physical +effects of climate change could also have an indirect affect on our financing and operations by +disrupting the transportation or process-related services provided by midstream companies, service +companies or suppliers with whom we have a business relationship. We may not be able to recover +through insurance some or any of the damages, losses or costs that may result from potential +physical effects of climate change. +25 +Table of Contents +Federal legislation and state legislative and regulatory initiatives relating to hydraulic +fracturing could result in increased costs and additional operating restrictions or delays. The +U.S. Senate and House of Representatives are currently considering bills entitled, the “Fracturing +Responsibility and Awareness of Chemicals Act,” or the “FRAC Act,” that would amend the federal +Safe Drinking Water Act, or the “SDWA,” to repeal an exemption from regulation for hydraulic +fracturing. If enacted, the FRAC Act would amend the definition of “underground injection” in the +SDWA to encompass hydraulic fracturing activities. +Such a provision could require hydraulic fracturing operations to meet permitting and financial +assurance requirements, adhere to certain construction specifications, fulfill monitoring, +reporting, and recordkeeping obligations, and meet plugging and abandonment requirements. The FRAC +Act also proposes to require the reporting and public disclosure of chemicals used in the +fracturing process, which could make it easier for third parties opposing the hydraulic fracturing +process to initiate legal proceedings based on allegations that specific chemicals used in the +fracturing process could adversely affect groundwater. The adoption of any future federal or state +laws or implementing regulations imposing reporting obligations on, or otherwise limiting, the +hydraulic fracturing process could make it more difficult to complete natural gas wells and +increase our costs of compliance and doing business. +Factors beyond our control affect our ability to market production and our financial results. The +ability to market oil and gas from our wells depends upon numerous factors beyond our control. +These factors include: +• +the extent of domestic production and imports of oil and gas; +• +the proximity of the gas production to gas pipelines; +• +the availability of pipeline capacity; +• +the demand for oil and gas by utilities and other end users; +• +the availability of alternative fuel sources; +• +the effects of inclement weather; +• +state and federal regulation of oil and gas marketing; and +• +federal regulation of gas sold or transported in interstate commerce. +Because of these factors, we may be unable to market all of the oil or gas we produce. In addition, +we may be unable to obtain favorable prices for the oil and gas we produce. +If oil and gas prices decrease or remain depressed for extended periods of time, we may be required +to take additional writedowns of the carrying value of our oil and gas properties. We may be +required to writedown the carrying value of our oil and gas properties when oil and gas prices are +low or if we have substantial downward adjustments to our estimated net proved reserves, increases +in our estimates of development costs or if we experience deterioration in our exploration results. +Under the full-cost method, which we use to account for our oil and gas properties, the net +capitalized costs of our oil and gas properties may not exceed the present value, discounted at +10%, of future net cash flows from estimated net proved reserves, using period end oil and gas +prices or prices as of the date of our auditor’s report, plus the lower of cost or fair market +value of our unproved properties. If net capitalized costs of our oil and gas properties exceed +this limit, we must charge the amount of the excess to earnings. This type of charge will not +affect our cash flows, but will reduce the book value of our stockholders’ equity. We review the +carrying value of our properties quarterly, based on prices in effect as of the end of each quarter +or at the time of reporting our results. Once incurred, a writedown of oil and gas properties is +not reversible at a later date, even if prices increase. See Note 15 to our Consolidated Financial +Statements. +26 +Table of Contents +There are inherent limitations in all control systems, and misstatements due to error or fraud that +could seriously harm our business may occur and not be detected. Our management, including our +Chief Executive Officer and Chief Financial Officer, do not expect that our internal controls and +disclosure controls will prevent all possible error and all fraud. A control system, no matter how +well conceived and operated, can provide only reasonable, not absolute, assurance that the +objectives of the control system are met. In addition, the design of a control system must reflect +the fact that there are resource constraints and the benefit of controls must be relative to their +costs. Because of the inherent limitations in all control systems, an evaluation of controls can +only provide reasonable assurance that all material control issues and instances of fraud, if any, +in our company have been detected. These inherent limitations include the realities that judgments +in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. +Further, controls can be circumvented by the individual acts of some persons or by collusion of two +or more persons. The design of any system of controls is based in part upon certain assumptions +about the likelihood of future events, and there can be no assurance that any design will succeed +in achieving its stated goals under all potential future conditions. Because of inherent +limitations in a cost-effective control system, misstatements due to error or fraud may occur and +not be detected. A failure of our controls and procedures to detect error or fraud could seriously +harm our business and results of operations. +Forward-Looking Statements +In this report, we have made many forward-looking statements. We cannot assure you that the plans, +intentions or expectations upon which our forward-looking statements are based will occur. Our +forward-looking statements are subject to risks, uncertainties and assumptions, including those +discussed elsewhere in this report. Forward-looking statements include statements regarding: +• +our oil and gas reserve quantities, and the discounted present value of these +reserves; +• +the amount and nature of our capital expenditures; +• +drilling of wells; +• +the timing and amount of future production and operating costs; +• +business strategies and plans of management; and +• +prospect development and property acquisitions. +Some of the risks, which could affect our future results and could cause results to differ +materially from those expressed in our forward-looking statements, include: +• +the current global economic downturn; +• +general economic conditions or including the availability of credit and access to +existing lines of credit +• +the volatility of oil and natural gas prices; +• +the uncertainty of estimates of oil and natural gas reserves; +• +the impact of competition; +• +the availability and cost of seismic, drilling and other equipment; +• +operating hazards inherent in the exploration for and production of oil and natural +gas; +• +difficulties encountered during the exploration for and production of oil and +natural gas; +• +difficulties encountered in delivering oil and natural gas to commercial markets; +• +changes in customer demand and producers’ supply; +• +the uncertainty of our ability to attract capital and obtain financing on favorable +terms; +• +compliance with, or the effect of changes in, the extensive governmental regulations +regarding the oil and natural gas business including those related to climate change and +greenhouse gases; +• +actions of operators of our oil and gas properties; and +• +weather conditions. +27 +Table of Contents +The information contained in this report, including the information set forth under the heading +“Risk Factors,” identifies additional factors that could affect our operating results and +performance. We urge you to carefully consider these factors and the other cautionary statements in +this report. Our forward-looking statements speak only as of the date made, and we have no +obligation to update these forward-looking statements. +ITEM 1B. Unresolved Staff Comments +None. +ITEM 3. LEGAL PROCEEDINGS +We are a defendant in various legal proceedings and claims, which arise in the ordinary course of +our business. We do not believe the ultimate resolution of any such actions will have a material +affect on our financial position or results of operations. +ITEM 4. RESERVED +PART II. +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock trades on the New York Stock Exchange under the symbol “CPE”. The following table +sets forth the high and low sale prices per share as reported for the periods indicated. +Quarter Ended +High +Low +2008: +First quarter +$ +19.22 +$ +13.42 +Second quarter +28.93 +17.63 +Third quarter +28.00 +16.18 +Fourth quarter +18.06 +1.02 +2009: +First quarter +$ +3.37 +$ +0.94 +Second quarter +2.93 +1.07 +Third quarter +2.33 +1.42 +Fourth quarter +2.12 +1.42 +As of March 8, 2010 there were approximately 3,556 common stockholders of record. +We have never paid dividends on our common stock and intend to retain our cash flow from operations +for the future operation and development of our business. In addition, our primary credit facility +and the terms of our outstanding debt prohibit the payment of cash dividends on our common +stock. +During the fourth quarter of 2009, neither we nor any affiliated purchasers made repurchases of our +equity securities. +28 +Table of Contents +Equity Compensation Plan Information. The following table summarizes information regarding +the number of shares of our common stock that are available for issuance under all of our existing +equity compensation plans as of December 31, 2009. +Number of +securities +Weighted-average +to be issued upon +exercise price of +Number of securities +exercise +outstanding +remaining available +of outstanding +options, warrants +for future issuance +Plan Category +options +and rights +under equity +Equity +compensation plans +approved by +security holders +402,875 +$ +10.85 +1,252,921 +Equity +compensation for +inducement of +employment +500,000 +2.76 +Equity +compensation plans +not approved by +security holders +75,483 +6.40 +37,466 +Total +978,358 +$ +6.37 +1,290,387 +See Notes 4 and 16 to our Consolidated Financial Statements. +Performance Graph +The following graph compares the yearly percentage change for the five years ended December 31, +2009, in the cumulative total shareholder return on the Company’s Common Stock against the +cumulative total return for the (i) Hemscott Industry and Market Index of SIC Group 123 (the +“Hemscott Group Index”) consisting of independent oil and gas drilling and exploration companies +and (ii) the New York Stock Exchange Market Index. The comparison of total return on an investment +for each of the periods assumes that $100 was invested on December 31, 2004 in the Company, the +Hemscott Group Index and the New York Stock Exchange Market Index, and that all dividends were +reinvested. +29 +Table of Contents +COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN AMONG CALLON PETROLEUM +COMPANY, NYSE MARKET INDEX AND HEMSCOTT GROUP INDEX +ASSUMES +$100 INVESTED ON JAN. 01, 2005 +ASSUMES DIVIDEND REINVESTED +FISCAL YEAR ENDING DEC. 31, 2009 +Company/Index/Market +2004 +2005 +2006 +2007 +2008 +2009 +Callon Petroleum Company +$ +100.00 +$ +122.06 +$ +103.94 +$ +113.76 +$ +17.98 +$ +10.37 +NYSE Market Index +$ +100.00 +$ +109.36 +$ +131.75 +$ +143.43 +$ +87.12 +$ +111.76 +Hemscott Group Index +$ +100.00 +$ +157.64 +$ +186.69 +$ +293.61 +$ +131.45 +$ +249.89 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth, as of the dates and for the periods indicated, selected financial +information about us. The financial information for each of the five years in the period ended +December 31, 2009 has been derived from our audited Consolidated Financial Statements for such +periods. The information should be read in conjunction with “Management’s Discussion and Analysis +of Financial Condition and Results of Operations” and the Consolidated Financial Statements and +Notes thereto. The following information is not necessarily indicative of our future results. +30 +Table of Contents +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(In thousands, except per share amounts) +Years Ended December 31, +2009 +2008 +2007 +2006 +2005 +Statement of Operations Data: +Operating revenues: +Oil and gas sales +$ +101,259 +$ +141,312 +$ +170,768 +$ +182,268 +$ +141,290 +Medusa MMS royalty recoupment +40,886 +— +— +— +— +Oil and gas sales +142,145 +141,312 +170,768 +182,268 +141,290 +Operating expenses: +Lease operating expenses +18,447 +19,208 +27,795 +28,881 +24,377 +Depreciation, depletion and amortization +33,443 +64,054 +72,762 +65,283 +44,946 +General and administrative +13,355 +9,565 +9,876 +8,591 +8,085 +Accretion expense +3,149 +4,172 +3,985 +4,960 +3,549 +Acquisition expense +298 +— +— +— +— +Derivative expense +— +498 +— +150 +6,028 +Impairment of oil and gas properties +— +485,498 +— +— +— +Total operating expenses +68,692 +582,995 +114,418 +107,865 +86,985 +Income (loss) from operations +73,453 +(441,683 +) +56,350 +74,403 +54,305 +Other (income) expenses: +Interest expense +19,089 +23,986 +34,329 +16,480 +16,660 +Callon Entrada (non-recourse) interest expense +7,072 +2,719 +— +— +— +9.75% Senior Note restructuring expense +1,024 +— +— +— +— +Interest on MMS royalty recoupment +(7,681 +) +— +— +— +— +Other (income) expense +190 +(1,379 +) +(1,172 +) +(1,869 +) +(998 +) +Loss on early extinguishment of debt +— +11,871 +— +— +— +Total other (income) expenses +19,694 +37,197 +33,157 +14,611 +15,662 +Income (loss) before income taxes +53,759 +(478,880 +) +23,193 +59,792 +38,643 +Income tax expense (benefit) +— +(39,725 +) +8,506 +20,707 +13,209 +Income (loss) before equity in earnings of Medusa Spar LLC +53,759 +(439,155 +) +14,687 +39,085 +25,434 +Equity in earnings of Medusa Spar LLC, net of tax +660 +262 +507 +1,475 +1,342 +Net income (loss) +54,419 +(438,893 +) +15,194 +40,560 +26,776 +Preferred stock dividends +— +— +— +— +318 +Net income (loss) available to common shares +$ +54,419 +$ +(438,893 +) +$ +15,194 +$ +40,560 +$ +26,458 +Net income (loss) per common share: +Basic +$ +2.47 +$ +(20.68 +) +$ +0.73 +$ +2.00 +$ +1.43 +Diluted +$ +2.45 +$ +(20.68 +) +$ +0.71 +$ +1.90 +$ +1.28 +Shares used in computing net income (loss) per common share: +Basic +22,072 +21,222 +20,776 +20,270 +18,453 +Diluted +22,200 +21,222 +21,290 +21,363 +20,883 +31 +Table of Contents +CALLON PETROLEUM COMPANY +SELECTED HISTORICAL FINANCIAL INFORMATION +(In thousands, except per share amounts) +Years Ended December 31, +2009 +2008 +2007 +2006 +2005 +Balance Sheet Data (end of period): +Oil and gas properties, net +$ +130,608 +$ +159,252 +$ +681,706 +$ +547,027 +$ +447,364 +Total assets +$ +227,991 +$ +266,090 +$ +792,482 +$ +625,527 +$ +533,776 +Long-term debt, less current portion +$ +179,174 +$ +272,855 +$ +392,012 +$ +225,521 +$ +188,813 +Stockholders’ equity (deficit) +$ +(80,854 +) +$ +(129,804 +) +$ +287,075 +$ +281,363 +$ +228,048 +We follow the full-cost method of accounting for oil and gas properties. Under this method of +accounting, our net capitalized costs to acquire, explore and develop oil and gas properties may +not exceed the sum of (1) the estimated future net revenues from proved reserves at current prices +discounted at 10% and (2) the lower of cost or market of unevaluated properties, net of tax (the +full-cost ceiling amount). If these capitalized costs exceed the full-cost ceiling amount, the +excess is charged to expense. For the year ended December 31, 2008, the Company recorded a $485.5 +million impairment of oil and gas properties as a result of the ceiling test. See Note 15 to the +Consolidated Financial Statements. +32 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +The following discussion is intended to assist in an understanding of our financial condition and +results of operations. Our consolidated financial statements and notes thereto contain detailed +information that should be referred to in conjunction with the following discussion. See Item 8 +“Financial Statements and Supplementary Data.” +We have been engaged in the exploration, development, acquisition and production of oil and gas +properties since 1950. Prior to 2009, our operations were focused on exploration and production in +the Gulf of Mexico. Following the abandonment of our Entrada project in 2008, we took steps to +change our operational focus to lower risk, onshore exploration and development activities. During +2009, we took the following actions: +• +We exchanged a new series of senior notes due 2016 and common stock for a substantial +portion of our existing $200 million of senior notes due 2010, and reduced principal from +$200 million to $154 million. +• +We filed for recoupment of deepwater royalty payments, and received a payment from the +MMS of $44.8 million in January 2010. We expect to receive an additional payment from the +MMS of approximately $7.7 million during 2010, representing interest. +• +We began negotiating a new $100 million revolving credit facility, with a borrowing base +of $20 million, which we finalized in January 2010. +These activities were undertaken to allow us to shift our operational focus from the offshore Gulf +of Mexico to longer life, lower risk onshore properties. As part of this strategy, we employed +Steven B. Hinchman as our Chief Operating Officer. Mr. Hinchman has substantial experience in +onshore oil and gas acquisition, exploration and development activities. During 2009, we closed +two acquisitions as part of this new focus: +• +In September 2009, we acquired a 70% working interest in a 577-acre unit in the heart of +the Haynesville Shale play in Bossier Parish, Louisiana for $3.0 million. We plan to +drill a total of seven horizontal wells on this property, with the first two wells to be +drilled in 2010. We will be operator of these wells. +• +On October 28, 2009, we acquired interests in properties producing from the Wolfberry +formation in Crockett, Ector, Midland and Upton Counties, Texas for total cash +consideration of $16.0. The acquisition included year-end proven reserves of 1.6 MMBoe, 22 +existing wells producing 350 Boe per day and upside from a multi-year inventory of drilling +opportunities. We will operate substantially all of the production and development of +these properties. +Deconsolidation of Callon Entrada Company +In June 2009, the FASB issued an accounting standard which amends US GAAP as follows: a) to require +an enterprise to perform an analysis to determine whether the enterprise’s variable interest or +interests give it a controlling financial interest in a variable interest entity (“VIE”), +identifying the primary beneficiary of a VIE, b) to require ongoing reassessment of whether an +enterprise is the primary beneficiary of a VIE, rather than only when specific events occur, c) to +eliminate the quantitative approach previously required for determining the primary beneficiary of +a VIE, d) to amend certain guidance for determining whether an entity is a VIE, e) to add an +additional reconsideration event when changes in facts and circumstances pertinent to a VIE occur, +f) to eliminate the exception for troubled debt restructuring regarding VIE reconsideration, and g) +to require advanced disclosures that will provide users of financial statement with more +transparent information about an enterprise’s involvement in a VIE. This pronouncement is +effective for the first annual reporting period that begins after November 15, 2009, with earlier +adoption prohibited. We adopted this pronouncement on January 1, 2010. Upon adoption, we +reevaluated our interest in our subsidiary, Callon Entrada Company (“Callon Entrada”) as a result +of the amendments described above. +33 +Table of Contents +Based on the evaluation performed applying the new standard, management has concluded that a VIE +reconsideration event had taken place resulting in the determination that Callon Entrada is a VIE, +for which we are not the primary beneficiary. Therefore, effective January 1, 2010, Callon Entrada +will be deconsolidated from our consolidated financial statements. Deconsolidation will result in +the removal of approximately $1.8 million of current assets, $2.0 million of current liabilities, +$30 million of deferred tax assets, $30 million of valuation allowance and approximately $84.8 +million of non-recourse debt and related obligation for the cumulative amount of interest. +Retained earnings will be increased by $85.1 million as a cumulative effect of change related to +this accounting standard. No gain will be reflected in the statement of operations. See Note 2 to +our Consolidated Financial Statements. +2010 OUTLOOK +In 2009, we set our course and began to re-shape our portfolio. We recognized that continuing to +solely focus on the Gulf of Mexico shelf and deep water could not sustain profitable growth at an +acceptable level of risk. We needed to initiate a transition of resources from offshore to a more +diverse and lower risk resource base located both onshore and offshore. We focused our attention +on the Permian Basin for oil and the shale gas plays. +In the Permian Basin we plan to drill and complete 16 wells in 2010. These wells are expected to +more than double our current Permian Basin production of 350 Boe per day by the end of the year. +In the Haynesville Shale gas play, we plan to drill two wells in 2010. We expect to spud the first +well by mid-year and have both wells completed and producing in the fourth quarter of 2010. +We are estimating full year production from our current properties of between 27 and 31 million +cubic feet of natural gas equivalent (“MMcfe”) per day, with an exit rate of approximately 35 MMcfe +per day. Additionally, any acquisition in 2010 would positively contribute to these estimates. +Our lease operating expense, including severance tax, is expected to range between $18 million and +$22 million in 2010 with abandonment costs estimated to be $4 million. +Our new onshore properties along with the strong cash flow from our Gulf of Mexico operations have +already begun to re-shape our portfolio and outlook. We are well positioned to continue the +pursuit of diversifying our portfolio by building profitable growth opportunities onshore. +Factors potentially impacting our expected production profile include: +• +a reduced level of capital expenditures, as discussed below; +• +allocation of capital expenditures to acquire producing properties; +• +natural field decline in the deepwater Gulf of Mexico and Gulf Coast areas of our US +operations; +• +timing of well completions in the Permian Basin and Haynesville Shale development +programs; +• +potential hurricane-related downtime and volume curtailments in the Gulf of Mexico and +Gulf Coast areas; and +• +inflation of capital costs and operating expenses. +2010 Budget —We have designed a flexible capital spending program that can be funded from cash +on hand and cashflows from operations. Our preliminary base capital program includes the +development of our Permian Basin assets as well as exploiting our Haynesville Shale play. +Including plugging and abandonment, capitalized interest and general and administrative costs our +2010 capital budget is $61.7 million. We do have a $20 million available borrowing base that could +be used for an attractive strategic opportunity. However, depending on commodity prices and other +economic conditions we experience in 2010, this base capital program may be adjusted up or down. +34 +Table of Contents +Inflation has not had a material impact on us, nor is it expected to have a material impact on us +in the immediate future. +Summary of Significant Accounting Policies +Property and Equipment. We follow the full-cost method of accounting for oil and gas properties +whereby all costs incurred in connection with the acquisition, exploration and development of oil +and gas reserves, including certain overhead costs, are capitalized into the “full-cost pool.” The +amounts we capitalize into the full-cost pool are depleted (charged against earnings) using the +unit-of-production method. The full-cost method of accounting for our proved oil and gas +properties requires that we make estimates based on assumptions as to future events that could +change. These estimates are described below. +Depreciation, Depletion and Amortization (DD&A) of Oil and Gas Properties . We calculate depletion +by using the net capitalized costs in our full-cost pool plus estimated future development costs +(combined, the depletable base) and our estimated net proved reserve quantities. Capitalized +costs added to the full-cost pool include the following: +• +cost of drilling and equipping productive wells, dry hole costs, acquisition costs of +properties with proved reserves, delay rentals and other costs related to exploration and +development of our oil and gas properties; +• +payroll costs including the related to fringe benefits paid to employees directly +engaged in the acquisition, exploration and/or development of oil and gas properties as +well as other directly identifiable general and administrative costs associated with such +activities. Such capitalized costs do not include any costs related to our production of +oil and gas or our general corporate overhead; +• +costs associated with properties that do not have proved reserves classified as +unevaluated property costs and are excluded from the depletable base. These unevaluated +property costs are added to the depletable base at such time as wells are completed on the +properties, the properties are sold or we determine these costs have been impaired. Our +determination that a property has or has not been impaired (which is discussed below) +requires that we make assumptions about future events; +• +estimated costs to dismantle, abandon and restore properties that are capitalized to the +full-cost pool when the related liabilities are incurred under guidance for accounting of +asset retirement obligations; and +• +estimated future costs to develop proved properties are added to the full-cost pool for +purposes of the DD&A computation. We use assumptions based on the latest geologic, +engineering, regulatory and cost data available to us to estimate these amounts. However, +the estimates we make are subjective and may change over time. Our estimates of future +development costs are periodically updated as additional information becomes available. +Capitalized costs included in the full-cost pool plus estimated future development costs are +depleted and charged against earnings using the unit-of-production method. Under this method, we +estimate the proved reserves quantities at the beginning of each accounting period. For each Mcfe +produced during the period, we record a depletion charge equal to the amount included in the +depletable base (net of accumulated depreciation, depletion and amortization) divided by our +estimated net proved reserve quantities. +Because we use estimates and assumptions to calculate proved reserves (as discussed below) and the +amounts included in the depletable base, our depletion rates may materially change if actual +results differ from these estimates. +35 +Table of Contents +Ceiling Test . Under the full-cost accounting rules of the SEC, we review the carrying value of our +proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and gas +properties, net of accumulated depreciation, depletion and amortization and deferred income taxes, +may not exceed the present value of estimated future net cash flows from proved oil and gas +reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of +related tax effects (the full-cost ceiling amount). These rules generally require pricing future +oil and gas production at the unescalated market price for oil and gas at the end of each fiscal +quarter, and require a write-down if the “ceiling” is exceeded. However, if prices recover +sufficiently subsequent to the balance sheet date before the release of the financial statements, +the use of the subsequent pricing is allowed and no write-down would be required. Given the +volatility of oil and gas prices, it is reasonably possible that our estimate of discounted future +net cash flows from proved oil and gas reserves could change in the near term. If oil and gas +prices decline significantly, even if only for a short period of time, it is possible that +write-downs of oil and gas properties could occur in the future. See Note 15 to our Consolidated +Financial Statements. +Estimating Reserves and Present Value of Estimated Future Net Cash Flows . The estimates of +quantities of proved oil and gas reserves including the discounted present value of estimated +future net cash flows from such reserves at the end of each quarter are based on numerous +assumptions, which are likely to change over time. These assumptions include: +• +the prices at which we can sell our oil and gas production in the future. Oil and gas +prices are volatile, but we are required to assume that they remain constant. In general, +higher oil and gas prices will increase quantities of proved reserves and the present value +of estimated future net cash flows from such reserves, while lower prices will decrease +these amounts. Because some of our properties have relatively short productive lives, +changes in prices will affect the present value of estimated future net cash flows more +than the estimated quantities of oil and gas reserves; and +• +the costs to develop and produce our reserves and the costs to dismantle our production +facilities when reserves are depleted. These costs are likely to change over time, but we +are required to assume that costs in effect at the end of the quarter will not change. +Increases in costs will reduce estimated oil and gas quantities and the present value of +estimated future net cash flows, while decreases in costs will increase such amounts. +Because some of our properties have relatively short productive lives, changes in costs +will affect the present value of estimated future net cash flows more than the estimated +quantities of oil and gas reserves. +In addition, the process of estimating proved oil and gas reserves requires that our independent +and internal reserve engineers exercise judgment based on available geological, geophysical and +technical information. We have described the risks associated with reserve estimation and the +volatility of oil and gas prices under “Risk Factors.” +Sales of oil and gas properties are accounted for as adjustments to the net full cost pool with no +gain or loss recognized unless the adjustment would significantly alter the relationship between +capitalized costs and proved reserves. +In December 2008 the SEC approved amendments to its oil and gas reserves estimation and disclosure +requirements. The amendments, among other things: +• +allow the use of reliable technologies to estimate proved reserves if those technologies +have been demonstrated to result in reliable conclusions about reserve volumes; +• +require disclosure of oil and gas proved reserves by significant geographic area; +• +permit the optional disclosure of probable and possible reserves; +• +modify the prices used to estimate reserves for SEC disclosure purposes to a 12-month +average beginning-of-the-month price instead of a period-end price; and +36 +Table of Contents +• +require that if a third party is primarily responsible for preparing or auditing the +reserve estimates, the company make disclosures relating to the independence and +qualifications of the third party, including filing as an exhibit any report received from +the third party. +The new requirements are effective for our year-end financial statements and our Annual Report on +Form 10-K for the year ended December 31, 2009. We have adopted the new requirements, which had no +material impact on our financial statements. +Unproved Properties . Costs associated with properties that do not have proved reserves, including +capitalized interest, are excluded from the depletable base. These unproved properties are +included in the line item “Unevaluated properties excluded from amortization.” Unproved property +costs are transferred to the depletable base when wells are completed on the properties or the +properties are sold. In addition, we are required to determine whether our unproved properties are +impaired and, if so, include the costs of such properties in the depletable base. We determine +whether an unproved property should be impaired by periodically reviewing our exploration program +on a property by property basis. This determination may require the exercise of substantial +judgment by our management. +Asset Retirement Obligations. We are required to record our estimate of the fair value of +liabilities for obligations associated with the retirement of tangible long-life assets and the +associated asset retirement costs. Interest is accreted on the present value of the asset +retirement obligation and reported as accretion expense within operating expenses in the +Consolidated Statements of Operations. See Note 11 to our Consolidated Financial Statements. +Derivatives. We periodically use derivative financial instruments to manage oil and gas price risk +on a limited amount of our future production and do not use these instruments for trading purposes. +Settlement of derivative contracts are generally based on the difference between the contract +price or prices specified in the derivative instrument and a NYMEX price or other cash or futures +index price. +Our derivative contracts, which are accounted for as cash flow hedges, are recorded at fair market +value with changes in fair value recorded through other comprehensive income (loss), net of tax, in +stockholders’ equity. The cash settlements on these contracts are recorded as an increase or +decrease in oil and gas sales. The changes in fair value related to ineffective derivative +contracts are recognized as derivative expense (income). The cash settlement on these contracts is +also recorded within derivative expense (income). See Note 8 to our Consolidated Financial +Statements. +Our derivative contracts are carried at fair value on our consolidated balance sheet under the +caption “Fair Market Value of Derivatives”. The oil and gas derivative contracts are settled based +upon reported prices on NYMEX. The estimated fair value of these contracts is based upon closing +exchange prices on NYMEX and in the case of collars and floors, the time value of options. See +Note 9, “Fair Value Measurements” to our Consolidated Financial Statements. +In March 2008, the FASB issued guidance for disclosures about derivative instruments and hedging +activities. Under the guidance changes the disclosure requirements for derivative instruments and +hedging activities, entities are required to provide enhanced disclosures about (a) how and why an +entity uses derivative instruments, (b) how derivative instruments and related hedged items are +accounted for under GAAP, and (c) how derivative instruments and related hedged items affect an +entity’s financial position, financial performance, and cash flows. We adopted the guidance on +January 1, 2009 and have added certain additional disclosures to our financial statements. +Fair Value Measurements. We adopted guidance issued by the FASB for fair value measurements which +defines fair value, establishes a framework for measuring fair value and requires enhanced +disclosures about fair value measurements. We also adopted guidance issued by the FASB for the +fair value option for financial +37 +Table of Contents +assets and liabilities, which permits entities to choose to measure various financial instruments +and certain other items at fair value. See Note 9 to our Consolidated Financial Statements. +Income Taxes. Provisions for income taxes include deferred taxes resulting primarily from temporary +differences due to different reporting methods for oil and gas properties for financial reporting +purposes and income tax purposes. GAAP provides for the recognition of a deferred tax asset for +net operating loss carryforwards, statutory depletion carryforward and tax credit carryforwards, +net of a valuation allowance. The valuation allowance is provided for that portion of the asset +for which it is deemed more likely than not will not be realized. +Share-Based Compensation. We account for share-based compensation under guidance issued by the +FASB. In June 2008, FASB issued guidance determining whether instruments granted in share-based +compensation transactions are participating securities. The guidance addresses whether instruments +granted in share-based compensation transactions are participating securities prior to vesting and, +therefore, need to be included in the earnings allocation in computing earnings per share under the +two-class method described in the FASB issued guidance for earning per share.” We adopted this +guidance on January 1, 2009 with no impact to its financial statements. +Business Combinations. In December 2007, the FASB issued an accounting standard to improve the +relevance, representational faithfulness, and comparability of the information that a reporting +entity provides in its financial reports about a business combination and its effects. To +accomplish that, the standard establishes principles and requirements for how the acquirer (a) +recognizes and measures in its financial statements the identifiable assets acquired, the +liabilities assumed, and any noncontrolling interest in the acquiree, (b) recognizes and measures +the goodwill acquired in the business combination or a gain from a bargain purchase, and (c) +determines what information to disclose to enable users of the financial statements to evaluate the +nature and financial effects of the business combination. The business combination guidance is +effective for business combinations with an acquisition date on or after the beginning of annual +reporting period beginning on or after December 15, 2008. The standard requires an acquirer to +recognize 100% of the fair values of acquired assets, with limited exceptions, even if the acquirer +has not acquired 100% of its target. Additionally contingent consideration arrangements and +preacquisition contingencies will be measured at fair value on the acquisition date and included in +the basis of the purchase price. Transaction costs are expensed as incurred and not considered as +part of the fair value of the acquisition; however, acquired research and development are no longer +expensed at acquisition, but instead are capitalized as an indefinite-lived intangible asset. We +adopted this accounting standard on January 1, 2009, and was applied to our ExL acquisition during +2009. See Note 13 for the impact of the acquisition on our Consolidated Financial Statements. +Subsequent Events. In May 2009, the FASB issued guidance for subsequent events. The objective of +this guidance is to establish general standards of accounting for and disclosures of events that +occur after the balance sheet date but before financial statements are issued or are available to +be issued. We adopted the guidance as of the quarter ended June 30, 2009 with limited impact to +its financial statements. See Note 20 to our consolidated financial statements. +Recent Accounting Standards +See Note 2 to our Consolidated Financial Statements. +Liquidity and Capital Resources +Historically, our primary sources of capital have been cash flows from operations, borrowings from +financial institutions and the sale of debt and equity securities. Net cash and cash equivalents +decreased by $13.5 million during 2009 to $3.6 million. Cash provided from operating activities +during 2009 totaled $26.4 million, a decrease of 72% from $93.2 million in 2008. The decrease in +liquidity is attributable to the reduction of accounts payable related to the Entrada project and +lower commodity prices. +38 +Table of Contents +During 2009, we recorded a receivable attributable to a recoupment of royalty overpayments we +previously made on our deep water properties. Following the decisions in several court cases, it +was determined that the MMS was not entitled to receive these royalty payments, and accordingly +refunded the payments previously made. We received the principal payment of $44.8 million in +January 2010, and expect to receive a payment of approximately $7.7 million representing interest +on the amounts previously withheld during 2010. See Note 12 to our Consolidated Financial +Statements. +On September 25, 2008, we closed on a four-year second amended and restated senior secured +revolving credit facility with Union Bank N.A. as administrative agent and issuing lender. The +borrowing base was $16.2 million at December 31, 2009. There was $10 million outstanding under the +credit facility at December 31, 2009. +Subsequent to December 31, 2009, our senior secured credit agreement was amended to include Regions +Bank as the sole arranger and administrative agent. The third amended and restated senior secured +credit agreement, which matures on September 25, 2012, provides for a $100 million facility with an +initial borrowing base of $20 million, which will be reviewed and re-determined on a semi-annual +basis. The third amended and restated credit facility bears interest at 4% above a defined base +rate and in no event will the interest rate be less than 6%. In addition, a commitment fee of 0.5% +per annum on the unused portion of the borrowing base, is payable quarterly. Subsequent to +December 31, 2009, simultaneously with the execution of the third amended and restated senior +secured credit agreement, the Company repaid the $10 million outstanding on the borrowing base +under the second amended and restated senior secured credit agreement. See Notes 7 and 20 to our +Consolidated Financial Statements. +During the fourth quarter of 2009, we completed an exchange offer for our outstanding 9.75% Senior +Notes due December 2010 (“Senior Notes”). For each $1,000 principal amount of outstanding Senior +Notes tendered in accordance with the terms and conditions of the exchange offer, each tendering +holder of the Senior Notes received $750 principal amount of 13% Senior Secured Notes due 2016 +(“Exchange Notes), 20.625 shares of common stock and 1.6875 shares of Convertible Preferred Stock. +Holders of approximately 92% of the Senior Notes tendered their notes in the exchange offer. On +December 31, 2009, each share of the Convertible Preferred Stock was automatically converted by us +into 10 shares of common stock following shareholder approval of the conversion and the filing of +an amendment to our charter increasing the number of authorized shares of common stock as necessary +to accommodate such conversion. We issued 6.9 million shares of common stock related to the +conversion of the Convertible Preferred Stock. In connection with the exchange offer, holders who +tendered Senior Notes consented to amend the indenture governing the Senior Notes, eliminating +substantially all of the indenture’s restrictive covenants. The outstanding principal amount of the +remaining Senior Notes is $16.1 million and the face value of the Exchange Notes is $137.9 million +as of December 31, 2009. In addition, we have reserved $16.1 million from proceeds received from +the MMS recoupment to retire the remaining Senior Notes during 2010. +The Company determined that the note exchange should be accounting for in accordance with guidance +provided by the FASB for accounting for a troubled debt restructuring. Immediately before the +issuance of the Exchange Notes, the total future cash payments on the restructured Senior Notes was +less than the remaining carrying amount of the Senior Notes after the carrying amount was reduced +by the fair value of the equity interests issued of $11.5 million. Therefore, as of November 23, +2009, in accordance with the troubled debt restructuring accounting standard, the Company reduced +the carrying amount of the Senior Notes by the fair value of the common and preferred stock issued. +The difference between the adjusted carrying amount of the Senior Notes and the face value of the +Exchange Notes was recorded as a deferred credit of $31.2 million which will be amortized as a +credit to interest expense at an 8.5% effective interest rate over the life of the Exchange Notes. +In addition, the Company incurred $1.0 million of costs associated with the note exchange and +expensed the amount in the fourth quarter of 2009 in accordance with the trouble debt restructuring +accounting standard. See Note 7 to our Consolidated Financial Statements. +39 +Table of Contents +The indentures governing our Exchange Notes and our senior secured credit facility contain various +covenants including restrictions on additional indebtedness and payment of cash dividends. In +addition, our senior secured credit facility contains covenants for maintenance of certain +financial ratios. We were in compliance with these covenants at December 31, 2009. +In April 2008, our wholly owned subsidiary, Callon Entrada, entered into a credit agreement with +CIECO Energy (Entrada) LLC (“CIECO Entrada”) pursuant to which Callon Entrada could borrow up to +$150 million, plus interest expense incurred of up to $12 million, to finance the development of +the Entrada project. The Callon Entrada credit agreement is a direct obligation of Callon Entrada. +The Callon Entrada credit agreement is secured by a lien on the assets of Callon Entrada, which +subsequent to the lease expiration of the Entrada Field, is comprised solely from the remaining +related equipment previously purchased during the development phase. Neither Callon Petroleum nor +any other subsidiary of Callon Petroleum guaranteed or otherwise agreed to pay the principal or +interest payments due on the Callon Entrada credit agreement, so such facility is effectively +non-recourse to Callon Petroleum and its other subsidiaries. +During 2008, Callon Entrada borrowed $78.4 million under the facility and as of December 31, 2009. +CIECO Entrada had failed to fund $40 million of loan requests which were due in October and +November of 2008. We are in discussions with CIECO and CIECO Entrada with regard to these loan +requests. No assurances can be made regarding the outcome of these discussions. We do not believe +that we have waived any of our rights under our agreements with CIECO or CIECO Entrada. +On April 2, 2009, Callon Entrada received a notice from CIECO Entrada advising Callon Entrada that +certain alleged events of default occurred under the credit agreement relating to failure to pay +interest when due and the breach of various other covenants related to the decision to abandon the +Entrada project. The notice of default received from CIECO Entrada invoked CIECO Entrada’s rights +under the Callon Entrada credit agreement to accelerate payment of the principal and interest due. +The acceleration of payment causes the principal and interest balances under the Callon Entrada +credit agreement to be reclassified as current liabilities from long-term liabilities under US +GAAP. The agreement has not been legally extinguished and as such under US GAAP, the agreement +remains a liability of Callon Entrada. We are currently required to continue to consolidate the +financial statements and results of operations of Callon Entrada which results in Callon Entrada’s +liability being reflected in a separate line item in the consolidated financial statements. Based +on the advice of counsel, we believe that the Callon Entrada credit agreement does not obligate +Callon or any of its subsidiaries (other than Callon Entrada) to pay principal, accrued interest or +other amounts which may be owed under such credit agreement. See Notes 2 and 3 to our Consolidated +Financial Statements. +Operating Activities. During the year ended December 31, 2009, net cash provided by operating +activities was $26.4 million, a 72% decrease from $93.2 million for the same period in +2008. The decrease in net cash provided by operating activities was largely attributable to the +reduction of accounts payable related to the Entrada project and lower commodity prices during the +year ended December 31, 2009 as compared to the same period in 2008. +Investing Activities. During the year ended December 31, 2009, net cash used in investing +activities was $49.8 million as compared to $8.7 million for the same period in 2008. The increase +in net cash used in investing activities is the timing of payments associated with capital costs +incurred during 2008 for the Entrada project and paid during 2009. +40 +Table of Contents +Financing Activities. During the year ended December 31, 2009, net cash provided by financing +activities was $10.0 million as compared to net cash used in financing activities of $120.7 million +for the same period in 2008. The increase in cash provided by net financing activities is primarily +attributable to the debt retirement of the $200 million senior secured revolving credit agreement +during 2008 that was used to purchase BP Exploration and Production Company’s interest in the +Entrada Fields. See Note 3 to our Consolidated Financial Statements. +Our current planned capital expenditures for 2010 total $58 million and include capitalized +interest and general and administrative expenses. The current portion of our asset retirement +obligation will require an additional $4 million resulting in capital expenditures of $62 million +for 2010. The current capital expenditure plans for 2010 include: +• +drilling and completing up to 16 wells in the Permian Basin; +• +drilling two wells in the Haynesville Shale play; +• +lease and seismic acquisition; and +• +capitalized interest and overhead. +We believe that our cash on hand and operating cash flow along with our credit facility, if needed, +will be adequate to meet our capital, debt repayment, and operating requirements for 2010. We fund +our day-to-day operating expenses and capital expenditures from operating cash flow, supplemented +as needed by borrowings under our credit facilities. +The following table describes our outstanding contractual obligations as of December 31, 2009 (in +thousands): +Payments due by Period +More +Contractual +Less Than +One-Three +Three-Five +Than-Five +Obligations +Total +One Year +Years +Years +Years +Senior Secured Credit Facility +$ +10,000 +$ +— +$ +10,000 +$ +— +$ +— +13% Senior Notes +137,961 +— +— +— +137,961 +9.75% Senior Notes +16,052 +16,052 +— +— +— +Throughput Commitments: +Medusa Oil Pipeline +163 +61 +62 +27 +13 +$ +164,176 +$ +16,113 +$ +10,062 +$ +27 +$ +137,974 +The Callon Entrada non-recourse credit agreement is not included in the contractual obligations +table because it is a direct obligation of Callon Entrada, an indirect, wholly owned subsidiary of +Callon. Neither Callon nor any other subsidiary of Callon guaranteed or otherwise agreed to pay +the principal and interest payments due on the Callon Entrada non-recourse credit agreement, so +this agreement is effectively non-recourse to Callon and its other subsidiaries. See Notes 2 and 3 +to our Consolidated Financial Statements. +41 +Table of Contents +Off-Balance Sheet Arrangements +We have a 10% ownership interest in Medusa Spar LLC (“LLC”), which is a limited liability company +that owns a 75% undivided ownership interest in the deepwater spar production facilities at our +Medusa Field in the Gulf of Mexico. In December 2003, we contributed a 15% undivided ownership +interest in the production facility to the LLC in return for approximately $25 million in cash and +a 10% ownership interest in the LLC. The LLC earns a tariff based upon production volume throughput +from the Medusa area. We are obligated to process our share of production from the Medusa Field and +any future discoveries in the area through the spar production facilities. This arrangement allowed +us to defer the cost of the spar production facility over the life of the Medusa Field. Our cash +proceeds were used to reduce the balance outstanding under our senior secured credit facility. The +LLC used the cash proceeds from $83.7 million of non-recourse financing and a cash contribution by +one of the LLC owners to acquire its 75% interest in the spar. In the second quarter at 2008, the +non-recourse financing was extinguished. The balance of Medusa Spar LLC is owned by Oceaneering +International, Inc. and Murphy. We are accounting for our 10% ownership interest in the LLC under +the equity method. +42 +Table of Contents +Results of Operations +The following table sets forth certain operating information with respect to our oil and gas +operations for each of the three years in the period ended December 31, 2009. +December 31, +2009 +2008 +2007 +Production: +Oil (MBbls) +1,012 +942 +1,063 +Gas (MMcf) +5,740 +5,839 +12,340 +Total production (MMcfe) +11,809 +11,494 +18,718 +Average daily production (MMcfe) +32.4 +31.4 +51.3 +Average sales price: +Oil (per Bbl) (a) +$ +73.00 +$ +88.07 +$ +67.63 +Gas (per Mcf) +$ +4.78 +$ +9.99 +$ +8.01 +Total (per Mcfe) +$ +8.57 +$ +12.29 +$ +9.12 +Oil and gas revenues (in thousands): +Oil revenue +$ +73,842 +$ +82,963 +$ +71,891 +Gas revenue +27,417 +58,349 +98,877 +Total +$ +101,259 +$ +141,312 +$ +170,768 +Lease operating expenses (in thousands) +$ +18,447 +$ +19,208 +$ +27,795 +Additional per Mcfe data: +Sales price +$ +8.57 +$ +12.29 +$ +9.12 +Lease operating expenses +1.56 +1.67 +1.48 +Operating margin +$ +7.01 +$ +10.62 +$ +7.64 +Depletion +$ +2.83 +$ +5.57 +$ +3.89 +General and administrative (net of management fees) +$ +1.13 +$ +.83 +$ +.53 +(a) +Below is a reconciliation of the average NYMEX price to the average realized sales price per barrel of oil: +Average NYMEX oil price +$ +61.80 +$ +99.67 +$ +72.33 +Basis differential and quality adjustments +(4.64 +) +(1.15 +) +(4.08 +) +Transportation +(1.32 +) +(1.15 +) +(1.15 +) +Hedging +17.16 +(9.30 +) +0.53 +Average realized oil price +$ +73.00 +$ +88.07 +$ +67.63 +43 +Table of Contents +Comparison of Results of Operations for the Years Ended December 31, 2009 and 2008 +Oil and Gas Revenues +Total oil and gas revenues decreased 28% from $141.3 million in 2008 to $101.3 million in 2009 due +to lower oil and gas pricing. Total production on an equivalent basis for 2009 increased 3% from +2008 production. +Gas production during 2009 totaled 5.7 Bcf and generated $27.4 million in revenues compared to 5.8 +Bcf and $58.3 million in revenues during the same period in 2008. Average gas prices realized for +2009 were $4.78 per Mcf compared to $9.99 per Mcf during the same period in 2008. The 2% decrease +in 2009 production was primarily normal and expected declines from our legacy properties. +Oil production during 2009 totaled 1,012,000 barrels and generated $73.8 million in revenues +compared to 942,000 barrels and $83.0 million in revenues for the same period in 2008. Average oil +prices realized in 2009 were $73.00 per barrel compared to $88.07 per barrel in 2008. See the +Results of Operations table for a reconciliation of the realized oil prices to average NYMEX. The +7% increase in 2009 production was primarily due to the 2009 volumes associated with the MMS +royalty recoupment for the Medusa Field. See Note 12 to our Consolidated Financial Statements. +Lease Operating Expenses +Lease operating expenses for 2009 decreased by 4% to $18.4 million compared to $19.2 million for +the same period in 2008. The decrease was primarily due to a lower number of producing wells in +the Gulf of Mexico Shelf area. Four of our gas wells were shut-in during 2008 due to early water +production and are plugged and abandoned or scheduled for plugging and abandonment. In addition, +our High Island Block A-540 well was shut-in during the second quarter of 2008, due to a plugged +flowline, which management determined uneconomic to repair. This well was plugged in the second +half of 2009. +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization for 2009 and 2008 totaled $33.4 million and $64.1 million, +respectively. The 48% decrease was due to a lower depletion rate resulting from the full-cost +ceiling writedown, which was recorded in the fourth quarter of 2008 and the downward revision of +plugging and abandonment cost for the Entrada field during 2009. +Impairment of Oil and Gas Properties +During the fourth quarter of 2008, capitalized costs of oil and gas properties, net of accumulated +amortization and deferred taxes relating to oil and gas properties, exceeded the sum of (1) the +estimated future net revenues from proved reserves at current prices discounted at 10% and (2) the +lower of cost or market of unevaluated properties, net of tax effects. As a result, $485.5 million +of excess costs was expensed as an impairment of oil and gas properties for the year ended December +31, 2008. See Note 15 to the Consolidated Financial Statements. +Accretion Expense +Accretion expense for 2009 and 2008 of $3.1 million and $4.2 million, respectively, represents +accretion of our asset retirement obligations. See Note 11 to the Consolidated Financial +Statements. +44 +Table of Contents +General and Administrative +General and administrative expenses for 2009, net of amounts capitalized, were $13.4 million +compared to $9.6 million in 2008. The 43% increase was primarily due to the $2.2 million of +nonrecurring expenses for staffing reductions and retirements and the result of overhead fees of +approximately $2.6 million received during the second half of 2008 as operator of the Entrada +Field, which was recorded as a reduction to general and administrative expenses in 2008. +Acquisition Expense +As a result of the ExL acquisition, we incurred $298,000 of costs in the fourth quarter of 2009 for +consultant and legal expenses. See Note 13 to our Consolidated Financial Statements. +Interest Expense +Interest expense related to debt obligations decreased to $19.1 million in 2009 compared to $24.0 +million in 2008. This 20% decrease was due to the retirement in April 2008 of the $200 million +senior revolving credit facility associated with the Entrada acquisition. See Note 7 to the +Consolidated Financial Statement for more details. +Callon Entrada Non-Recourse Credit Agreement Interest Expense +We incurred interest expense under the Callon Entrada credit agreement for the twelve-month periods +ended December 31, 2009 and 2008 of $7.1 million and $2.7 million, respectively. The increase was +due to a larger outstanding loan balance for the twelve-month period ended December 31, 2009 and an +increase in the interest rate due to the notice of default received from CIECO on April 2, 2009. +Principal and related interest was payable from the assets of Callon Entrada, primarily production +from the Entrada Field with no recourse to the assets of Callon. Accordingly, due to the +abandonment of the Entrada project, no cash payments for principal or interest have been made by +Callon Entrada except with proceeds from our 50% share of the sale of surplus equipment. See Note 3 +to the Consolidated Financial Statements for details. +Loss on Early Extinguishment of Debt +Due to the early extinguishment of the $200 million senior revolving credit facility on April 8, +2008, we incurred expenses of $11.9 million consisting of $6.3 million in cash pre-payment +penalties plus a non-cash charge of $5.6 million related to the amortization expense associated +with the deferred financing costs related to the senior revolving credit facility. See Note 7 to +the Consolidated Financial Statements for more details. +Debt Restructuring Expense +As a result of the 9.75% Senior Note exchange for the 13% Senior Notes we incurred $1.0 million of +financing cost in the fourth quarter of 2009 for consultant and legal expenses. See Note 7 to the +Consolidated Financial Statements for more details. +45 +Table of Contents +Income Taxes +For 2009, income tax expense was zero compared to an income tax benefit of $39.7 million in 2008. +The income tax benefit in 2008 was primarily the result of expensing the impairment of oil and gas +properties in the amount of $485.5 million. We established a valuation allowance of $128.1 million +as of December 31, 2008. We revised the valuation allowance for the twelve-month period ended +December 31, 2009 as a result of current year ordinary income, the impact of which is included in +our effective tax rate. See Note 6 to the Consolidated Financial Statements. +Comparison of Results of Operations for the Years Ended December 31, 2008 and 2007 +Oil and Gas Revenues +Total oil and gas revenues decreased 17% from $170.8 million in 2007 to $143.1 million in 2008 +primarily due to lower gas production. Total production on an equivalent basis for 2008 decreased +by 39% versus 2007. +Gas production during 2008 totaled 5.8 Bcf and generated $58.3 million in revenues compared to 12.3 +Bcf and $98.9 million in revenues during the same period in 2007. Average gas prices realized for +2008 were $9.99 per Mcf compared to $8.01 per Mcf during the same period in 2007. The 53% decrease +in 2008 production was primarily due to the sale of our Mobile Bay Field on Blocks 952, 953, and +955, effective May 1, 2007, a lower number of producing wells, downtime resulting from Hurricanes +Gustav and Ike and normal and expected declines in production from our older properties. Three of +our gas wells were shut-in due to early water production, two of which are now scheduled for +plugging and abandonment, and the third was sold for the plugging and abandonment liability. In +addition, our High Island Block A-540 well was shut in during the second quarter of 2008, due to a +plugged flowline, and management has determined it to be uneconomic to repair. +Oil production during 2008 totaled 942,000 barrels and generated $83.0 million in revenues compared +to 1,063,000 barrels and $71.9 million in revenues for the same period in 2007. Average oil prices +realized in 2008 were $88.07 per barrel compared to $67.63 per barrel in 2007. The 11% decrease in +2008 production was primarily due to downtime resulting from Hurricanes Gustav and Ike and normal +and expected declines in producing wells. In addition, our High Island Block A-540 well was shut +in during the second quarter of 2008, due to a plugged flowline, and management has determined it +to be uneconomic to repair. See the Results of Operations table for a reconciliation of the +realized oil prices to average NYMEX. +Lease Operating Expenses +Lease operating expenses for 2008 decreased by 31% to $19.2 million compared to $27.8 million for +the same period in 2007. The decrease was primarily due to the sale of the Mobile Bay Field on +Blocks 952, 953 and 955 effective May 1, 2007, a lower number of producing wells and downtime in +the third and fourth quarters of 2008 caused by Hurricanes Gustav and Ike resulting in lower +throughput charges. Three of our gas wells were shut-in due to early water production, two of +which are now scheduled for plugging and abandonment, and the third was sold for the plugging and +abandonment liability. In addition, our High Island Block A-540 well was shut in during the second +quarter of 2008, due to a plugged flowline, and management has determined it to be uneconomic to +repair. +46 +Table of Contents +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization for 2008 and 2007 totaled $64.1 million and $72.8 million, +respectively. The 12% decrease was due to lower production volumes which were partially offset by +a higher depletion rate. The 43% increase in the depletion rate from 2007 to 2008 was higher +Entrada development costs in addition to the abandonment of operations. +Impairment of Oil and Gas Properties +During the fourth quarter of 2008, capitalized costs of oil and gas properties, net of accumulated +amortization and deferred taxes relating to oil and gas properties exceeded the sum of (1) the +estimated future net revenues from proved reserves at current prices discounted at 10% and (2) the +lower of cost or market of unevaluated properties, net of tax effects. As a result, $485.5 million +of excess costs was expensed as an impairment of oil and gas properties for the year ended December +31, 2008. See Note 15 to the Consolidated Financial Statements. +Accretion Expense +Accretion expense for 2008 and 2007 of $4.2 million and $4.0 million, respectively, represents +accretion of our asset retirement obligations. See Note 11 to the Consolidated Financial +Statements. +General and Administrative +General and administrative expenses for 2008, net of amounts capitalized, were $9.6 million +compared to $9.9 million in 2007, or a 3% decrease. +Interest Expense +Interest expense decreased to $26.7 million in 2008 compared to $34.3 million in 2007. This +decrease was due to the retirement of the $200 million senior revolving credit facility associated +with the Entrada acquisition. See Note 7 to the Consolidated Financial Statement for more details. +Loss on Early Extinguishment of Debt +Due to the early extinguishment of the $200 million senior revolving credit facility on April 8, +2008, we incurred expenses of $11.9 million consisting of $6.3 million in cash pre-payment +penalties plus a non-cash charge of $5.6 million related to the amortization expense associated +with the deferred financing costs related to the senior revolving credit facility. See Note 7 to +the Consolidated Financial Statements for more details. +Income Taxes +For 2008, we recorded an income tax benefit of $39.7 million compared to an income tax expense of +$8.5 million in 2007. The income tax benefit in 2008 was primarily the result of expensing the +impairment of oil and gas properties in the amount of $485.5 million. We evaluated our deferred +income tax asset in light of our reserve quantity estimates, our long-term outlook for oil and gas +prices and our expected level of future revenues and expenses and based upon this evaluation, we +believe it is more likely than not, that we will not realize the recorded deferred income tax +asset. As a result, we have established a valuation allowance in the amount of $128.1 million, as +of December 31, 2008, the amount of the deferred income tax asset. See Note 6 to the Consolidated +Financial Statements. +47 +Table of Contents +ITEM +7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS +Commodity Price Risk +Our revenues are derived from the sale of our crude oil and natural gas production. Prices for oil +and gas remain extremely volatile, sometimes experiencing large fluctuations as a result of +relatively small changes in supply, weather conditions, economic conditions and government actions. +From time to time, we enter into derivative financial instruments to manage oil and gas price +risk. +We may utilize fixed price “swaps,” which reduce our exposure to decreases in commodity prices and +limit the benefit we might otherwise have received from any increases in commodity prices. +We may utilize price “collars” to reduce the risk of changes in oil and gas prices. Under these +arrangements, no payments are due by either party as long as the market price is above the floor +price and below the ceiling price set in the collar. If the price falls below the floor, the +counter-party to the collar pays the difference to us, and if the price rises above the ceiling, +the counter-party receives the difference from us. +We may purchase “puts” which reduce our exposure to decreases in oil and gas prices while allowing +realization of the full benefit from any increases in oil and gas prices. If the price falls below +the floor, the counter-party pays the difference to us. +We enter into these various agreements from time to time to reduce the effects of volatile oil and +gas prices and do not enter into derivative transactions for speculative purposes. However, +certain of our derivative positions may not be designated as hedges for accounting purposes. See +Note 8 to the Consolidated Financial Statements for a description of our hedged position at +December 31, 2009. +Based on projected annual sales volumes for 2010 (excluding production from 2010 exploratory +drilling), a 10% decline in the prices we receive for its crude oil and natural gas production +would result in an approximate $9.6 million reduction of our revenues. +48 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +Report of Independent Registered Public Accounting Firm +50 +Consolidated Balance Sheets as of December 31, 2009 and 2008 +51 +Consolidated Statements of Operations for Each of the Three Years +in the Period Ended December 31, 2009 +52 +Consolidated Statements of Stockholders’ Equity (Deficit) +for Each of the Three Years in the Period Ended December 31, 2009 +53 +Consolidated Statements of Cash Flows for Each of the Three Years +in the Period Ended December 31, 2009 +54 +Notes to Consolidated Financial Statements +55 +49 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited the accompanying consolidated balance sheets of Callon Petroleum Company as of +December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders’ +equity (deficit) and cash flows for each of the three years in the period ended December 31, 2009. +These financial statements are the responsibility of the Company’s management. Our responsibility +is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting +Oversight Board (United States). Those standards require that we plan and perform the audit to +obtain reasonable assurance about whether the financial statements are free of material +misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and +disclosures in the financial statements. An audit also includes assessing the accounting +principles used and significant estimates made by management, as well as evaluating the overall +financial statement presentation. We believe that our audits provide a reasonable basis for our +opinion. +In our opinion, the financial statements referred to above present fairly, in all material +respects, the consolidated financial position of Callon Petroleum Company as of December 31, 2009 +and 2008, and the consolidated results of its operations and its cash flows for each of the three +years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting +principles. +As discussed in Note 2 to the financial statements, in 2008 the Company changed its method of +accounting for income taxes. In 2009, the Company changed its reserve estimates and related +disclosures as a result of adopting new oil and gas reserve estimation and disclosure requirements. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight +Board (United States), Callon Petroleum Company’s internal control over financial reporting as of +December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued +by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March +12, 2010, expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 12, 2010 +50 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(In thousands, except share data) +December 31, +2009 +2008 +ASSETS +Current assets: +Cash and cash equivalents +$ +3,635 +$ +17,126 +Accounts receivable +20,798 +44,290 +Accounts receivable-MMS royalty recoupment +51,534 +— +Fair market value of derivatives +145 +21,780 +Other current assets +1,572 +1,103 +Total current assets +77,684 +84,299 +Oil and gas properties, full-cost accounting method: +Evaluated properties +1,593,884 +1,581,698 +Less accumulated depreciation, depletion and amortization +(1,488,718 +) +(1,455,275 +) +105,166 +126,423 +Unevaluated properties excluded from amortization +25,442 +32,829 +Total oil and gas properties +130,608 +159,252 +Other property and equipment, net +2,508 +2,536 +Restricted investments +4,065 +4,759 +Investment in Medusa Spar LLC +11,537 +12,577 +Other assets, net +1,589 +2,667 +Total assets +$ +227,991 +$ +266,090 +LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) +Current liabilities: +Accounts payable and accrued liabilities +$ +12,887 +$ +76,516 +Asset retirement obligations +4,002 +9,151 +9.75% Senior Notes +15,820 +— +32,709 +85,667 +Callon Entrada (non-recourse) credit facility (See Note 3) +84,847 +— +Total current liabilities +117,556 +85,667 +Senior Notes (See Note 7) +Principal outstanding +137,961 +200,000 +Deferred credit +31,213 +— +Discount +— +(5,580 +) +Total Senior Notes +169,174 +194,420 +Senior secured revolving credit facility +10,000 +Callon Entrada (non-recourse) credit facility (See Note 3) +— +81,154 +Total long-term debt +179,174 +275,574 +Asset retirement obligations +10,648 +33,043 +Other long-term liabilities +1,467 +1,610 +Total liabilities +308,845 +395,894 +Stockholders’ equity (deficit): +Preferred Stock, $.01 par value; 2,500,000 shares authorized; +— +— +Common Stock, $.01 par value; 60,000,000 shares +authorized; 28,742,926 shares and 21,621,142 shares issued +outstanding at December 31, 2009 and 2008, respectively +287 +216 +Capital in excess of par value +243,898 +227,803 +Other comprehensive income (loss) +(7,478 +) +14,157 +Retained (deficit) earnings +(317,561 +) +(371,980 +) +Total stockholders’ equity (deficit) (See Note 2) +(80,854 +) +(129,804 +) +Total liabilities and stockholders’ equity (deficit) +$ +227,991 +$ +266,090 +The accompanying notes are an integral part of these financial statements. +51 +Table of Contents +Callon Petroleum Company +Consolidated Statements of Operations +(In thousands, except per share amounts) +Year Ended December 31, +2009 +2008 +2007 +Operating revenues: +Oil sales +$ +73,842 +$ +82,963 +$ +71,891 +Gas sales +27,417 +58,349 +98,877 +MMS royalty recoupment (See Note 12) +40,886 +— +— +Total operating revenues +142,145 +141,312 +170,768 +Operating expenses: +Lease operating expenses +18,447 +19,208 +27,795 +Depreciation, depletion and amortization +33,443 +64,054 +72,762 +General and administrative +13,355 +9,565 +9,876 +Accretion expense +3,149 +4,172 +3,985 +Acquisition expenses (See Note 13) +298 +— +— +Derivative expense +— +498 +— +Impairment of oil and gas properties +— +485,498 +— +Total operating expenses +68,692 +582,995 +114,418 +Income (loss) from operations +73,453 +(441,683 +) +56,350 +Other (income) expenses: +Interest expense +19,089 +23,986 +34,329 +Callon Entrada (non-recourse) credit facility interest +expense (See Note 3) +7,072 +2,719 +— +Loss on early extinguishment of debt +— +11,871 +— +9.75% Senior Notes restructuring expenses (See Note 7) +1,024 +— +— +Interest on MMS royalty recoupment +(7,681 +) +— +— +Other (income) expense +190 +(1,379 +) +(1,172 +) +Total other (income) expenses +19,694 +37,197 +33,157 +Income (loss) before income taxes +53,759 +(478,880 +) +23,193 +Income tax (benefit) expense +— +(39,725 +) +8,506 +Income (loss) before equity in earnings of Medusa Spar LLC +53,759 +(439,155 +) +14,687 +Equity in earnings of Medusa Spar LLC +660 +262 +507 +Net income (loss) available to common shares +$ +54,419 +$ +(438,893 +) +$ +15,194 +Net income (loss) per common share: +Basic +$ +2.47 +$ +(20.68 +) +$ +0.73 +Diluted +$ +2.45 +$ +(20.68 +) +$ +0.71 +Shares used in computing net income (loss) per share +amounts: +Basic +22,072 +21,222 +20,776 +Diluted +22,200 +21,222 +21,290 +The accompanying notes are an integral part of these financial statements. +52 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT) +(In thousands) +Accumulated +Total +Capital in +Other +Retained +Stock- +Preferred +Common +Excess of +Comprehensive +Earnings +holders’ +Stock +Stock +Par Value +Income (Loss) +(Deficit) +Equity (Deficit) +Balances, December 31, 2006 +$ +— +$ +207 +$ +220,785 +$ +8,652 +$ +51,759 +$ +281,363 +Comprehensive income: +Net income +— +— +— +— +15,194 +Other comprehensive loss +— +— +— +(12,035 +) +— +Total comprehensive income +3,159 +Tax benefits related to stock +compensation plans +— +— +163 +— +— +163 +Restricted stock +— +2 +2,388 +— +— +2,390 +Balances, December 31, 2007 +— +209 +223,336 +(3,383 +) +66,913 +287,075 +Comprehensive income (loss): +Net loss +— +— +— +— +(438,893 +) +Other comprehensive income +— +— +— +17,540 +— +Total comprehensive loss +(421,353 +) +Shares issued pursuant to employee +benefit and option plan +— +1 +(1,153 +) +— +— +(1,152 +) +Tax benefits related to stock +compensation plans +— +— +2,050 +— +— +2,050 +Restricted stock +— +1 +3,575 +— +— +3,576 +Warrants +— +5 +(5 +) +— +— +— +Balances, December 31, 2008 +— +216 +227,803 +14,157 +(371,980 +) +(129,804 +) +Comprehensive income: +Net income +— +— +— +— +54,419 +Other comprehensive loss +— +— +— +(21,635 +) +— +Total comprehensive income +32,784 +Shares issued pursuant to employee +benefit and option plan +— +1 +205 +— +— +206 +Restricted stock +— +1 +4,432 +— +— +4,433 +Common stock issued-note exchange +— +69 +11,458 +— +— +11,527 +Balances, December 31, 2009 +$ +— +$ +287 +$ +243,898 +$ +(7,478 +) +$ +(317,561 +) +$ +(80,854 +) +The accompanying notes are an integral part of these financial statements. +53 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In thousands) +Years Ended December 31, +2009 +2008 +2007 +Cash flows from operating activities: +Net income (loss) +$ +54,419 +$ +(438,893 +) +$ +15,194 +Adjustments to reconcile net income (loss) to +cash provided by operating activities: +Depreciation, depletion and amortization +34,274 +64,862 +73,677 +Impairment of oil and gas properties +— +485,498 +— +Accretion expense +3,149 +4,172 +3,985 +Amortization of deferred financing costs +2,522 +4,185 +3,009 +Non-cash interest expense for Callon Entrada credit agreement +3,693 +— +— +Non-cash loss on early extinguishment of debt +— +5,598 +— +Equity in earnings of Medusa Spar, LLC +(660 +) +(262 +) +(507 +) +Deferred income tax (benefit) expense +18,816 +(167,848 +) +8,506 +Valuation allowance +(18,816 +) +128,123 +— +Non-cash charge related to compensation plans +2,335 +1,550 +849 +Excess tax benefits from share-based payment arrangements +— +(2,050 +) +(163 +) +Changes in current assets and liabilities: +Accounts receivable +(45,573 +) +(22,215 +) +6,658 +Other current assets +(468 +) +5,489 +(619 +) +Current liabilities +(27,260 +) +22,987 +(2,057 +) +Change in gas balancing receivable +279 +630 +(938 +) +Change in gas balancing payable +(312 +) +156 +889 +Change in other long-term liabilities +(12 +) +2,708 +(10 +) +Change in other assets, net +(31 +) +(1,458 +) +810 +Cash provided by operating activities +26,355 +93,232 +109,283 +Cash flows from investing activities: +Capital expenditures +(35,790 +) +(176,536 +) +(127,409 +) +ExL acquisition +(15,756 +) +— +— +Entrada acquisition +— +— +(150,000 +) +Proceeds from sale of mineral interests +— +167,349 +60,931 +Distribution from Medusa Spar, LLC +1,700 +498 +687 +Cash used by investing activities +(49,846 +) +(8,689 +) +(215,791 +) +Cash flows from financing activities: +Increases in debt +20,337 +94,435 +229,000 +Payments on debt +(10,337 +) +(216,000 +) +(64,000 +) +Deferred financing costs +— +— +(6,429 +) +Equity issued related to employee stock plans +— +(1,152 +) +— +Excess tax benefits from share-based payment arrangements +— +2,050 +163 +Capital leases +— +— +(872 +) +Cash provided by (used in) financing activities +10,000 +(120,667 +) +157,862 +Net (decrease) increase in cash and cash equivalents +(13,491 +) +(36,124 +) +51,354 +Cash and cash equivalents: +Balance, beginning of period +17,126 +53,250 +1,896 +Balance, end of period +$ +3,635 +$ +17,126 +$ +53,250 +The accompanying notes are an integral part of these financial statements. +54 +Table of Contents +CALLON PETROLEUM COMPANY +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +General +Callon Petroleum Company (“the Company” or “Callon”) was organized under the laws of the state of +Delaware in March 1994 to serve as the surviving entity in the consolidation and combination of +several related entities (referred to herein collectively as the “Constituent Entities”). The +combination of the businesses and properties of the Constituent Entities with the Company was +completed on September 16, 1994 (“Consolidation”). +As a result of the Consolidation, all of the businesses and properties of the Constituent Entities +are owned (directly or indirectly) by the Company. Certain registration rights were granted to the +stockholders of certain of the Constituent Entities. See Note 14. +The Company and its predecessors have been engaged in the acquisition, development and exploration +of crude oil and natural gas since 1950. The Company’s properties are geographically concentrated +onshore in Louisiana and Texas and the offshore waters of the Gulf of Mexico. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Principles of Consolidation and Reporting +The Consolidated Financial Statements include the accounts of the Company, and its subsidiary, +Callon Petroleum Operating Company (“CPOC”). CPOC also has subsidiaries, namely Callon Offshore +Production, Inc., Callon Entrada Company (“Callon Entrada”) and Mississippi Marketing, Inc. All +intercompany accounts and transactions have been eliminated. Certain prior year amounts have been +reclassified to conform to presentation in the current year. +Use of Estimates +The preparation of financial statements in conformity with United States generally accepted +accounting principles (“US GAAP”) requires management to make estimates and assumptions that affect +the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities +at the date of the financial statements and the reported amounts of revenues and expenses during +the reporting period. Actual results could differ from those estimates. +Asset Retirement Obligations +The Company is required to record its estimate of the fair value of liabilities for obligations +associated with the retirement of tangible long-lived assets and the associated asset retirement +costs. Interest is accreted on the present value of the asset retirement obligation and reported +as accretion expense within operating expenses in the consolidated statements of operations. See +Note 11. +55 +Table of Contents +Oil and Gas Properties +The Company follows the full-cost method of accounting for oil and gas properties whereby all costs +incurred in connection with the acquisition, exploration and development of oil and gas reserves, +including certain overhead costs, are capitalized. Such amounts include the cost of drilling and +equipping productive wells, dry hole costs, lease acquisition costs, delay rentals, interest +capitalized on unevaluated leases, other costs related to exploration and development activities, +and site restoration, dismantlement and abandonment costs capitalized in accordance with asset +retirement obligation accounting guidance. Costs capitalized include salaries and related fringe +benefits paid to employees directly engaged in the acquisition, exploration and/or development of +oil and gas properties as well as other directly identifiable general and administrative costs +associated with such activities. Such capitalized costs ($10.1 million in 2009, $12.6 million in +2008 and $10.8 million in 2007) do not include any costs related to production or general corporate +overhead. Costs associated with unevaluated properties, including capitalized interest on such +costs, are excluded from amortization. Unevaluated property costs are transferred to evaluated +property costs at such time as wells are completed on the properties or management determines that +these costs have been impaired. +Costs of oil and gas properties, including future development costs, which have proved reserves and +properties which have been determined to be worthless, are depleted using the unit-of-production +method based on proved reserves. If the total capitalized costs of oil and gas properties net of +accumulated amortization and deferred taxes relating to oil and gas properties exceed the sum of +(1) the estimated future net revenues from proved reserves at current prices discounted at 10% and +(2) the lower of cost or market of unevaluated properties, net of tax effects (the full-cost +ceiling amount), then such excess is charged to expense during the period in which the excess +occurs. See Note 15. +Upon the acquisition or discovery of oil and gas properties, management estimates the future net +costs to be incurred to dismantle, abandon and restore the property using available geological, +engineering and regulatory data. Such cost estimates are periodically updated for changes in +conditions and requirements. In accordance with asset retirement obligation guidance issued by the +Financial Accounting Standards Board (“FASB”), such costs are capitalized to the full-cost pool +when the related liabilities are incurred. In accordance with Securities and Exchange Commission +(“SEC”) Staff Accounting Bulletin No. 106, assets recorded in connection with the recognition of an +asset retirement obligation are included as part of the costs subject to the full-cost ceiling +limitation. The future cash outflows associated with settling the recorded asset retirement +obligations are excluded from the computation of the present value of estimated future net revenues +used in determining the full-cost ceiling amount. +Sales of oil and gas properties are accounted for as adjustments to the net full cost pool with no +gain or loss recognized, unless the adjustment would significantly alter the relationship between +capitalized costs and proved reserves. +Amendments to Oil and Gas Reserves Estimation and Disclosure Requirements +In December 2008, the SEC approved amendments to its oil and gas reserves estimation and disclosure +requirements. The amendments, among other things: +• +allow the use of reliable technologies to estimate proved reserves if those technologies +have been demonstrated to result in reliable conclusions about reserve volumes; +• +require disclosure of oil and gas proved reserves by significant geographic area; +• +permit the optional disclosure of probable and possible reserves; +• +modify the prices used to estimate reserves for SEC disclosure purposes to a 12-month +average beginning-of-the-month price instead of a period-end price; and +56 +Table of Contents +• +require that if a third party is primarily responsible for preparing or auditing the +reserve estimates, the company make disclosures relating to the independence and +qualifications of the third party, including filing as an exhibit any report received from +the third party. +Additionally, during January 2010, the FASB issued accounting guidance to align the reserve +calculation and disclosure requirements of US GAAP with the new SEC oil and gas reserve estimation +and disclosure rules. +The new requirements are effective for the Company’s year-end financial statements and its Annual +Report on Form 10-K for the year ended December 31, 2009. +Property and Equipment +Depreciation of other property and equipment is provided using the straight-line method over +estimated lives of three to 20 years. Depreciation expense of $423,000, $437,000 and $457,000 +relating to other property and equipment was included in general and administrative expenses in the +Company’s consolidated statements of operations for the years ended December 31, 2009, 2008 and +2007, respectively. The accumulated depreciation on other property and equipment was $11.8 million +and $11.6 million as of December 31, 2009 and 2008, respectively. +Investment in Medusa Spar LLC +The Company has a 10% ownership interest in Medusa Spar, LLC (“LLC”), which is a limited liability +company that owns a 75% undivided ownership interest in the deepwater spar production facilities on +Callon’s Medusa Field in the Gulf of Mexico. In December 2003, the Company contributed a 15% +undivided ownership interest in the production facility to the LLC in return for approximately $25 +million in cash and a 10% ownership interest in the LLC. The LLC earns a tariff based upon +production volume throughput from the Medusa area. Callon is obligated to process its share of +production from the Medusa Field and any future discoveries in the area through the spar production +facilities. This arrangement allowed Callon to defer the cost of the spar production facility over +the life of the Medusa Field. The Company’s cash proceeds were used to reduce the balance +outstanding under its senior secured credit facility. The LLC used the cash proceeds from $83.7 +million of non-recourse financing and a cash contribution by one of the LLC owners to acquire its +75% interest in the spar. During the second quarter of 2008, the non-recourse financing was +extinguished. The balance of Medusa Spar LLC is owned by Oceaneering International, Inc. +(NYSE:OII) and Murphy Oil Corporation (NYSE:MUR). The Company is accounting for its 10% ownership +interest in the LLC under the equity method. +Revenue Recognition and Gas Balancing +The Company recognizes revenue under the entitlement method of accounting. Under the method, +revenue is deferred for deliveries in excess of the Company’s net revenue interest, while revenue +is accrued for the undelivered volumes. Production imbalances are generally recorded at the +estimated sale price in effect at the time of production. Gas balancing receivables were $743,000 +and $1.0 million as of December 31, 2009 and 2008, respectively. Gas balancing payables were $1.2 +million and $1.5 million as of December 31, 2009 and 2008, respectively. +57 +Table of Contents +Derivatives +The Company periodically uses derivative financial instruments to manage oil and gas price risk on +a limited amount of its future production, and does not use these instruments for trading purposes. +Settlement of derivative contracts is generally based on the difference between the contract price +or prices specified in the derivative instrument and a New York Mercantile Exchange (“NYMEX”) price +or other cash or futures index price. +The Company’s derivative contracts that are accounted for as cash flow hedges are recorded at fair +market value and the changes in fair value are recorded through other comprehensive income (loss), +net of tax, in stockholders’ equity. The cash settlements on these contracts are recorded as an +increase or decrease in oil and gas sales. The changes in fair value related to ineffective +derivative contracts are recognized as derivative expense (income). The cash settlement on these +contracts is also recorded within derivative expense (income). See Note 8. +Callon’s derivative contracts are carried at fair value on the Company’s consolidated balance sheet +under the caption “Fair Market Value of Derivatives”. The oil and gas derivative contracts are +settled based upon reported prices on NYMEX. The estimated fair value of these contracts is based +upon closing exchange prices on NYMEX and in the case of collars and floors, the time value of +options. +In March 2008, the FASB issued guidance for disclosures about derivative instruments and hedging +activities. Under the guidance for disclosures about derivative instruments and hedging activities, +entities are required to provide enhanced disclosures about (a) how and why an entity uses +derivative instruments, (b) how derivative instruments and related hedged items are accounted for +under US GAAP, and (c) how derivative instruments and related hedged items affect an entity’s +financial position, financial performance, and cash flows. The Company adopted the guidance on +January 1, 2009 and has added certain additional disclosures to its financial statements. +Fair Value Measurements +Effective January 1, 2008, the Company adopted guidance issued by the FASB for fair value +measurements. The guidance for fair value measurements defines fair value, establishes a framework +for measuring fair value and requires enhanced disclosures about fair value measurements. The +adoption of the fair value measurements guidance did not have a significant impact on the Company’s +financial statements. The Company also adopted guidance issued by the FASB for the fair value +option for financial assets and liabilities on January 1, 2008, which permits entities to choose to +measure various financial instruments and certain other items at fair value. The adoption of the +fair value option for financial assets and liabilities guidance did not have an impact on the +Company’s financial statements. See Note 9. +Income Taxes +Provisions for income taxes include deferred taxes resulting primarily from temporary differences +due to different reporting methods for oil and gas properties for financial reporting purposes and +income tax purposes. US GAAP requires the recognition of a deferred tax asset for net operating +loss carryforwards, statutory depletion carryforward and tax credit carryforwards, net of a +valuation allowance. The valuation allowance is provided for that portion of the asset for which +it is deemed more likely than not will not be realized. See Note 6. +58 +Table of Contents +Earnings per Share +The Company accounts for earnings per share (“EPS”) in accordance with guidance issued by the FASB. +The guidance on accounting for earnings per share requires all entities with publicly held common +stock or potential common stock must disclose EPS — basic and diluted. Basic EPS is computed by +dividing reported earnings available to common stockholders by weighted average shares outstanding. +Diluted EPS reflects the potential dilution that could occur if securities or other contracts to +issue common stock were exercised or converted into common stock or resulted in the issuance of +common stock that then shared in the earnings of the entity. The earnings component of EPS is +limited to earnings applicable to common shares or earnings after deduction of preferred stock +dividends if incurred. If discontinued operations, extraordinary items, and /or the cumulative +effect of a change in accounting principles are reported, EPS information is required for each of +the following: (a) income from continuing operations, (b) income before extraordinary items, (c) +the cumulative effect of the change in accounting principle, net of tax, and (d) net income. See +Note 5. +In June 2008, the FASB issued guidance determining whether instruments granted in share-based +payment transactions are participating securities. The guidance addresses whether instruments +granted in share-based payment transactions are participating securities prior to vesting and, +therefore, need to be included in the earnings allocation in computing earnings per share under the +two-class method described in the FASB issued guidance for earning per share”. The Company adopted +this guidance on January 1, 2009 with no impact to its financial statements. +Stock-Based Compensation +Share-based compensation requires the cash flows from tax benefits resulting from tax deductions in +excess of compensation cost recognized for stock options exercised (excess tax benefits) to be +classified as financing cash flows. The $2.1 million and $163,000 of excess tax benefits +classified as a financing cash inflow for the years ended December 31, 2008 and 2007, respectively +would have been classified as an operating cash flow had the Company not adopted the guidance +issued by the FASB for share-based compensation. There were no stock option exercises in the years +ended December 31, 2009 and 2007 and no cash proceeds from the exercise of stock options for the +year ended December 31, 2008 due to the fact that all options were exercised through net-share +settlements. See Note 4. +Accounts Receivable +Accounts receivable consists primarily of accrued oil and gas production receivables. The balance +in the reserve for doubtful accounts netted within accounts receivable was $65,000 at both December +31, 2009 and 2008. There were no provisions to expense in the three-year period ended December 31, +2009. +Major Customers +The Company’s production is generally sold on month-to-month contracts at prevailing prices. The +following table identifies customers to whom it sold a significant percentage of its total oil and +gas production during each of the years ended: +December 31, +2009 +2008 +2007 +Shell Trading Company +45 +% +33 +% +25 +% +Plains Marketing, L.P. +23 +% +23 +% +10 +% +Louis Dreyfus Energy Services +15 +% +16 +% +20 +% +StatoilHydro +— +— +13 +% +59 +Table of Contents +Because alternative purchasers of oil and gas are readily available, the Company believes that the +loss of any of these purchasers would not result in a material adverse effect on its ability to +market future oil and gas production. +Cash and Cash Equivalents +The Company considers all highly liquid investments with an original maturity of three months or +less to be cash equivalents. +Statements of Cash Flows +The Company paid no federal income taxes for the three years in the period ended December 31, 2009. +During the years ended December 31, 2009, 2008 and 2007, the Company made cash payments for +interest of $19.8 million, $27.0 million and $37.6 million, respectively. +During the fourth quarter of 2009, the Company commenced an exchange offer for any and all of its +outstanding Senior Notes. For each $1,000 principal amount of outstanding Senior Notes tendered in +accordance with the terms and conditions of the exchange offer, each tendering holder of the Senior +Notes received $750 principal amount of 13% Senior Secured Notes due 2016 (“Exchange Notes), 20.625 +shares of common stock and 1.6875 shares of Convertible Preferred Stock. On December 31, 2009, +each share of the Convertible Preferred Stock was automatically converted by the Company into 10 +shares of common stock following shareholder approval and the filing of an amendment to the +Company’s charter increasing the number of authorized shares of common stock as necessary to +accommodate such conversion. Holders of approximately 92% of the Senior Notes tender their notes in +the exchange offer and 6.9 million shares of common stock, after the Convertible Preferred Stock +was converted into common shares, were issued to the tendering notes holders. See Note 7. +Fair Value of Financial Instruments +Fair value of cash and cash equivalents, accounts receivable and accounts payable, approximated +book value at December 31, 2009 and 2008. The senior secured revolving credit facility had a +balance outstanding of $10.0 million at December 31, 2009 and the fair value approximated book +value at December 31, 2009. The Company’s 9.75% Senior Notes due 2010 had an estimated fair market +value of 95% and 52% of face value at December 31, 2009 and 2008, respectively. The Company’s 13% +Senior Notes due 2016 had an estimated fair market value of 75% of face value at December 31, 2009. +Callon Entrada’s non-recourse credit agreement had a fair market value of zero at December 31, +2009. +Business Combinations +In December 2007, the FASB issued an accounting standard to improve the relevance, representational +faithfulness, and comparability of the information that a reporting entity provides in its +financial reports about a business combination and its effects. To accomplish that, the standard +establishes principles and requirements for how the acquirer (a) recognizes and measures in its +financial statements the identifiable assets acquired, the liabilities assumed, and any +noncontrolling interest in the acquiree, (b) recognizes and measures the goodwill acquired in the +business combination or a gain from a bargain purchase, and (c) determines what information to +disclose to enable users of the financial statements to evaluate the nature and financial effects +of the business combination. The business combination guidance is effective for business +combinations with an acquisition date on or after the beginning of annual reporting period +beginning on or after December 15, 2008. The standard requires an acquirer to recognize 100% of +the fair values of acquired assets, with limited exceptions, even if the acquirer has not acquired +100% of its target. Additionally contingent consideration arrangements and preacquisition +contingencies will be measured at fair value on the +60 +Table of Contents +acquisition date and included in the basis of the purchase price. Transaction costs are expensed +as incurred and not considered as part of the fair value of the acquisition; however, acquired +research and development are no longer expensed at acquisition, but instead are capitalized as an +indefinite-lived intangible asset. The Company adopted this accounting standard on January 1, +2009, and was applied to the Company’s ExL acquisition during 2009. See Note 13 for the impact of +the acquisition on the financial statements. +Subsequent Events +In May 2009, the FASB issued guidance for subsequent events. The objective of this guidance is to +establish general standards of accounting for and disclosures of events that occur after the +balance sheet date but before financial statements are issued or are available to be issued. The +Company adopted the guidance as of the quarter ended June 30, 2009 with limited impact to its +financial statements. See Note 20. +Recent Accounting Pronouncements +Consolidation of Variable Interest Entities (“VIE”). In June 2009, the FASB issued an accounting +standard which amends US GAAP as follows: a) to require an enterprise to perform an analysis to +determine whether the enterprise’s variable interest or interests give it a controlling financial +interest in a VIE, identifying the primary beneficiary of a VIE, b) to require ongoing reassessment +of whether an enterprise is the primary beneficiary of a VIE, rather than only when specific events +occur, c) to eliminate the quantitative approach previously required for determining the primary +beneficiary of a VIE. d) to amend certain guidance for determining whether an entity is a VIE, e) +to add an additional reconsideration event when changes in facts and circumstances pertinent to a +VIE occur, f) to eliminate the exception for troubled debt restructuring regarding VIE +reconsideration, and g) to require advanced disclosures that will provide users of financial +statement with more transparent information about an enterprise’s involvement in a VIE. This +pronouncement is effective for the first annual reporting period that begins after November 15, +2009, with earlier adoption prohibited. The Company adopted this pronouncement on January 1, 2010. +Upon adoption, the Company reevaluated its interest in its subsidiary, Callon Entrada as a result +of the amendments described above. Based on the evaluation performed, management has concluded +that a VIE reconsideration event had taken place resulting in the determination that Callon Entrada +is a VIE, for which the Company is not the primary beneficiary. Therefore, effective January 1, +2010, Callon Entrada will be deconsolidated from the consolidated financial statements of the +Company. Deconsolidation will result in the removal of approximately $1.8 million of current +assets, $2.0 million of current liabilities, $30.0 million of deferred tax assets, $30.0 million of +valuation allowance and approximately $84.8 million of non-recourse debt and related obligation for +the cumulative amount of interest. Retained earnings will be increased by $85.1 million as a +cumulative effect of change related to this accounting standard. +61 +Table of Contents +The following table shows the impact of deconsolidation as of January 1, 2010. +Callon +Consolidated +Callon +Callon +as reported +Entrada +After +12/31/09 +Deconsolidation +Deconsolidation +Balance Sheet (in thousands) +Total current assets +$ +77,684 +$ +(1,767 +) +$ +75,917 +Total oil and gas properties +130,608 +— +130,608 +Other property and equipment +2,508 +— +2,508 +Other assets +17,191 +— +17,191 +Total assets +$ +227,991 +$ +(1,767 +) +$ +226,224 +Other current liabilities +$ +16,889 +$ +(2,015 +) +$ +14,874 +9.75% Senior Notes, due December 2010 +15,820 +— +15,820 +Callon Entrada credit agreement +84,847 +(84,847 +) +— +Total current liabilities +117,556 +(86,862 +) +30,694 +Total long-term debt +179,174 +— +179,174 +Total other long-term liabilities +12,115 +— +12,115 +Total stockholders’ equity (deficit) +(80,854 +) +85,095 +4,241 +Total liabilities and stockholders’ +equity (deficit) +$ +227,991 +$ +(1,767 +) +$ +226,224 +The Company also reevaluated its interest in its equity method investment, Medusa Spar LLC, +upon the adoption of this accounting standard. No changes in the Company’s accounting of Medusa +Spar LLC resulted from the adoption of this accounting standard. +Noncontrolling Interest in Consolidated Financial Statements. In December 2007, the FASB issued an +accounting standard for noncontrolling interest in consolidated financial statements. The +objective of this standard is to improve the relevance, comparability, and transparency of the +financial information that a reporting entity provides in its consolidated financial statements by +establishing accounting and reporting standards for the noncontrolling interest in a subsidiary and +for the deconsolidation of a subsidiary. This standard is effective for first fiscal year and +interim periods within the fiscal year, beginning on or after December 15, 2008. The Company +adopted this standard on January 1, 2009 with no impact to its financial statements. +Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion. Effective +January 1, 2009, the FASB issued an accounting standard for accounting for convertible debt +instruments that may be settled in cash upon conversion (including partial cash settlement). +Additionally, this standard specifies that issuers of such instruments should separately account +for the liability and equity components in a manner that will reflect the entity’s nonconvertible +debt borrowing rate when interest cost is recognized in subsequent periods. The Company’s adoption +of this standard had no impact to its financial statements. +Business Combinations — Identifiable Assets, Liabilities and Any Noncontrolling Interest. In +April 2009, the FASB issued accounting guidance for business combinations that arise from +contingencies. The guidance addresses application issues raised by preparers, auditors, and +members of the legal profession on initial recognition and measurement, subsequent measurement and +accounting, and disclosure of assets and liabilities arising from contingencies in a business +combination. The Company adopted this guidance as of the quarter ended June 30, 2009 with no +impact to the Company’s financial statements. +62 +Table of Contents +Fair Value of Financial Instruments for Interim Reporting Periods. The Company adopted the +accounting guidance issued by the FASB for fair value of financial instruments for interim +reporting periods which requires disclosures about fair value of financial instruments for interim +reporting periods of publicly traded companies as well as in annual financial statements. This +guidance also amends the guidance for interim reporting, to require those disclosures in summarized +financial information at interim reporting periods. Accordingly, the Company adopted this guidance +as of the quarter ended June 30, 2009 with limited impact to the Company’s financial statements. +Financial Accounting Standards Board Accounting Standards Codification. The FASB voted to approve +the FASB Accounting Standards Codification (“ASC”) as the single source of authoritative +nongovernmental US GAAP as of July 1, 2009. ASC was effective for interim and annual periods ending +after September 15, 2009. ASC reorganizes the many US GAAP pronouncements into approximately 90 +accounting topics, with all topics using a consistent structure. It also includes relevant +authoritative content issued by the SEC, as well as selected SEC staff interpretations and +administrative guidance. ASC does not change or alter existing US GAAP and effective July 1, 2009, +changes to ASC were communicated through an Accounting Standards Update (“ASU”). The Company +adopted ASC for the September 30, 2009 reporting period with no impact on the consolidated +financial statements. +3. CALLON ENTRADA CREDIT AGREEMENT +In April 2008, Callon completed the sale of a 50% working interest in the Entrada Field to CIECO +Energy (US) Limited (“CIECO”) effective January 1, 2008. At closing, CIECO paid Callon $155 +million and reimbursed the Company $12.6 million for 50% of Entrada capital expenditures incurred +prior to the closing date. In addition, as part of the purchase and sale agreement, CIECO agreed +to loan the Company up to $150 million for its share of the development costs for the Entrada +project. +A wholly-owned subsidiary of Callon, Callon Entrada, entered into a credit agreement with CIECO +Energy (Entrada) LLC, (“CIECO Entrada”) pursuant to which Callon Entrada was entitled to borrow up +to $150 million, plus interest expense incurred of up to $12 million, to finance the development of +the Entrada project prior to the abandonment of the project in November 2008. Based on the terms of +the credit agreement, the debt was to be repaid solely from assets, primarily production, from the +Entrada field. As a result of abandoning the project prior to completion and the lease expiring on +June 1, 2009, Callon Entrada’s only source of payment is the proceeds from the sale of equipment +purchased but not used for the Entrada project. The agreement bears interest at six-month LIBOR (as +in effect on the first day of each interest period) plus 375 basis points and is subject to +customary representations, warranties, covenants and events of default. The interest rate +increased by 400 basis points as of April 2, 2009 due to a notice of default received from CIECO +Entrada, which is discussed below. As of December 31, 2009, $78.4 million of principal and $6.4 +million of interest were outstanding under this facility. +On April 2, 2009, Callon Entrada received a notice from CIECO Entrada advising Callon Entrada that +certain alleged events of default occurred under the credit agreement relating to failure to pay +interest when due and the breach of various other covenants related to the decision to abandon the +Entrada project. The notice of default received from CIECO Entrada invoked CIECO Entrada’s rights +under the Callon Entrada credit agreement to accelerate payment of the principal and interest due. +The acceleration of payment caused the principal and interest balances under the Callon Entrada +credit agreement to be reclassified effective as of the date of notice to current liabilities from +long-term liabilities under US GAAP. The agreement has not been legally extinguished, and as such +under US GAAP, the agreement remains as a liability of Callon Entrada. Until January 1, 2010, the +Company is required to continue to consolidate the financial statements and results of operations +of Callon Entrada, and as such, Callon Entrada’s liability is reflected in a separate line item in +Callon’s consolidated financial statements. +63 +Table of Contents +All assets of Callon Entrada, and its stock, are pledged to CIECO Entrada under the Callon Entrada +credit agreement. Callon and its subsidiaries (other than Callon Entrada) did not guarantee the +Callon Enrada credit facility and, based on the advice of legal counsel, the Company believes that +it and its subsidiaries are not otherwise obligated to repay the principal, accrued interest or any +other amount which may become due under the Callon Entrada credit facility. However, Callon has +entered into a customary indemnification agreement pursuant to which it agrees to indemnify the +lenders under the Callon Entrada credit facility against Callon Entrada’s misappropriation of +funds, non-performance of certain covenants, excluding the events of default discussed above, and +similar matters. In addition, Callon also guaranteed the obligations of Callon Entrada to fund its +proportionate share of any operating costs related to the Entrada project that Callon Entrada may, +from time to time, expressly approve under the Entrada joint operating agreement for which none +remain nor are planned. Callon also has guaranteed Callon Entrada’s payment of all amounts to plug +and abandon wells and related facilities and for a breach of law, rule or regulation (including +environmental laws) and for any losses of CIECO Entrada attributable to gross negligence of Callon +Entrada. The well for which Callon Entrada was responsible was plugged and abandoned in the fourth +of quarter of 2008, and the Minerals Management Service (“MMS”) confirmed to Callon during 2009 +that all abandonment obligations in the Entrada field have been satisfied. +Prior to abandonment of the Entrada project, CIECO Entrada failed to fund two loan requests +totaling $40 million under the Callon Entrada credit agreement. These loan requests were to cover +Callon Entrada’s share of the costs incurred to develop the Entrada field up to the suspension of +the project. Such amounts were subsequently funded by the Company to Callon Entrada and were +included as part of the Company’s full-cost pool impairment adjustment recorded in the fourth +quarter of 2008. The Company continues to discuss with CIECO Entrada its failure to fund the $40 +million in loan requests. +CIECO Entrada also failed to fund its working interest share of a settlement payment in the amount +of $7.3 million to terminate a drilling contract for the Entrada Project. No assurances can be +made regarding the outcome of discussions related to the Company’s ability to recover its funds +related to the Entrada Project. The Company does not believe that we have waived any of our rights +under the agreements with CIECO Entrada or its parent, CIECO. +As of December 31, 2009, the wind down of the Entrada project was complete and all of the costs +related to the Entrada project have been paid. The lease expired June 1, 2009 and reverted to the +MMS. In addition, the sale of equipment purchased for the Entrada project, but not used, is in +progress. As of December 2009, Callon Entrada has collected $3.4 million in sales proceeds from +the sale of equipment, net to its interest, which was applied to unpaid interest expense as +required under the Callon Entrada credit facility. The Company believes that the amount of future +operating costs of Callon Entrada, for which the Company would be responsible for, is not +significant and is limited to minimal storage fees for the surplus equipment, while the equipment +is being liquidated. +The Company adopted the pronouncement for consolidation of variable interest entities on January 1, +2010. Upon adoption, the Company reevaluated its interest in its subsidiary, Callon Entrada. +Based on the evaluation performed, management has concluded that a VIE reconsideration event had +taken place resulting in the determination that Callon Entrada is a VIE, for which the Company is +not the primary beneficiary and Callon Entrada will be deconsolidated from the Company’s +consolidated financial statements as of January 1, 2010. See Note 2 above under “Recent Accounting +Pronouncements” for more details. +64 +Table of Contents +4. STOCK-BASED COMPENSATION +The Company has various stock plans (“Plans”) under which employees of the Company and its +subsidiaries and non-employee members of the Board of Directors of the Company have been or may be +granted certain stock-based compensation. For further discussion of the Plans, refer to Note 16. +For the year ended December 31, 2009, the Company recorded stock-based compensation expense of $4.8 +million, of which $2.3 million was included in general and administrative expenses and $2.5 million +was capitalized to oil and gas properties. For the year ended December 31, 2008, the Company +recorded stock-based compensation expense of $4.5 million, of which $2.5 million was included in +general and administrative expenses and $2.0 million was capitalized to oil and gas properties. +For the year ended December 31, 2007, the Company recorded stock-based compensation expense of $2.9 +million, of which $1.4 million was included in general and administrative expenses and $1.5 million +was capitalized to oil and gas properties. Shares available for future stock option or restricted +stock grants to employees and directors under existing plans were 1,290,387 at December 31, 2009. +Stock Options +The Company uses the Black-Scholes option pricing model to estimate the fair value of +stock option awards with the following weighted-average assumptions for the indicated periods. +There were no stock options issued during 2008. +Years Ended +December 31, +2009 +2008 +2007 +Dividend yield +— +— +— +Expected volatility +136.0 +% +— +36.2 +% +Risk-free interest rate +3.9 +% +— +4.7 +% +Expected life of option (in years) +9 +— +5 +Weighted-average grant-date fair value +$ +1.23 +— +$ +5.64 +Forfeiture rate +0.0 +% +— +2.0 +% +The assumptions above are based on multiple factors, including historical exercise patterns of +employees with respect to exercise and post-vesting employment termination behaviors, expected +future exercising patterns and the historical volatility of the Company’s stock price. +The following table represents stock option activity for the three years ended December 31: +2009 +2008 +2007 +Wtd Avg +Wtd Avg +Wtd Avg +Shares +Ex Price +Shares +Ex Price +Shares +Ex Price +Outstanding, beginning of year +513,275 +$ +10.27 +755,225 +$ +10.00 +740,225 +$ +9.93 +Granted (at market) +500,000 +2.76 +— +— +30,000 +14.27 +Exercised +— +— +(238,950 +) +9.34 +— +— +Forfeited +(15,000 +) +14.44 +(3,000 +) +15.97 +— +— +Expired +(19,917 +) +9.99 +— +— +(15,000 +) +15.31 +Outstanding, end of year +978,358 +$ +6.37 +513,275 +$ +10.27 +755,225 +$ +10.00 +Exercisable, end of year +464,558 +$ +9.93 +488,075 +$ +9.91 +710,225 +$ +9.57 +Weighted-average remaining +Contract life: +Outstanding options at end of period +5.75 yrs. +2.92 yrs. +3.39 yrs. +Outstanding exercisable at end of period +1.78 yrs. +2.68 yrs. +3.08 yrs. +65 +Table of Contents +As of December 31, 2009 and 2008, the aggregate intrinsic value of options outstanding and +options exercisable was zero. As of December 31, 2007, the aggregate intrinsic value of options +outstanding was $5.0 million and the aggregate intrinsic value of options exercisable was $4.9 +million. Total intrinsic value of options exercised was $4.1 million for the year ended December +31, 2008. At December 31, 2009, there was $54,000 of unrecognized compensation cost related to +nonvested stock options, which is expected to be recognized over one year. +Restricted Stock +The Plans allow for the issuance of restricted stock awards. The unearned stock-based compensation +related to these awards is being amortized to compensation expense on a straight-line basis over +the requisite service period for the entire award. The compensation expense for these awards was +determined based on the market price of our stock at the date of grant applied to the total numbers +of shares that were anticipated to fully vest. As of December 31, 2009, there was $3.2 million of +unrecognized compensation cost associated with these awards, which is expected to be recognized +over a weighted average period of 1.5 years. +The following table represents unvested restricted stock activity for the year ended December 31, +2009: +Weighted-Average +Number of +Grant-Date +Shares +Fair Value +Outstanding shares at beginning of period +509,300 +$ +17.43 +Granted +650,975 +1.98 +Vested +(157,750 +) +15.00 +Forfeited +(75,100 +) +17.36 +Outstanding shares at end of period +927,425 +$ +7.01 +For the years ended December 31, 2009, 2008 and 2007 the Company recognized non-cash compensation +expense associated with the restricted stock awards of $4.6 million, $4.3 million and $2.7 million, +respectively. +As part of the 2009 award, 121,525 shares were issued as stock appreciation rights (“SARs”). The +SARs will vest three years from grant date. At December 31, 2009, the Company had recorded a +stock-based compensation liability of $182,000 for this award. +5. NET INCOME PER SHARE +Basic net income per common share was computed by dividing net income by the weighted average +number of shares of common stock outstanding during the year. Diluted net income per common share +was determined on a weighted average basis using common shares issued and outstanding adjusted for +the effect of stock options and restricted stock considered common stock equivalents computed using +the treasury stock method. +66 +Table of Contents +A +reconciliation of the basic and diluted net income per share +computation is as follows for the years ended December 31 (in thousands, except per share amounts): +2009 +2008 +2007 +(a) Net income (loss) available to common shares +$ +54,419 +$ +(438,893 +) +$ +15,194 +(b) Weighted average shares outstanding +22,072 +21,222 +20,776 +Dilutive impact of stock options +— +— +148 +Dilutive impact of restricted stock +128 +— +40 +Dilutive impact of warrants +— +— +326 +(c) Weighted average shares outstanding for diluted +net income per share +22,200 +21,222 +21,290 +Stock options excluded due to the exercise +price being greater than the stock price +978 +399 +75 +Basic net income (loss) per share (a ¸ b) +$ +2.47 +$ +(20.68 +) +$ +0.73 +Diluted net income (loss) per share (a ¸ c) +$ +2.45 +$ +(20.68 +) +$ +0.71 +In addition, below are the shares (in thousands) relating to stock option, warrants and restricted +stock that were not included in diluted shares for the year ended December 31, 2008 due to the fact +that the Company had a loss for this period. The Company had net income for the years ended +December 31, 2009 and 2007 and all such shares were included as described above. +2008 +Stock options +161 +Warrants +328 +Restricted Stock +129 +67 +Table of Contents +6. INCOME TAXES +Below is +an analysis of deferred income taxes: +December 31, +2009 +2008 +(In thousands) +Deferred tax assets: +Federal net operating loss carryforwards +$ +94,125 +$ +68,432 +Statutory depletion carryforward +4,895 +4,561 +Alternative minimum tax credit carryforward +383 +375 +Asset retirement obligations +3,704 +13,102 +Oil and gas properties +— +58,061 +Other +34,170 +.2,241 +Valuation allowance +(116,676 +) +(128,123 +) +Total deferred tax assets +20,601 +18,649 +Deferred tax liabilities: +Oil and gas properties +9,555 +— +Other +11,046 +18,649 +Total deferred tax liabilities +20,601 +18,649 +Net deferred tax +$ +— +$ +— +US GAAP provides for the weighing of positive and negative evidence in determining whether it is +more likely than not that a deferred tax asset is recoverable. As a result of the impairment of +oil and gas properties in the fourth quarter of 2008, the Company incurred losses on an aggregate +basis for the three-year period ended December 31, 2008. As a result, the Company has established +a full valuation allowance for its net deferred tax asset which reflects federal net operating loss +carryforwards of $268 million as of December 31, 2009. +If not utilized, the Company’s federal net operating loss carryforwards will expire in 2013 through +2024. The Company’s state net operating loss carryforwards in the amount of $56.8 million as of +December 31, 2009 will expire in 2010 through 2024. The Company has limited state taxable income +as primarily all of its revenue is generated in federal waters and is not subject to state income +taxes. Accordingly, the Company has established a full valuation allowance on the tax benefit +associated with these state net operating loss carryforwards as the Company does not anticipate +generating taxable state income in the states in which these carryforwards apply. +The Company had no significant unrecognized tax benefits at the date of adoption or at December 31, +2009. Accordingly, the Company does not have any interest or penalties related to uncertain tax +positions. However, if interest or penalties were to be incurred related to uncertain tax +positions, such amounts would be recognized in income tax expense. Tax periods for years 2004 +through 2008 remain open to examination by the federal and state taxing jurisdictions to which the +Company is subject. +68 +Table of Contents +Below is a reconciliation of the reported amount of income tax expense attributable to continuing +operations for the year to the amount of income tax expense that would result from applying +domestic federal statutory tax rates to pretax income from continuing operations. +Years Ended December 31, +2009 +2008 +2007 +Income tax expense computed at the statutory +federal income tax rate +(35 +)% +(35 +)% +35 +% +Change in valuation allowance +34 +% +27 +% +— +Other +1 +% +— +2 +% +Effective income tax rate +0 +% +(8 +)% +37 +% +Included in the table below are the components of income tax expense. +Years Ended December 31, +2009 +2008 +2007 +Current income tax expense (benefit) +$ +— +$ +— +$ +— +Deferred income tax (benefit) expense +18,816 +(167,848 +) +8,506 +Valuation allowance +(18,816 +) +128,123 +— +Total income tax expenses +$ +— +$ +(39,725 +) +$ +8,506 +During 2009, the Company reduced the valuation allowance by the income tax expense incurred for the +year. +7. LONG-TERM DEBT +Long-term debt consisted of the following at: +December 31, +2009 +2008 +(In Thousands) +Senior Secured Credit Facility (matures +September 25, 2012) +$ +10,000 +$ +— +9.75% Senior Notes (due December 2010) +16,052 +200,000 +Discount +(232 +) +(5,580 +) +13% Senior Notes (due September 2016) +137,961 +— +Deferred Credit +31,213 +— +Callon Entrada (non-recourse) credit agreement +84,847 +78,435 +Total long-term debt +279,841 +272,855 +Less current portion +100,667 +— +Long-term portion +$ +179,174 +$ +272,855 +Senior Secured Credit Facility . On September 25, 2008, the Company completed a $250 million second +amended and restated senior secured revolving credit agreement with Union Bank N.A. (“Union Bank”) +as administrative agent and issuing lender. The borrowing base was $16.2 million at December 31, +2009. Borrowings under the credit agreement are secured by mortgages covering the Company’s major +fields. As of December 31, 2009, $10.0 million was outstanding under the agreement. The credit +facility bears +69 +Table of Contents +interest at 0% to 0.50% above a defined base rate depending on utilization of the borrowing base +or, at the option of the Company, LIBOR plus 1.375% to 2.0% based on utilization of the borrowing +base. Under the senior secured credit facility, a commitment fee of 0.25% or 0.375% per annum, +depending on the amount of the unused portion of the borrowing base, is payable quarterly. The +range of interest rates on the senior secured credit facility during 2009 was 1.87% to 3.25%. +Subsequent to December 31, 2009, the Company’s senior secured credit agreement was amended to +include Regions Bank as the sole arranger and administrative agent. The third amended and restated +senior secured credit agreement, which matures on September 25, 2012, provides for a $100 million +facility with an initial borrowing base of $20 million, which will be reviewed and re-determined on +a semi-annual basis. The third amended and restated credit facility bears interest at 4% above a +defined base rate and in no event will the interest rate be less than 6%. In addition, a +commitment fee of 0.5% per annum on the unused portion of the borrowing base, is payable quarterly. +Subsequent to December 31, 2009, simultaneously with the execution of the third amended and +restated senior secured credit agreement, the Company repaid the $10 million outstanding on the +borrowing base under the second amended and restated senior secured credit agreement. See Note 20. +9.75% Senior Notes due 2010 . In the fourth quarter of 2003, the Company issued $200 million of +9.75% senior notes (“Senior Notes”), due 2010. In conjunction with the Senior Notes, the Company +issued warrants to purchase 2.775 million shares of its common stock at an exercise price of $10 +per share and an expiration date of December 2010. The warrants were valued at $10.6 million and +were treated as a discount on the debt. The Senior Notes mature December 8, 2010 and have an +effective interest rate of 11.4%. The Company recorded the issuance of the Senior Notes at a fair +value of $185 million. Deferred costs of $15 million associated with the Senior Notes are being +amortized over the life of the notes. As of December 31, 2009, 2.410 million of the 2.775 million +warrants issued with the Senior Notes were exercised. +During the fourth quarter of 2009, Callon commenced an exchange offer for any and all of its +outstanding Senior Notes. For each $1,000 principal amount of outstanding Senior Notes tendered in +accordance with the terms and conditions of the exchange offer, each tendering holder of the Senior +Notes received $750 principal amount of 13% Senior Secured Notes due 2016 (“Exchange Notes), 20.625 +shares of common stock and 1.6875 shares of Convertible Preferred Stock. Holders of approximately +92% of the Senior Notes tendered their Senior Notes in the exchange offer. On December 31, 2009, +each share of the Convertible Preferred Stock was automatically converted by the Company into 10 +shares of common stock following shareholder approval and the filing of an amendment to the +Company’s charter increasing the number of authorized shares of common stock as necessary to +accommodate such conversion. In connection with the exchange offer, holders who tendered their +Senior Notes consented to amend the indenture governing the Senior Notes, eliminating substantially +all of the indenture’s restrictive covenants. The principal amount of the remaining Senior Notes is +$16.1 million at December 31, 2009 and is due in 2010. +13% Senior Notes due 2016 (“Exchange Notes”). As described above, during the fourth quarter of +2009, the Company exchanged approximately 92% of the principal amount, or $183.9 million, of the +Senior Notes for $137.9 million of Exchange Notes plus 3.8 million shares of common stock and +310,802 shares of Convertible Preferred Stock which was valued on November 24, 2009 in the amount +of $11.5 million and recorded as an increase to stockholders’ equity. On December 31, 2009, each +share of the Convertible Preferred Stock was automatically converted by the Company into 10 shares +of common stock following shareholder approval and the filing of an amendment to the Company’s +charter increasing the number of authorized shares of common stock as necessary to accommodate such +conversion. +70 +Table of Contents +The Company determined that the note exchange should be accounted for in accordance with guidance +provided by the FASB for accounting for troubled debt restructuring. Immediately before the +issuance of the Exchange Notes, the total future cash payments on the restructured Senior Notes was +less than the remaining carrying amount of the Senior Notes after the carrying amount was reduced +by the fair value of the equity interests issued. Therefore, as of November 23, 2009, in +accordance with the troubled debt restructuring accounting standard, the Company reduced the +carrying amount of the Senior Notes by the fair value of the common and preferred stock issued in +the amount of $11.5 million The difference between the adjusted carrying amount of the Senior +Notes and the face value of the Exchange Notes was recorded as a deferred credit of $31.2 million +which will be amortized as a credit to interest expense at an 8.5% effective interest rate over the +life of the Exchange Notes. In addition, the Company incurred $1.0 million of costs associated +with the note exchange and expensed the amount in the fourth quarter of 2009 in accordance with +troubled debt restructuring accounting standard. +Certain of the Company’s subsidiaries guarantee the Company’s obligations under the Exchange Notes. +The subsidiary guarantors are 100% owned, all of the guarantees are full and unconditional and +joint and several, the parent company has no independent assets or operations and any subsidiaries +of the parent company other than the subsidiary guarantors are minor. +Restrictive Covenants . The Indenture governing our Exchange Notes and the Company’s senior secured +credit facility contains various covenants including restrictions on additional indebtedness and +payment of cash dividends. In addition, Callon’s senior secured credit facility contains covenants +for maintenance of certain financial ratios. The Company was in compliance with these covenants at +December 31, 2009. +Callon Entrada (Non-Recourse) Credit Agreement. A wholly-owned subsidiary of Callon, Callon +Entrada, entered into a credit agreement with CIECO Entrada in April 2008, pursuant to which Callon +Entrada may borrow up to $150 million, plus interest expense incurred of up to $12 million, to +finance the development of the Entrada project. The Callon Entrada credit agreement is a direct +obligation of Callon Entrada. The Callon Entrada credit agreement is secured by a lien on the +assets of Callon Entrada, which generally are comprised of the Entrada Field and related equipment. +Neither Callon Petroleum nor any other subsidiary of Callon Petroleum guaranteed or otherwise +agreed to pay the principal or interest payments due on the Callon Entrada credit agreement. As +such, the facility is effectively non-recourse to Callon Petroleum and its other subsidiaries. +The agreement bears interest at six-month LIBOR (as in effect on the first day of each interest +period) plus 0.375% and is subject to customary representations, warranties, covenants and events +of default. The interest rate increased by 4.0% as of April 2, 2009 due to a notice of default +received from CIECO Entrada. As of December 31, 2009, $78.4 million of principal and $6.4 million +of accrued interest was outstanding under this Callon Entrada credit agreement. See Note 3 for more +details. +Senior Revolving Credit Facility (due 2014) . On April 18, 2007, Callon closed the Entrada +acquisition contemporaneous with a seven-year $200 million senior revolving credit facility +arranged by Merrill Lynch Capital Corporation, which is secured by a lien on the Entrada +properties. On April 8, 2008, Callon extinguished the $200 million senior revolving credit +facility. The retirement was made with cash on hand, a $16 million draw under the Union Bank +credit facility and proceeds from the sale of a 50% working interest in Callon’s Entrada Field to +CIECO. Due to the early extinguishment of this credit facility, Callon incurred expenses of $11.9 +million, consisting of $6.3 million in pre-payment penalties plus a non-cash charge of $5.6 million +related to the amortization expense associated with the deferred financing costs related to the +credit facility. These amounts are included in “Loss on early extinguishment of debt” in the +accompanying Consolidated Statements of Operations. +71 +Table of Contents +8. DERIVATIVES +During 2008, the change in fair value and settlements of ineffective derivative contracts of +$498,000 were related to contracts that were deemed ineffective as a result of a shortfall in +production volumes due to downtime resulting from damages caused by Hurricanes Gustav and Ike. No +contracts were deemed ineffective during 2009 and 2007. For the years ended December 31, 2009, and +2007 cash settlements on effective cash flow hedges resulted in an increase in oil and gas sales of +$19.2 million and $8.1 million, respectively. Cash settlements on effective cash flow hedges for +the year ended December 31, 2008 resulted in a reduction in oil and gas sales of $9.4 million. +Listed in the table below are the outstanding derivative contracts, which are collars, as of +December 31, 2009: +Average +Average +Volumes per +Quantity +Floor +Ceiling +Product +Month +Type +Price +Price +Period +Natural Gas +75,000 +MMBtu +$ +5.00 +$ +8.30 +01/10-12/10 +9. FAIR VALUE MEASUREMENTS +US GAAP establishes a fair value hierarchy which consists of three broad levels that prioritize the +inputs to valuation techniques used to measure fair value. +• +Level 1 valuations consist of unadjusted quoted prices in active markets for +identical assets and liabilities and have the highest priority. +• +Level 2 valuations rely on quoted market information for the calculation of +fair market value. +• +Level 3 valuations are internal estimates and have the lowest priority. +The Company has classified its derivatives into these levels depending upon the data relied on to +determine the fair values of the derivative instruments. The fair values of collars and natural +gas basis swaps are estimated using internal discounted cash flow calculations based upon forward +commodity price curves or quotes obtained from counterparties to the agreements and are designated +as Level 3. The following table summarizes the valuation of our assets and liabilities measured at +fair value on a recurring basis at December 31, 2009 (in thousands): +Fair Value Measurements Using +Quoted +Significant +Prices in +Other +Significant +Active +Observable +Unobservable +Assets +Markets +Inputs +Inputs +(Liabilities) +(Level 1) +(Level 2) +(Level 3) +At Fair Value +Derivative assets +$ +— +$ +— +$ +145 +$ +145 +Derivative liabilities +— +— +— +— +Total +$ +— +$ +— +$ +145 +$ +145 +72 +Table of Contents +The table below presents a reconciliation for assets and liabilities measured at fair value on a +recurring basis using significant unobservable inputs (Level 3) during the period ended December +31, 2009. The fair values of Level 3 derivative instruments are estimated using proprietary +valuation models that utilize both market observable and unobservable parameters. Level 3 +instruments presented in the table consist of net derivatives valued using pricing models +incorporating assumptions that, in management’s judgment, reflect the assumptions a marketplace +participant would have used at December 31, 2009 (in thousands): +Derivatives +Balance at January 1, 2009 +$ +21,780 +Total gains or losses (realized or unrealized): +Included in earnings +19,242 +Included in other comprehensive income +(21,635 +) +Purchases, issuances and settlements +(19,242 +) +Balance at December 31, 2009 +$ +145 +Change in unrealized gains (losses) included in +earnings relating to derivatives still held as of +December 31, 2009 +$ +— +10. OTHER COMPREHENSIVE INCOME +A summary of the Company’s comprehensive income (loss) is detailed below (in thousands, net of tax) +for the twelve months ended December 31: +2009 +2008 +2007 +Net income (loss) +$ +54,419 +$ +(438,893 +) +$ +15,194 +Other comprehensive income (loss): +Change in fair value of derivatives +(21,635 +) +17,540 +(12,035 +) +Total comprehensive income (loss) +$ +32,784 +$ +(421,353 +) +$ +3,159 +11. ASSET RETIREMENT OBLIGATIONS +The following table summarizes the activity for the Company’s asset retirement obligations (in +thousands): +Years Ended December 31, +2009 +2008 +Asset retirement obligations at beginning of +period +$ +42,194 +$ +36,837 +Accretion expense +3,149 +4,172 +Liabilities incurred +9 +2,851 +Liabilities settled +(8,194 +) +(6,586 +) +Revisions to estimate +(22,508 +) +4,920 +Asset retirement obligations at end of period +14,650 +42,194 +Less: current retirement obligations +(4,002 +) +(9,151 +) +Long-term retirement obligations +$ +10,648 +$ +33,043 +The revisions to estimate of $22.5 million was primarily due to the MMS approval to abandon in +place the Company’s Entrada #1 and #2 wells in place resulting in a reduction in asset retirement +obligation liabilities of $16.0 million and reduction in estimated costs for other obligations. +73 +Table of Contents +Assets, primarily short-term U.S. Government securities, of approximately $4.1 million at December +31, 2009, were recorded as restricted investments. These assets are held in abandonment trusts +dedicated to pay future abandonment costs for several of the Company’s oil and gas properties. +12. MMS ROYALTY RECOUPMENT +The Company’s Medusa deepwater property is eligible for royalty suspensions pursuant to the Outer +Continental Shelf Deep Water Royalty Relief Act 1995. From first production during November 2003 +and until August 2009, the Company paid $44.8 million of royalties to the MMS based on price +thresholds imposed by the MMS. Kerr-McGee Oil & Gas Corporation sued the MMS on the grounds that +the MMS had no right to impose price thresholds on royalty relief leases located in the Gulf of +Mexico deep water. In October 2009, the Supreme Court refused to review the decision by the Fifth +Circuit Court of Appeals which was in favor of Kerr-McGee. As a result, in November the Company +filed for a recoupment of the royalties paid in the amount of $44.8 million from production at the +Company’s Medusa field. As of December 31, 2009, Callon accrued royalty recoupment of $44.8 +million and estimated interest of $7.7 million. The recoupment of principal was received by the +Company in January 2010 with the interest expected to be received in the first quarter of 2010. +Royalty recoupment of $3.0 million related to 2009 production was recorded as oil and gas sales in +the fourth quarter of 2009. Royalty recoupment for years prior to 2009 of $40.9 million was +included in operating revenues as MMS royalty recoupment. Interest income related to the +recoupment was recorded as a component of other income and expense. +13. ACQUISITIONS +In September 2009, the Company acquired for $3.0 million a 70% working interest in a 577-acre unit +in the heart of the Haynesville Shale play in Bossier Parish, Louisiana. The development plan for +this acreage includes drilling a total of seven horizontal wells with the first two wells to be +drilled in 2010. Callon will be the operator of this project. +On October 28, 2009, Callon completed the acquisition of proved oil and gas property interests in +Wolfberry play located in Crockett, Ector, Midland and Upton Counties, Texas from Ambrose Energy I, +Ltd., a subsidiary of ExL Petroleum, LP for a total cash consideration of $16.0 million. The +acquisition was funded by the Company’s senior secured credit facility in the amount of $10 million +and the remaining $6.0 million with cash on hand. The acquisition included year-end proved +reserves of 1.6 million barrels of oil equivalent, 22 existing wells producing 350 barrels of oil +equivalent per day and upside from a multi-year inventory of drilling and recompletion +opportunities. The Company will operate substantially all of the production and development. The +Company accounted for the acquisition in accordance with guidance the amended issued by the FASB +for business combinations, which was adopted on January 1, 2009, and recorded acquisition expenses +in the fourth quarter of 2009 of $298,000. +74 +Table of Contents +The following table summarizes the estimated fair value of the assets acquired and liabilities +assumed at the acquisition date (In thousands): +Cash paid for acquired assets at closing +$ +15,958 +Post-closing adjustment +(690 +) (a) +Assumed liabilities +339 +Net assets acquired +$ +15,607 +(a) +Represents net cash flow from the operations of the acquired properties during the period from +September 1, 2008 (effective date) to October 28, 2009 (closing date). +The allocation of the purchase price of the acquired properties at the date of acquisition follows +(In thousands): +Accounts receivable +$ +690 +Oil and gas properties +15,607 +Other accrued liabilities +(339 +) +Cash paid for acquired assets as closing +$ +15,958 +14. COMMITMENTS AND CONTINGENCIES +From time to time, the Company, as part of the Consolidation and other capital transactions, enters +into registration rights agreements whereby certain parties to the transactions are entitled to +require the Company to register common stock of the Company owned by them with the SEC for sale to +the public in firm commitment public offerings and generally to include shares owned by them, at no +cost, in registration statements filed by the Company. Costs of the offering will not include +broker’s discounts and commissions, which will be paid by the respective sellers of the common +stock. +The Company is involved in various claims and lawsuits incidental to its business. In the opinion +of management, the ultimate liability hereunder, if any, will not have a material adverse effect on +the financial position or results of operations of the Company. +The Company’s activities are subject to federal, state and local laws and regulations governing +environmental quality and pollution control. Although no assurances can be made, the Company +believes that, absent the occurrence of an extraordinary event, compliance with existing federal, +state and local laws, rules and regulations governing the release of materials into the environment +or otherwise relating to the protection of the environment will not have a material effect upon the +capital expenditures, earnings or the competitive position of the Company with respect to its +existing assets and operations. The Company cannot predict what effect additional regulation or +legislation, enforcement polices hereunder, and claims for damages to property, employees, other +persons and the environment resulting from the Company’s operations could have on its activities +75 +Table of Contents +15. OIL AND GAS PROPERTIES +The following table discloses certain financial data relating to the Company’s oil and gas +activities, all of which are located in the United States. +Years Ended December 31, +2009 +2008 +2007 +(In thousands) +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance +$ +1,581,698 +$ +1,349,904 +$ +1,096,907 +Property acquisition costs +23,748 +6,126 +154,193 +Exploration costs +— +2,578 +35,959 +Development costs +(11,562 +) +223,090 +62,845 +End of period balance +$ +1,593,884 +$ +1,581,698 +$ +1,349,904 +Unevaluated Properties (excluded from +amortization) - +Beginning of period balance +$ +32,829 +$ +70,176 +$ +54,802 +Additions +6,140 +6,409 +21,525 +Capitalized interest +3,213 +6,496 +7,152 +Transfers to evaluated +(16,740 +) +(50,252 +) +(13,303 +) +End of period balance +$ +25,442 +$ +32,829 +$ +70,176 +Accumulated depreciation, depletion +and amortization- +Beginning of period balance +$ +1,455,275 +$ +738,374 +$ +604,682 +Provision charged to expense +33,443 +549,552 +72,762 +Sale of mineral interests +— +167,349 +60,930 +End of period balance +$ +1,488,718 +$ +1,455,275 +$ +738,374 +Unevaluated property costs, primarily including lease acquisition costs incurred at federal and +state lease sales, unevaluated drilling costs, seismic, capitalized interest and general and +administrative costs being excluded from the amortizable evaluated property base, consisted of $8.6 +million incurred in 2009, $7.2 million incurred in 2008, and $3.9 million incurred in 2007 and $5.7 +million incurred in 2006 and prior. These costs are directly related to the acquisition and +evaluation of unproved properties and major development projects. The excluded costs and related +reserves are included in the amortization base as the properties are evaluated and proved reserves +are established or impairment is determined. The Company expects that the majority of these costs +will be evaluated over the next three to five years. +Depletion per unit-of-production (thousand cubic feet of gas equivalent) amounted to $2.83, $5.57 +and $3.89 for the years ended December 31, 2009, 2008, and 2007, respectively. +Under the full-cost accounting rules of the SEC, the Company reviews the carrying value of its +proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and gas +properties, net of accumulated depreciation, depletion and amortization and deferred income taxes, +may not exceed the present value of estimated future net cash flows from proved oil and gas +reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of +related tax effects (the full-cost ceiling amount). These rules generally require pricing future +oil and gas production at the unescalated market price for oil and gas at the end of each fiscal +quarter and require a write-down if the “ceiling” is exceeded. However, if prices recover +sufficiently subsequent to the balance sheet date before the release of the financial statements +then use of subsequent pricing is allowed and no write-down would be required if such pricing was +used. Given +76 +Table of Contents +the volatility of oil and gas prices, it is reasonably possible that the Company’s estimate of +discounted future net cash flows from proved oil and gas reserves could change in the near term. +If oil and gas prices decline significantly, even if only for a short period of time, it is +possible that write-downs of oil and gas properties could occur in the future. For the year ended +December 31, 2008, the Company recorded a $485.5 million impairment of oil and gas properties as a +result of the ceiling test calculation. +16. EMPLOYEE BENEFIT PLANS +The Company has adopted a series of incentive compensation plans designed to align the interest of +the executives and employees with those of its stockholders. The following is a brief description +of each plan: +Savings and Protection Plan +The Savings and Protection Plan (“401-K Plan”) provides employees with the option to +defer receipt of a portion of their compensation, and the Company may, at its +discretion, match a portion of the employee’s deferral with cash and Company Common +Stock. The Company may also elect, at its discretion, to contribute a non-matching +amount in cash and Company Common Stock to employees. The amounts held under the +401-K Plan are invested in various funds maintained by a third party in accordance +with the directions of each employee. An employee is fully vested, including Company +discretionary contributions, immediately upon participation in the 401-K Plan. The +total amounts contributed by the Company, including the value of the common stock +contributed, were $640,000, $747,000 and $680,000 in the years 2009, 2008 and 2007, +respectively. +1996 Stock Incentive Plan +On August 23, 1996, the Board of Directors of the Company approved and adopted the +Callon Petroleum Company 1996 Stock Incentive Plan (the “1996 Plan”). The 1996 Plan +was approved by the shareholders in 1997 and limited to a maximum of 1,200,000 +shares (as amended from the original 900,000 shares) of common stock subject to +outstanding awards. The 1996 Plan was amended again and approved on May 9, 2000 at +the Annual Meeting of Shareholders, increasing the number of shares reserved for +issuance under the 1996 plan to 2,200,000 shares. Unvested options are subject to +forfeiture upon certain termination of employment events and expire 10 years from +the date of grant. +In August 2006, the Board of Directors approved the award of 520,000 shares of +restricted stock from the 1996 Plan. Of the 520,000 shares, 20,000 shares were +granted to non-employee members of the Board of Directors and vested immediately. +The remaining 500,000 shares were issued to employees of the Company with 20% vesting +immediately and the remaining 80% vesting ratably over the next four years. The +compensation cost with respect to the 20% that vested immediately was recognized as +an expense on the grant date and the compensation cost with respect to the remaining +80% is being amortized to expense over the vesting period. +During 2009, the Company awarded 80,000 shares of restricted stock to non-employee +members of the Board of Directors, which will vest one year from the grant date. +77 +Table of Contents +2002 Stock Incentive Plan +On February 14, 2002, the Board of Directors of the Company approved and adopted the +2002 Stock Incentive Plan (the “2002 Plan”). Pursuant to the 2002 Plan, 350,000 +shares of common stock shall be reserved for issuance upon the exercise of options or +for grants of stock options, stock appreciation rights or units, bonus stock, or +performance shares or units. This Plan qualified as a “broadly based” plan under the +provisions of the New York Stock Exchange’s rules and regulations and therefore did +not require shareholder approval. Because the 2002 Plan is a broadly based plan, the +aggregate number of shares underlying awards granted to officers and directors cannot +exceed 50% of the total number of shares underlying the awards granted to all +employees during any three-year period. +In 2006, 17,500 shares were awarded as restricted stock with 20% vesting immediately +and the remaining 80% vesting ratably over the next four years. The compensation cost +with respect to the 20% that vested immediately was recognized as an expense on the +grant date and the compensation cost with respect to the remaining 80% is being +amortized to expense over the vesting period. +During 2009, the Company awarded 20,000 share of restricted stock to employees of the +Company, which will vest three years from grant date. +2006 Stock Incentive Plan +On March 9, 2006, the Board of Directors of the Company approved the 2006 Stock +Incentive Plan (“2006 Plan”). The 2006 Plan was approved by the shareholders at the +May 4, 2006 annual meeting. Pursuant to the 2006 Plan, 500,000 shares of common +stock shall be reserved for issuance upon exercise of stock options, restricted +stock or other stock-based awards. In 2006, 45,000 shares were awarded as +restricted stock that will vest ratably over the next four years. The compensation +cost with respect to this grant is being amortized to expense over the vesting +period. +In April 2008, 217,600 shares were awarded as restricted stock with cliff vesting +over the next three years and the compensation cost is being amortized over the +vesting period. In addition, 25,000 shares were awarded as restricted stock vesting +immediately and the compensation cost was recognized as an expense on the grant +date. +During 2009, the Company awarded 179,150 shares of restricted stock to employees of +the Company, which will vest three years from grant date. In addition, the Company +awarded 8,850 of stock appreciation rights, which vest three years from the grant +date. +2009 Stock Incentive Plan +On March 5, 2009, the Board of Directors of the Company approved the Callon +Petroleum Company 2009 Stock Incentive Plan (“2009 Plan”), subject to the approval +of the shareholders of the Company. The 2009 Plan was approved by shareholders on +April 30, 2009. Pursuant to the 2009 Plan, 1,250,000 shares of common stock shall +be reserved for issuance upon exercise of vested stock options and stock +appreciation rights, restricted stock awards, restricted stock unit awards, and +other stock-based awards. During 2009, 171,825 restricted stock units were issued +with vesting scheduled for the third anniversary date following the award. In +addition, the Company awarded 112,675 of stock appreciation rights, which vest three +years from the grant date. +78 +Table of Contents +Stock Incentive Award for Inducement of Employment +On June 1, 2009, the Company awarded 100,000 shares of restricted stock, 100,000 +shares of performance stock and 500,000 options to the Company’s new Executive Vice +President and Chief Operating Officer. These shares were issued from the authorized +but unissued corporate shares under an exception available by the New York Stock +Exchange as a inducement of employment. The restricted stock will vest four years +from the grant date, and the performance shares will vest three years from the grant +date based on the performance of the Company. The options vest over a ten year +period based on the performance of the Company. +17. EQUITY TRANSACTIONS +The Company adopted a stockholder rights plan on March 30, 2000, designed to assure that the +Company’s stockholders receive fair and equal treatment in the event of any proposed takeover of +the Company and to guard against partial tender offers, squeeze-outs, open market accumulations, +and other abusive tactics to gain control without paying all stockholders a fair price. The rights +plan was not adopted in response to any specific takeover proposal. Under the rights plan, the +Company declared a dividend of one right (“Right”) on each share of the Company’s Common Stock. +Each Right will entitle the holder to purchase one one-thousandth of a share of a Series B +Preferred Stock, par value $0.01 per share, at an exercise price of $90 per one one-thousandth of a +share. +The Rights are not currently exercisable, and will become exercisable only in the event a person or +group acquires, or engages in a tender or exchange offer to acquire, beneficial ownership of 15 +percent or more (one existing stockholder was granted an exception for up to 21 percent) of the +Company’s common stock. After the Rights become exercisable, each Right will also entitle its +holder to purchase a number of common shares of the Company having a market value of twice the +exercise price. The dividend distribution was made to stockholders of record at the close of +business on April 10, 2000. The Rights will expire on March 30, 2010. +During the fourth quarter of 2009, Callon commenced an exchange offer for any and all of its +outstanding Senior Notes. For each $1,000 principal amount of outstanding Senior Notes tendered in +accordance with the terms and conditions of the exchange offer, each tendering holder of the Senior +Notes will receive $750 principal amount of 13% Senior Secured Notes due 2016 (“Exchange Notes), +20.625 shares of common stock and 1.6875 shares of Convertible Preferred Stock. On December 31, +2009, each share of the Convertible Preferred Stock was automatically converted by the Company into +10 shares of common stock following shareholder approval and the filing of an amendment to the +Company’s charter increasing the number of authorized shares of common stock as necessary to +accommodate such conversion. Holders of approximately 92% of the Senior Notes tender their notes in +the exchange offer and 6.9 million shares of common stock, after the Convertible Preferred Stock +was converted into common shares, were issued to the tendering notes holders. +18. SUPPLEMENTAL OIL AND GAS RESERVE DATA (UNAUDITED) +The Company’s proved oil and gas reserves at December 31, 2009, 2008 and 2007 have been estimated +by Huddleston & Co., Inc., the Company’s independent petroleum engineers. The reserves were +prepared in accordance with guidelines established by the SEC. Accordingly, the following reserve +estimates are based upon existing economic and operating conditions. +79 +Table of Contents +There are numerous uncertainties inherent in establishing quantities of proved reserves. The +following reserve data represents estimates only and should not be construed as being exact. In +addition, the standardized measure of discounted future net cash flows should not be construed as +the current market value of the Company’s oil and gas properties or the cost that would be incurred +to obtain equivalent reserves. +Estimated Reserves +Changes in the estimated net quantities of crude oil and natural gas reserves, all of which are +located onshore and offshore in the continental United States, are as follows: +Reserve Quantities +Years Ended December 31, +2009 +2008 +2007 +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period +6,027 +24,531 +13,265 +Revisions to previous estimates +(356 +) +(9,026 +) +(1,152 +) +Change in ownership +563 +— +144 +Purchase of reserves in place +1,257 +— +13,658 +Sale of reserves in place +— +(8,536 +) +(356 +) +Extensions and discoveries +— +— +35 +Production +(1,012 +) +(942 +) +(1,063 +) +End of period +6,479 +6,027 +24,531 +Natural Gas (MMcf): +Beginning of period +18,651 +116,454 +66,037 +Revisions to previous estimates +3,632 +(49,526 +) +(3,022 +) +Change in ownership +420 +— +192 +Purchase of reserves in place +2,140 +— +68,068 +Sale of reserves in place +— +(42,542 +) +(3,690 +) +Extensions and discoveries +— +105 +1,209 +Production +(5,740 +) +(5,840 +) +(12,340 +) +End of period +19,103 +18,651 +116,454 +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period +4,663 +4,723 +5,159 +End of period +4,346 +4,663 +4,723 +Natural Gas (MMcf): +Beginning of period +13,463 +22,340 +36,750 +End of period +12,301 +13,463 +22,340 +80 +Table of Contents +Standardized Measure +The following tables present the Company’s standardized measure of discounted future net cash flows +and changes therein relating to proved oil and gas reserves, and were computed using reserve +valuations based on regulations prescribed by the SEC. These regulations provide that the oil and +gas price structure utilized to project future net cash flows reflect the average of the preceding +12-month, first of the month product prices (approximately $4.75 per Mcf for natural gas and $57.40 +per Bbl for oil for the 2009 disclosures, $6.36 per Mcf and $36.80 per Bbl for 2008 disclosures, +and $7.59 per Mcf and $90.92 per Bbl for 2007 disclosures) at each date presented with no +escalation. Future production and development costs are based on current costs without escalation. +The resulting net future cash flows have been discounted to their present values based on a 10% +annual discount factor. +Gas production from our deepwater and Permian Basin properties has a high BTU content of separator +gas. The natural gas price $4.75 used in the 2009 reserve estimate reflects estimated revenues +from our natural gas and associated natural gas liquids. +Standardized Measure +Years Ended December 31, +2009 +2008 +2007 +(In thousands) +Future cash inflows +$ +462,607 +$ +340,485 +$ +3,113,759 +Future costs - +Production +(195,735 +) +(192,819 +) +(390,669 +) +Development and net abandonment +(50,170 +) +(34,111 +) +(405,186 +) +Future net inflows before income taxes +216,702 +113,555 +2,317,904 +Future income taxes +(2,809 +) +(565 +) +(699,967 +) +Future net cash flows +213,893 +112,990 +1,617,937 +10% discount factor +(77,972 +) +(26,685 +) +(483,948 +) +Standardized measure of discounted +future net cash flows +$ +135,921 +$ +86,305 +$ +1,133,989 +Changes in Standardized Measure +Years Ended December 31, +2009 +2008 +2007 +( In thousands) +Standardized measure — beginning of period +$ +86,305 +$ +1,133,989 +$ +470,791 +Sales and transfers, net of production costs +(82,674 +) +(122,104 +) +(142,973 +) +Net change +in sales and transfer prices, net of production costs +94,435 +(111,140 +) +411,525 +Net change +due to purchases and sales of in place reserves +45,009 +(558,652 +) +795,595 +Extensions, +discoveries, and improved recovery, net of future production and development costs incurred +— +162,566 +(201,750 +) +Changes in future development cost +6,194 +33,652 +— +Revisions of quantity estimates +39,242 +(786,001 +) +(66,735 +) +Accretion of discount +5,797 +159,147 +53,474 +Net change in income taxes +(2,368 +) +457,483 +(393,530 +) +Changes in production rates, timing and other +(56,019 +) +(282,635 +) +207,592 +Aggregate change +49,616 +(1,047,684 +) +663,198 +Standardized measure — end of period +$ +135,921 +$ +86,305 +$ +1,133,989 +81 +Table of Contents +At year-end 2008, the Company had a reduction in reserves due to the sale to CIECO of a 50% +interest in the Entrada field and the abandonment of the Entrada project. +The Company ended the year 2009 with estimated net proved reserves of 58.0 billion cubic feet of +natural gas equivalent (“Bcfe”). This increase from 2008 year-end estimated net proved reserves of +54.8 Bcfe is primarily due to the ExL acquisition which closed October 28, 2009. +The Company annually reviews its proved undeveloped reserves (“PUDs”) to ensure an appropriate plan +for development exists. Generally, reserves for the Company’s onshore properties are booked as PUDs +only if the Company has plans to convert the PUDs into proved developed reserves within five years +of the date they are first booked as PUDs. Callon had 19.6 Bcfe of PUDs at December 31, 2009, +compared with 13.4 Bcfe of PUDs at December 31, 2008. Of these 2009 PUDs, 7.1 Bcfe and 6.9 Bcfe +were attributable to the Company’s offshore properties in the Medusa and Habanero fields in the +Gulf of Mexico, respectively. Callon plans are to develop these PUDs by side tracking existing +wells when the zones currently being produced by the wells are depleted. The Company’s current +reserve reports forecast that these producing zones in the Habenero field will be depleted in 2014 +and in the Medusa field in 2022, at which time Callon plans to develop the PUDs. The Company did +not convert any offshore PUDs to proved developed in 2009. +During 2009, the Company acquired 711 MBbls and 1.3 Bcf, or 5.6 Bcfe, of PUDs in its ExL +acquisition. Callon’s development plan for these PUDs will begin in 2010 with an anticipated +completion within five years, allowing the PUDs to be converted to PDPs. The remaining 0.6 Bcfe +increase in PUDs from 2008 to 2009 is associated with the Company’s deepwater property, Medusa, and +is a result of including reserves related to the Deepwater Royalty Relief Act. These PUDs were +previously excluded due to prices exceeding the MMS imposed thresholds. As a result of court +decisions, the MMS is no longer enforcing its price thresholds. At year end 2008, the Company had +no PUDs located onshore. See Note 12. +82 +Table of Contents +19. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) +First +Second +Third +Fourth +Quarter +Quarter +Quarter +Quarter +(In thousands, except per share data) +2009 +Total revenues +$ +24,815 +$ +25,025 +$ +21,320 +$ +70,985 +(a) +Income from operations +8,506 +5,731 +5,799 +53,417 +(a) +Net income +(loss) +2,404 +(925 +) +(955 +) +53,895 +(b) +Net income +(loss) per common share-basic +$ +0.11 +$ +(0.04 +) +$ +(0.04 +) +$ +2.31 +Net income +(loss) per common share-diluted +0.11 +(0.04 +) +(0.04 +) +2.27 +First +Second +Third +Fourth +Quarter +Quarter +Quarter +Quarter +(In thousands, except per share data) +2008 +Total revenues +$ +44,960 +$ +48,029 +$ +32,783 +$ +15,540 +Income (loss) from operations +21,069 +24,046 +13,640 +(500,438 +) (c) +Net income (loss) +7,632 +5,153 +5,856 +(457,534 +) (c) +Net income (loss) per common share-basic +$ +0.37 +$ +0.25 +$ +0.27 +$ +(21.19 +) (c) +Net income (loss) per common share-diluted +0.35 +0.23 +0.27 +(21.19 +) (c) +(a) +Includes Medusa royalty recoupment of $43.9 million, net of override, due from the MMS. See +Note 12. +(b) +Includes Medusa royalty recoupment of $43.9 million, net of override, and estimated interest in +the amount of $7.7 million due from the MMS. +(c) +Loss resulting from impairment of oil and gas properties in the amount of $485.5 million and +establishing a full valuation allowance on the tax benefit in the amount +of $128.1 million associated with net operating loss carryforwards as of December 31, +2009. +20. SUBSEQUENT EVENTS +Subsequent to December 31, 2009, the Company completed a $100 million third amended and restated +senior secured credit agreement with Regions Bank as the sole arranger and administrative agent, +which matures on September 25, 2012. The new senior secured credit agreement provides an initial +borrowing base of $20 million, which will be reviewed and re-determined on a semi-annual basis. +See Note 7. +In January 2010, Callon received a royalty refund of $44.8 million from the MMS on the royalties +paid from November 2003 through August 2009 on the Medusa field. See Note 12. +83 +Table of Contents +ITEM +9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +There have been no disagreements with the independent auditors on any matters of accounting +principles or practices, financial statement disclosure, or auditing scope or procedures. +ITEM 9A. CONTROLS AND PROCEDURES +The term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the +Securities Exchange Act of 1934, or the Exchange Act. This term refers to the controls and +procedures of a company that are designed to ensure that information required to be disclosed by a +company in the reports that it files or submits under the Exchange Act is recorded, processed, +summarized and reported within the time periods specified by the Securities and Exchange +Commission. Our management, including our Chief Executive Officer and Chief Financial Officer, has +evaluated the effectiveness of our disclosure controls and procedures as of the end of the period +covered by this annual report. Based upon that evaluation, our Chief Executive Officer and Chief +Financial Officer have concluded that our disclosure controls and procedures were effective as of +the end of the period covered by this annual report. There were no changes to our internal control +over financial reporting during our last fiscal quarter that have materially affected, or are +reasonable likely to materially affect, our internal control over financial reporting. +Management’s Report On Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over +financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the +supervision and with the participation of our management, including our principal executive and +financial officers, we conducted an evaluation of the effectiveness of our internal control over +financial reporting as of December 31, 2009 based on the frame work in the Internal +Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our evaluation under the framework in Internal Control-Integrated Framework, +our management concluded that our internal control over financial reporting was effective as of +December 31, 2009. +Ernst & Young LLP, our independent registered public accounting firm, has issued an attestation +report on the Company’s internal control over financial reporting as of December 31, 2009. +ITEM 9A (T). CONTROLS AND PROCEDURES +See Item 9A. +84 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited Callon Petroleum Company’s internal control over financial reporting as of December +31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the +Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Callon +Petroleum Company’s management is responsible for maintaining effective internal control over +financial reporting and for its assessment of the effectiveness of internal control over financial +reporting included in the accompanying Management’s Report on Internal Control over Financial +Reporting. Our responsibility is to express an opinion on the Company’s internal control over +financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight +Board (United States). Those standards require that we plan and perform the audit to obtain +reasonable assurance about whether effective internal control over financial reporting was +maintained in all material respects. Our audit included obtaining an understanding of internal +control over financial reporting, assessing the risk that a material weakness exists, testing and +evaluating the design and operating effectiveness of internal control based on the assessed risk, +and performing such other procedures as we considered necessary in the circumstances. We believe +that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable +assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A +company’s internal control over financial reporting includes those policies and procedures that (1) +pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the +transactions and dispositions of the assets of the company; (2) provide reasonable assurance that +transactions are recorded as necessary to permit preparation of financial statements in accordance +with generally accepted accounting principles, and that receipts and expenditures of the company +are being made only in accordance with authorizations of management and directors of the company; +and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the +financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or +detect misstatements. Also, projections of any evaluation of effectiveness to future periods are +subject to the risk that controls may become inadequate because of changes in conditions, or that +the degree of compliance with the policies or procedures may deteriorate. +In our opinion, Callon Petroleum Company maintained, in all material respects, effective internal +control over financial reporting as of December 31, 2009, based on the COSO criteria. +85 +Table of Contents +We also have audited, in accordance with the standards of the Public Company Accounting Oversight +Board (United States), the consolidated balance sheets of Callon Petroleum Company as of December +31, +2009 and 2008, and the related consolidated statements of operations, stockholders’ equity and cash +flows for each of the three years in the period ended December 31, 2009 and our report dated March +12, 2010, expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 12, 2010 +86 +Table of Contents +ITEM 9B. OTHER INFORMATION +SUBMISSION OF MATTERS TO A VOTE OF THE SECURITY HOLDERS +The Company held a special meeting of shareholders on December 31, 2009. At the special meeting, +the shareholders had two proposals to consider for vote. +Proposal I — The shareholders approved an amendment to article four of the Company’s certificate +of incorporation increasing the number of authorized shares of common stock of the Company from 30 +million shares to 60 million shares. +Proposal II — The shareholders approved the issuance of common stock upon conversion of +convertible preferred stock. +The votes cast for the amendments proposed in the Company’s definitive proxy statement on Schedule +14A, out of a total of 25,598,743 shares outstanding on the record date for the special meeting was +as follow: +For +Against or Abstained +Proposal I +18,057,317 +2,141,666 +Proposal II +11,948,390 +539,905 +There were broker non-votes of 7,710,688 cast for Proposal I. +We have disclosed all information required to be disclosed in a current report on Form 8-K during +the fourth quarter of the year ended December 31, 2009 in previously filed reports on Form 8-K. +87 +Table of Contents +PART III. +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +For information concerning Item 10, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 4, 2010 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +The Company has adopted a code of ethics that applies to the Company’s chief executive officer, +chief financial officer and chief accounting officer. The full text of such code of ethics has +been posted on the Company’s website at www.callon.com, and is available free of charge in print to +any shareholder who requests it. Request for copies should be addressed to the Secretary at 200 +North Canal Street, Natchez, Mississippi 39120. +ITEM 11. EXECUTIVE COMPENSATION. +For information concerning Item 11, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 4, 2010 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED +STOCKHOLDER MATTERS. +For information concerning the security ownership of certain beneficial owners and management, see +the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of +Stockholders to be held on May 4, 2010 which will be filed with the Securities and Exchange +Commission and is incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 4, 2010 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES. +For information concerning Item 14, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 4, 2010 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. +88 +Table of Contents +PART IV. +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +(a) 1. The following is an index to the financial statements and financial statement schedules +that are filed as part of this Form 10-K on pages 49 through 83. +Report of Independent Registered Public Accounting Firm +Consolidated Balance Sheets as of the Years Ended December 31, 2009 and 2008 +Consolidated Statements of Operations for the Three Years in the Period Ended +December 31, 2009 +Consolidated Statements of Stockholders’ Equity for the Three Years in the Period Ended +December 31, 2009 +Consolidated Statements of Cash Flows for the Three Years in the Period Ended +December 31, 2009 +Notes to Consolidated Financial Statements +(a) 2. Schedules other than those listed above are omitted because they are not required, not +applicable or the required information is included in the financial statements or notes thereto. +(a) 3. Exhibits: +2. +Plan of acquisition, reorganization, arrangement, liquidation or succession* +3. +Articles of Incorporation and Bylaws +3.1 +Certificate of Incorporation of the Company, as amended (incorporated by +reference to Exhibit 3.1 of the Company’s Annual Report on Form 10-K for the year +ended December 31, 2003, File No. 001-14039) +3.2 +Bylaws of the Company (incorporated by reference from Exhibit 3.2 of the +Company’s Registration Statement on Form S-4, filed August 4, 1994, Reg. No. +33-82408) +3.3 +Certificate of Amendment to Certificate of Incorporation of the Company +(incorporated by reference to Exhibit 3.3 of the Company’s Annual Report on Form +10-K for the year ended December 31, 2003, File No. 001-14039) +3.4 +Certificate of Designations, Preferences and Rights of Convertible +Preferred Stock of the Company (incorporated by reference to Appendix A of the +Company’s Definitive Proxy Statement on Schedule 14A, filed December 1, 2009, File +No. 001-14039) +3.5 +Certificate of Correction to the Certificate of Designations, Preferences +and Rights of Convertible Preferred Stock of the Company (incorporated by reference +to Exhibit 3.1 of the Company’s Current Report on Form 8-K, filed January 4, 2010, +File No. 001-14039) +89 +Table of Contents +4. +Instruments defining the rights of security holders, including indentures +4.1 +Specimen Common Stock Certificate (incorporated by reference from Exhibit +4.1 of the Company’s Registration Statement on Form S-4, filed August 4, 1994, Reg. +No. 33-82408) +4.2 +Rights Agreement between Callon Petroleum Company and American Stock +Transfer & Trust Company, Rights Agent, dated March 30, 2000 (incorporated by +reference from Exhibit 99.1 of the Company’s Registration Statement on Form 8-A, +filed April 6, 2000, File No. 001-14039) +4.3 +Form of Warrants dated December 8, 2003 and December 29, 2003 entitling +lenders under the Company’s $185 million amended and restated senior unsecured credit +agreement dated December 23, 2003 to purchase common stock from the Company +(incorporated by reference to Exhibit 4.14 of the Company’s Annual Report on Form +10-K for the year ended December 31, 2003, File No. 001-14039) +4.4 +Indenture for the Company’s 9.75% Senior Notes due 2010, dated March 15, +2004 between Callon Petroleum Company and American Stock Transfer & Trust Company +(incorporated by reference to Exhibit 4.16 of the Company’s Quarterly Report on Form +10-Q for the period ended March 31, 2004, File No. 001-14039) +4.5 +Supplemental Indenture for the Company’s 9.75% Senior Notes due 2010, dated +April 4, 2008 (incorporated by reference to Exhibit 10.1 of the Company’s Current +Report on Form 8-K, filed April 9, 2008, File No. 001-14039) +4.6 +Second Supplemental Indenture for the Company’s 9.75% Senior Notes due +2010, dated November 24, 2009, between Callon Petroleum Company and American Stock +Transfer & Trust Company +4.7 +Indenture for the Company’s 13.00% Senior Notes due 2016, dated November +24, 2009, between Callon Petroleum Company, the subsidiary guarantors described +therein, Regions Bank and American Stock Transfer & Trust +Company (incorporated by reference to Exhibit T3C to the Company’s +Form T-3, filed November 19, 2009, File No. 022-28916) +9. +Voting trust agreement +None +10. +Material contracts +10.1 +Callon Petroleum Company 1994 Stock Incentive Plan (incorporated by +reference from Exhibit 10.5 of the Company’s Registration Statement on Form 8-B, +filed October 3, 1994) +10.2 +Callon Petroleum Company 1996 Stock Incentive Plan as amended on May 9, 2000 +(incorporated by reference from Appendix I of the Company’s Definitive Proxy Statement +on Schedule 14A, filed March 28, 2000, File No. 001-14039) +10.3 +Callon Petroleum Company 2002 Stock Incentive Plan (incorporated by reference +to Exhibit 10.13 of the Company’s Annual Report on Form 10-K for the year ended +December 31, 2001, File No. 001-14039) +90 +Table of Contents +10.4 +Medusa Spar Agreement dated as of August 8, 2003, among Callon Petroleum +Operating Company, Murphy Exploration & Production Company-USA and Oceaneering +International, +Inc. (incorporated by reference to Exhibit 10.19 of the Company’s Annual Report on +Form 10-K for the year ended December 31, 2003, File No. 001-14039) +10.5 +Purchase and Sale Agreement between Callon Petroleum Company and Callon +Petroleum Operating Company as Seller, and Indigo Minerals LLC, as Buyer (incorporated +by reference from Exhibit 2.1 of the Company’s Current Report on Form 8-K, filed +December 13, 2007, File No. 001-14039) +10.6 +Purchase and Sale Agreement by and between Callon Petroleum Operating Company +and CIECO Energy (US) Limited (incorporated by reference from Exhibit 1.1 of the +Company’s Current Report on Form 8-K, filed February 13, 2008, File No. 001-14039) +10.7 +Credit Agreement between Callon Entrada and CIECO Energy (Entrada) LLC dated +April 4, 2008 (incorporated by reference to Exhibit 10.3 of the Company’s Current +Report on Form 8-K, filed April 9, 2008, File No. 001-14039) +10.8 +Indemnity Agreement dated April 4, 2008 (incorporated by reference to Exhibit +10.4 of the Company’s Current Report on Form 8-K, filed April 9, 2008, File No. +001-14039) +10.9 +Non-Recourse Guaranty dated April 4, 2008 (incorporated by reference to +Exhibit 10.5 of the Company’s Current Report on Form 8-K, filed April 9, 2008, File +No. 001-14039) +10.10 +Severance Compensation Agreement dated April 18, 2008 by and between Fred L. +Callon and Callon Petroleum Company (incorporated by reference to Exhibit 10.1 of the +Company’s Current Report on Form 8-K, filed April 23, 2008, File No. 001-14039) +10.11 +Form of Severance Compensation Agreement dated April 18, 2008 by and between +Callon Petroleum Company and its executive officers (incorporated by reference to +Exhibit 10.2 of the Company’s Current Report on Form 8-K, filed April 23, 2008, File +No. 001-14039) +10.12 +Second Amended and Restated Credit Agreement dated as of September 25, 2008, +by and among Callon Petroleum Company, the “Lenders” described therein, Regions Bank, +as Syndication Agent, Capital One, N.A., as Documentation Agent, and Union Bank of +California, N.A., as Administrative Agent (incorporated by reference to Exhibit 10.1 +of the Company’s Current Report on Form 8-K, filed October 1, 2008, File No. +001-14039) +10.13 +Amendment No. 1 to Severance Compensation Agreement executed on December 31, +2008 by and between Fred L. Callon and Callon Petroleum Company (incorporated by +reference from Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed January +5, 2009, File No. 001-14039) +10.14 +Form of Amendment No. 1 to Severance Compensation Agreement by and between +Callon Petroleum Company and its executive officers (incorporated by reference from +Exhibit 10.2 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File +No. 001-14039) +10.15 +Amendment No. 3 to the Callon Petroleum Company 1996 Stock Incentive Plan +(incorporated by reference from Exhibit 10.1 of the Company’s Current Report on Form +8-K, filed January 5, 2009, File No. 001-14039) +91 +Table of Contents +10.16 +Amendment No. 1 to the Callon Petroleum Company 2002 Stock Incentive Plan +(incorporated by reference from Exhibit 10.2 of the Company’s Current Report on Form +8-K, filed January 5, 2009, File No. 001-14039) +10.17 +Callon Petroleum Company Amended and Restated 2006 Stock Incentive Plan +(incorporated by reference from Exhibit 10.3 of the Company’s Current Report on Form +8-K, filed January 5, 2009, File No. 001-14039) +10.18 +Amendment No. 1 dated as of March 19, 2009 to the Second Amended and Restated +Credit Agreement dated September 25, 2008, among Callon Petroleum Company, the +“Lenders” described therein and Union Bank of California, N.A., as Administrative +Agent and as Issuing Lender (incorporated by reference from Exhibit 10.25 to the +Company’s Annual Report on Form 10-K for the year ended December 31, 2008, File No. +001-14039) +10.19 +Callon Petroleum Company 2009 Stock Incentive Plan effective as of April 30, +2009 (incorporated by reference from Exhibit A to the Company’s Definitive Proxy +Statement on Schedule 14A, filed March 30, 2009, File No. 001-14039) +10.20 +Callon Petroleum Company Nonqualified Stock Option Award Agreement, dated +June 1, 2009, between Callon Petroleum Company and Steven B. Hinchman (incorporated by +reference from Exhibit 10.1 of the Company’s Quarterly Report on Form 10-Q for the +period ended June 30, 2009, File No. 001-14039) +10.21 +Callon Petroleum Company Performance Share Award Agreement, dated June 1, +2009, between Callon Petroleum Company and Steven B. Hinchman (incorporated by +reference from Exhibit 10.2 of the Company’s Quarterly Report on Form 10-Q for the +period ended June 30, 2009, File No. 001-14039) +10.22 +Amendment to the Callon Petroleum Company 1996 Stock Incentive Plan effective +as of August 7, 2009 (incorporated by reference from Exhibit 10.1 of the Company’s +Quarterly Report on Form 10-Q for the period ended September 30, 2009, File No. +001-14039) +10.23 +Purchase and Sale Agreement by and between Callon Petroleum Operating Company +and Ambrose Energy I, Ltd. dated September 9, 2009 (incorporated by reference to +Exhibit 2.1 of the Company’s Current Report on Form 8-K, filed September 11, 2009, +File No. 001-14039) +10.24 +Amendment No. 3 and Agreement dated as of October 16, 2009 to the Second +Amended and Restated Credit Agreement dated September 25, 2008, among Callon Petroleum +Company, the “Lenders” described therein, and Union Bank, N.A., as Administrative +Agent and as Issuing Lender (incorporated by reference to Exhibit 2.1 of the Company’s +Current Report on Form 8-K, filed October 22, 2010, File No. 001-14039) +10.25 +Third Amended and Restated Credit Agreement dated January 29, 2010, by and +among Callon Petroleum Company, the “Lenders” described therein, Regions Bank, as +Administrative Agent, Documentation Agent and Syndication Agent (incorporated by +reference from Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed +February 3, 2010, File No. 001-14039) +11. +Statement re computation of per share earnings* +12. +Statements re computation of ratios* +92 +Table of Contents +13. +Annual Report to security holders, Form 10-Q or quarterly reports* +14. +Code of Ethics +14.1 +Code of Ethics for Chief Executive Officers and Senior Financial Officers +(incorporated by +reference to Exhibit 14.1 of the Company’s Annual Report on Form 10-K +for the year ended December 31, 2003, File No. 001-14039) +16. +Letter re change in certifying accountant* +18. +Letter re change in accounting principles* +21. +Subsidiaries of the Company +21.1 +Subsidiaries of the Company (incorporated by reference from Exhibit 21.1 of +the Company’s Registration Statement on Form 8-B filed October 3, 1994) +22. +Published report regarding matters submitted to vote of security holders* +23. +Consents of experts and counsel +23.1 +Consent of Ernst & Young LLP +23.3 +Consent of Huddleston & Co., Inc. +24. +Power of attorney* +31. +Rule 13a-14(a) Certifications +31.1 +Certification of Chief Executive Officer pursuant to Rule 13(a)-14(a) +31.2 +Certification of Chief Financial Officer pursuant to Rule 13(a)-14(a) +32. +Section 1350 Certifications +32.1 +Certification of Chief Executive Officer pursuant to Rule 13(a)-14(b) +32.2 +Certification of Chief Financial Officer pursuant to Rule 13(a)-14(b) +99. +Additional Exhibits +99.1 +Reserve Report Summary prepared by Huddleston and Co. as of December 31, 2009. +* +Inapplicable to this filing. +93 +Table of Contents +SIGNATURES +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed +below by the following persons on behalf of the registrant and in the capacities and on the dates +indicated. +CALLON PETROLEUM COMPANY +Date: March 12, 2010 +/s/ Fred L. Callon +Fred L. Callon (principal executive officer, director) +Date: March 12, 2010 +/s/ B. F. Weatherly +B. F. Weatherly (principal financial officer, director) +Date: March 12, 2010 +/s/ Rodger W. Smith +Rodger W. Smith (principal accounting officer) +Date: March 12, 2010 +/s/ L. Richard Flury +Richard Flury (director) +Date: March 12, 2010 +/s/ John C. Wallace +John C. Wallace (director) +Date: March 12, 2010 +/s/ Richard O. Wilson +Richard O. Wilson (director) +Date: March 12, 2010 +/s/ Larry D. McVay +Larry McVay (director) +94 +Table of Contents +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the +registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto +duly authorized. +CALLON PETROLEUM COMPANY +Date: March 12, 2010 +By: +/s/ B. F. Weatherly +B. F. Weatherly, Executive Vice-President and +Chief Financial Officer +95 \ No newline at end of file diff --git a/raw/filings/0000928022/2009/0000950123-10-024025/filing_metadata.csv b/raw/filings/0000928022/2009/0000950123-10-024025/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..cd8e5567797d452527c676709fcbdd6f93036d84 --- /dev/null +++ b/raw/filings/0000928022/2009/0000950123-10-024025/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000928022,CPE,Callon Petroleum Co,10-K,2010-03-12,2009-12-31,2010-03-12T18:55:01.000Z,0000950123-10-024025,h71486e10vk.htm,FORM 10-K,1010980,0,0,https://www.sec.gov/Archives/edgar/data/928022/000095012310024025/h71486e10vk.htm,https://www.sec.gov/Archives/edgar/data/928022/000095012310024025/,2009,2009,1 diff --git a/raw/filings/0000928022/2009/0000950123-10-024025/item1.txt b/raw/filings/0000928022/2009/0000950123-10-024025/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..40ae593a139dc4e68e7e94ea5beeb114b90a435f --- /dev/null +++ b/raw/filings/0000928022/2009/0000950123-10-024025/item1.txt @@ -0,0 +1,996 @@ +ITEM 1 and 2. BUSINESS and PROPERTIES +Overview +Callon Petroleum Company was incorporated under the laws of the state of Delaware in 1994 and +succeeded to the business of a publicly traded limited partnership, a joint venture with a +consortium of European investors and an independent energy company partially owned by a member of +current management. As used herein, the “Company,” “Callon,” “we,” “us,” and “our” refer to Callon +Petroleum Company and its predecessors and subsidiaries unless the context requires otherwise. +Prior to 2009, our operations were focused on exploration and production in the Gulf of Mexico. +Following the abandonment of our Entrada project in 2008, we took steps to change our operational +focus to lower risk, onshore exploration and development activities. During 2009, we took the +following actions: +• +We exchanged a new series of senior notes due 2016 and common stock for a substantial +portion of our existing $200 million of senior notes due 2010, and reduced principal from +$200 million to $154 million. +• +We filed for recoupment of deepwater royalty payments, and received a payment from the +Minerals Management Service (“MMS”) of $44.8 million in January 2010. We expect to receive +an additional payment from the MMS of approximately $7.7 million during 2010, representing +interest. +• +We began negotiating a new $100 million revolving credit facility, with a borrowing base +of $20 million, which we finalized in January 2010. +These activities were undertaken to allow us to shift our operational focus from the offshore Gulf +of Mexico to longer life, lower risk onshore properties. As part of this strategy, we employed +Steven B. Hinchman as our Chief Operating Officer. Mr. Hinchman has substantial experience in +onshore oil and gas acquisition, exploration and development activities. During 2009, we closed +two acquisitions as part of this new focus, including: +• +In September 2009, we acquired a 70% working interest in a 577-acre unit in the heart of +the Haynesville Shale play in Bossier Parish, Louisiana for $3.0 million. We plan to +drill a total of seven horizontal wells on this property, with the first two wells to be +drilled in 2010. We will be the operator of these wells. +• +On October 28, 2009, we acquired interests in properties producing from the Wolfberry +formation in Crockett, Ector, Midland and Upton Counties, Texas for total cash +consideration of $16.0 million. The acquisition included year-end proved reserves of 1.6 +million barrels of oil equivalent (“MMBoe”) 22 existing wells producing 350 barrels of oil +equivalent (“Boe”) per day and upside from a multi-year inventory of drilling +opportunities. We will operate substantially all of the production and development of +these properties. See Note 13 to our Consolidated Financial Statements. +3 +Table of Contents +Our Business Strategy +Our strategy for 2010 and going forward will be, +• +To increase reserves and production levels by using cash flows from, or monetization of, +our Gulf of Mexico properties to acquire and develop lower risk, longer life onshore oil +and gas properties; +• +To increase our reserve life by focusing on acquisition of long-life onshore properties; +• +To diversify risk by substantially increasing the number of wells we own; and +• +To strengthen our balance sheet by focusing on a reduction of our average debt per +thousand cubic feet of natural gas equivalent (“Mcfe”) of proved reserves. +Exploration and Development Activities +In 2009, capital expenditures on an accrual basis for exploration and development costs related to +oil and gas properties totaled approximately $40 million. These expenditures included: +• +$19 million for on-shore property acquisitions; +• +$2 million for development costs in the Gulf of Mexico and onshore south Louisiana; +• +$6 million for plugging and abandonment costs in the Gulf of Mexico; and +• +$3 million for capitalized interest and $10 million for capitalized general and +administration costs allocable directly to exploration and development projects. +Acquisitions and Divestitures +In September 2009, we acquired a 70% operating interest in a 577-acre Haynesville Shale Unit in +Bossier Parish, Louisiana at a cost of $3.0 million. The Unit is in the core of the play offset by +wells having demonstrated initial production rates of 20 million cubic feet of natural gas (“MMcf”) +per day. We plan to drill and complete two of seven horizontal wells in 2010. We estimate that the +typical well in this field will have gross recoverable reserves of 6.4 billion cubic feet of +natural gas (“Bcf”) per well and cost approximately $9.0 million to drill and complete. Callon +will be the operator of this project. +On October 28, 2009, we completed the acquisition of proved oil and gas property interests in +Wolfberry play located in Crockett, Ector, Midland and Upton Counties, Texas from Ambrose Energy I, +Ltd., a subsidiary of ExL Petroleum, LP for a total cash consideration of $16.0 million. The +acquisition was funded by our senior secured credit facility in the amount of $10 million, and the +remaining $6.0 million with cash on hand. The acquisition included year-end proved reserves of 1.6 +MMBoe, 22 existing wells producing 350 Boe per day and upside from a multi-year inventory of +drilling and recompletion opportunities. We will operate substantially all of the production and +development. We accounted for the acquisition in accordance with the amended guidance issued by the +Financial Accounting Standards Board (“FASB”) for business combinations which was adopted on +January 1, 2009, and recorded acquisition expenses in the fourth quarter of 2009 of $298,000. See +Note 13 to our Consolidated Financial Statements. +Oil and Gas Properties Summary +Overview. As of December 31, 2009, our estimated net proved reserves totaled 58.0 billion cubic +feet of natural gas equivalent (“Bcfe”) and included 6.5 million barrels of oil (“MMBbls”) and 19.1 +Bcf, with a pre-tax present value of $137.4 million. Pre-tax present value may be deemed to be a +non-U.S. generally accepted accounting principle (“US GAAP”) financial measure, which we reconcile +to standardized measure, the US GAAP measure, in the table below. Oil constitutes approximately +67% on an equivalent basis of our total estimated net proved reserves, and approximately 66% of our +total estimated proved reserves are proved developed reserves. +4 +Table of Contents +The following table sets forth certain information about our estimated proved reserves by our +independent petroleum reserve engineers by major field and for all other properties combined at +December 31, 2009. +Pre-tax +Discounted +Estimated Net Proved Reserves +Present +Oil +Gas +Total +Value +Operator +(MBbls) +(MMcf) +(MMcfe) +($000) +(a)(b)(c) +Gulf of Mexico Deepwater: +Mississippi Canyon 538/582 +“Medusa” +Murphy +4,412 +3,268 +29,740 +$ +89,795 +Garden Banks Block 341 +“Habanero” +Shell +725 +4,729 +9,077 +25,084 +Gulf of Mexico Shelf and Onshore: +West Cameron Block 295 +Mariner Energy +12 +1,724 +1,798 +3,402 +East Cameron Block 109 +Energy Partners LTD +18 +1,224 +1,332 +4,193 +Permian Basin +Callon +1,242 +2,117 +9,571 +17,873 +Other +Various +70 +6,041 +6,457 +(2,979 +) +Total Net Proved Reserves +6,479 +19,103 +57,975 +$ +137,368 +(a) +Represents the present value of future net cash flows before deduction of federal income +taxes, discounted at 10%, attributable to estimated net proved reserves as of December 31, +2009, as set forth in the Company’s reserve reports prepared by its independent petroleum +reserve engineers, Huddleston & Co., Inc. +(b) +Includes a reduction for estimated plugging and abandonment costs that is reflected as a +liability on our balance sheet at December 31, 2009, in accordance with accounting for asset +retirement obligations rules. See the Oil and Gas Reserve table for the standardized measure +of discounted future net cash flow in Note 18 of our consolidated financial statements. The +negative Pre-Tax Present Value of the Gulf of Mexico Shelf and Onshore Other reflects plugging +and abandonment obligations, of which most are estimated to occur within the next five years, +exceeding the future net cash flows. +(c) +We use the financial measure “Pre Tax Present Value” which is a non-US GAAP financial +measure. We believe that Pre Tax Present Value, while not a financial measure in accordance +with US GAAP, is an important financial measure used by investors and independent oil and gas +producers for evaluating the relative value of oil and natural gas properties and acquisitions +because the tax characteristics of comparable companies can differ materially. The total +standardized measure for our proved reserves as of December 31, 2009 was $135.9 million. The +standardized measure gives effect to income taxes, and is calculated in accordance with the +guidance issued by the FASB for disclosures about oil and gas producing activities.” The +$135.9 million of standardized measure of our estimated net proved reserves equals the present +value of our estimated future net revenue from proved reserves of $137.4 million, which +excludes the discounted estimated future income taxes relating to such future net revenues of +$1.5 million. +5 +Table of Contents +Onshore Oil and Gas Properties +Permian Basin +During the fourth quarter of 2009, we acquired 22 producing wells with associated proved reserves +of 1.6 MMBoe. Our primary target in the Permian Basin is the Wolfberry trend, which is a proven, +low-permeability oil play. The Wolfberry interval includes the Sprayberry, Dean, and Wolfcamp +formations. We have identified 148 drilling locations based on a 40-acre spacing development. We +commenced drilling in February 2010 and plan to drill up to 16 Wolfberry wells in 2010. +Haynesville Shale +In addition to the significant properties discussed above, we acquired a 70% working interest in a +Haynesville Shale unit located in Southern Bossier Parish, Louisiana in September 2009. We plan to +drill two horizontal wells in 2010. +Gulf of Mexico Deepwater +Medusa, Mississippi Canyon Blocks 538/582 +Our Medusa deepwater discovery was announced in September 1999, after we drilled the initial test +well in 2,235 feet of water to a total depth of 16,241 feet and encountered over 120 feet of pay in +two intervals. Subsequent sidetrack drilling from the wellbore was used to determine the extent of +the discovery, and a second well was drilled in the first quarter of 2000 to further delineate the +extent of the pay intervals. In 2001, a drilling program began which included four development +wells and one sidetrack. The program included production casing being set on six wells to provide +initial production take-points and was completed in the first half of 2002. The construction of a +floating production system, spar, at Medusa was completed during the second quarter of 2003. The +A-1 well was completed and tied into the spar and commenced production in late November 2003. The +remaining five wells were completed and commenced production in 2004. We have participated in +additional development of the Medusa field which includes the drilling and completion of two +additional wells, Mississippi Canyon 538 #4, North Medusa, and Mississippi Canyon 538 #5. We own a +15% working interest. Murphy Exploration & Production Company (“Murphy”), the operator, owns a 60% +working interest and ENI Deepwater, LLC, owns the remaining 25% working interest. +During 2009 the field produced 4.5 Bcfe net to us from eight wells which accounted for 38% of our +total production. Inception to date as of December 31, 2009, the Medusa Field had produced 43 +Bcfe, net to us. Most of the wells are still producing from their initial completion and have +14.2 Bcfe of proved developed non-producing reserves that will be accessed by recompletions in the +existing wells. Another 7.1 Bcfe of proved undeveloped reserves will be developed by side tracking +an existing well. These operations will occur as existing completions reach their economic limit +which is estimated as of December 31, 2009 to be in 2022. +In December 2003, we transferred our undivided 15% working interest in the spar production +facilities to Medusa Spar LLC (“LLC”) in exchange for cash proceeds of approximately $25 million +and a 10% ownership interest in the LLC. A detailed discussion of this transaction is included in +“Management’s Discussion and Analysis of Financial Condition and Results of Operations-Off-Balance +Sheet Arrangements.” +Habanero, Garden Banks Block 341 +During February 1999, the initial test well on our Habanero deepwater discovery encountered over +200 feet of net pay in two zones. Located in 2,015 feet of water, the well was drilled to a +measured depth of 21,158 feet. A field delineation program began in mid-year 2001, which included +three sidetracks of the discovery well. Production casing was set on this well through the last of +the sidetracks to the Habanero 52 oil and gas +6 +Table of Contents +sand and the Habanero 55 gas sand. Also, a development well was drilled in the summer of 2003 +which provides a take-point for production from the Habanero 52 oil sand. By means of a sub-sea +completion and tie-back to an existing production facility in the area operated by Shell, +production from the Habanero 52 oil sand commenced in late November 2003 and from the Habanero 55 +gas sand in January 2004. We own an 11.25% working interest in the well. The well is operated by +Shell Deepwater Development Inc., which owns a 55% working interest, with the remaining working +interest owned by Murphy. +During 2009, Habanero produced 2.2 Bcfe net to us from two wells which accounted for 19% of our +total production. Future plans include sidetracks of both the wells to drain updip and partially +fault-separated gas in the Habanero 52 sand when the existing completions reach their economic +limit, which is estimated as of December 31, 2009 to be in 2014. +Gulf of Mexico Shelf and Onshore Louisiana +We own interests in 18 wells in 12 oil and gas fields in the shelf area of the Gulf of Mexico. +These wells produced 5.0 Bcfe net to our interest in 2009. +Proved Reserves +In December 2008 the Securities and Exchange Commission (“SEC”) approved amendments to its oil and +gas reserves estimation and disclosure requirements. The amendments, among other things: +• +allow the use of reliable technologies to estimate proved reserves if those technologies +have been demonstrated to result in reliable conclusions about reserve volumes; +• +require disclosure of oil and gas proved reserves by significant geographic area; +• +permit the optional disclosure of probable and possible reserves; +• +modify the prices used to estimate reserves for SEC disclosure purposes to a 12-month +average beginning-of-the-month price instead of a period-end price; and +• +require that if a third party is primarily responsible for preparing or auditing the +reserve estimates, the company make disclosures relating to the independence and +qualifications of the third party, including filing as an exhibit any report received from +the third party. +The new requirements are effective for our year-end financial statements and our Annual Report on +Form 10-K for the year ended December 31, 2009, and as such the reserves and related information +for 2009 are presented consistent with the requirements of the new rule. The new rule does not +require prior-year reserve information to be restated, so all information related to periods prior +to 2009 is presented consistent with the prior SEC rules for the estimation of proved reserves. +Estimates of volumes of proved reserves, net to our interest, at year end are presented in Mmcf at +a pressure base of 15.025 pounds per square inch for natural gas and in MBbls for oil. Total +volumes are presented in million cubic feet of natural gas equivalent (“MMcfe”). For the +computation, one barrel is the equivalent of 6,000 cubic feet of gas. +7 +Table of Contents +The following table sets forth certain information about our estimated proved reserves. All of our +proved reserves are located in the United States. +Years Ended December 31, +2009 +2008 +2007 +Proved developed: +Oil (MBbls) +4,346 +4,663 +4,723 +Gas (MMcf) +12,301 +13,463 +22,340 +MMcfe +38,377 +41,441 +50,676 +Proved undeveloped: +Oil (MBbls) (c) +2,133 +1,364 +19,808 +Gas (MMcf) (c) +6,802 +5,189 +94,114 +MMcfe (c) +19,600 +13,375 +212,964 +Total proved: +Oil (MBbls) (c) +6,479 +6,027 +24,531 +Gas (MMcf) (c) +19,103 +18,652 +116,454 +MMcfe (c) +57,977 +54,816 +263,640 +Estimated pre-tax future net cash flows (a) +$ +216,702 +$ +113,555 +$ +2,317,905 +Pre-tax discounted present value (a) (b) +$ +137,368 +$ +86,591 +$ +1,591,472 +Standardized measure of discounted future +net cash flows(a) (b) +$ +135,921 +$ +86,305 +$ +1,133,989 +(a) +Includes a reduction for estimated plugging and abandonment costs that is reflected as +a liability on our balance sheet at December 31, 2009, in accordance with accounting for +asset retirement obligations rule. +(b) +We use the financial measure “Pre Tax Present Value” which is a non-US GAAP financial +measure. We believe that Pre Tax Present Value, while not a financial measure in +accordance with US GAAP, is an important financial measure used by investors and +independent oil and gas producers for evaluating the relative value of oil and natural gas +properties and acquisitions because the tax characteristics of comparable companies can +differ materially. The total standardized measure for our proved reserves as of December +31, 2009 was $135.9 million. The standardized measure gives effect to income taxes, and is +calculated in accordance with guidance issued by the FASB for disclosures about oil and gas +producing activities. The $135.9 million of standardized measure of our estimated net +proved reserves equals the present value of our estimated future net revenue from proved +reserves of $137.4 million, which excludes the discounted estimated future income taxes +relating to such future net revenues of $1.5 million. Year-end average pricing was $4.75 +per Mcf for natural gas and $57.40 per Bbl for oil. +(c) +The reduction in 2008 reserves as compared to 2007 year-end proved reserves of 263.6 +Bcfe was primarily associated with the sale of a 50% working interest in the Entrada Field +and the abandonment of the Entrada project. See Note 3 to our consolidated financial +statements. +8 +Table of Contents +Our estimates of proved reserves, proved developed reserves (“PDPs”), proved undeveloped reserves +(“PUDs”) at December 31, 2009, 2008 and 2007 and changes in proved reserves during the last three +years are included in Note 18 of our Consolidated Financial Statements. Also included in Note 18 +are our estimates of future net cash flows and discounted future net cash flows from proved +reserves. +Proved Undeveloped Reserves. We annually review our PUDs to ensure an appropriate plan exists for +development. Generally, reserves for our onshore properties are booked as PUDs only if we have +plans to convert the PUDs into PDPs within five years of the date they are first booked as PUDs. +We had 19.6 Bcfe of PUDs at December 31, 2009, compared with 13.4 Bcfe of PUDs at December 31, +2008. Of these 2009 PUDs, 7.1 Bcfe and 6.9 Bcfe were attributable to our offshore properties in +the Medusa and Habanero fields in the Gulf of Mexico, respectively. Our plans are to develop these +PUDs by side tracking existing wells when the zones currently being produced by the wells are +depleted. Our current reserve reports forecast that these producing zones in the Habenero field +will be depleted in 2014 and in the Medusa field in 2022, at which time we plan to develop the +PUDs. We did not convert any offshore PUDs to PDPs in 2009. +During 2009, we acquired 711 MBbls and 1.3 Bcf, or 5.6 Bcfe, of PUDs in our ExL acquisition. Our +development plan for these PUDs will begin in 2010 and are anticipated to be completed within five +years allowing the PUDs to be converted to PDPs. The remaining 0.6 Bcfe increase in PUDs from 2008 +to 2009 is associated with our deepwater property, Medusa, and is a result of including reserves +related to the Deepwater Royalty Relief Act. These PUDs were previously excluded due to prices +exceeding the MMS imposed thresholds. As a result of the court decisions, the MMS is no longer +enforcing its price thresholds. At year end 2008, we had no PUDs located onshore. See Note 12 to +our Consolidated Financial Statements. +Controls Over Reserve Estimates. Our policies and practices regarding internal controls over the +recording of reserves are structured to objectively and accurately estimate our oil and gas +reserves quantities and present values in compliance with the SEC’s regulations and US GAAP. +Compliance in reserves bookings is the responsibility of our Executive Vice President and Chief +Operating Officer, who is our principal engineer. Our principal engineer has over 30 years of +experience in the oil and gas industry, including over 25 years as a manager. Further professional +qualifications include a degree in petroleum engineering and asset evaluation and management. In +addition, the principal engineer is an over 30-year member of the Society of Petroleum Engineers. +Our controls over reserve estimates included retaining Huddleston & Co. as our independent +petroleum and geological firm. We provided information about our oil and gas properties, +including production profiles, prices and costs, to Huddleston and they prepare their own estimates +of the reserves attributable to our properties. All of the information regarding reserves in this +annual report is derived from the report of Huddleston. The report of Huddleston is included as an +Exhibit to this annual report. The principal engineer at Huddleston who is responsible for +preparing our reserve estimates has over 29 years of experience in the oil and gas industry and is +a Texas Licensed Professional Engineer. Further professional qualifications include a degree in +petroleum engineering as well as being a member of the Society of Petroleum Engineers. The +Huddleston & Co., Inc. engineer firm is a Texas Registered Engineering Firm. +The Audit Committee of our Board of Directors meets with management, including the Chief Operating +Officer to discuss matters and policies including those related to reserves. +There are numerous uncertainties inherent in estimating quantities of proved reserves, including +many factors beyond our control or the control of the reserve engineers. Reserve engineering is a +subjective process of estimating underground accumulations of oil and gas that cannot be measured +in an exact manner. The accuracy of any reserve or cash flow estimate is a function of the quality +of available data and of engineering and geological interpretation and judgment. Estimates by +different engineers often vary, sometimes significantly. In addition, physical factors, such as +the results of drilling, testing and production subsequent to the date of an +9 +Table of Contents +estimate, as well as economic factors, such as an increase or decrease in product prices that +renders production of such reserves more or less economic, may justify revision of such estimates. +Accordingly, reserve estimates could be different from the quantities of oil and gas that are +ultimately recovered. +During our last fiscal year, we have not filed any reports with other federal agencies which +contain an estimate of total proved net oil and gas reserves. +Production Volumes, Average Sales Prices and Average Production Costs +The following table sets forth certain information regarding the production volumes and average +sales prices received for and average production costs associated with the Company’s sale of oil +and natural gas for the periods indicated. +Year ended December 31, +2009 +2008 +2007 +(In thousands, except per unit data) +Production +Natural gas (Mcf) +5,740 +5,839 +12,340 +Oil (MBbl) +1,012 +942 +1,063 +Total (MMcfe) +11,809 +11,494 +18,718 +Revenues +Natural gas sales +$ +27,417 +$ +58,349 +$ +98,877 +Oil sales +73,842 +82,963 +71,891 +Total revenues +$ +101,259 +$ +141,312 +$ +170,768 +Lease Operating Expenses +Production costs +$ +16,778 +$ +17,604 +$ +24,254 +Severance/production taxes +528 +626 +1,378 +Gathering +1,141 +977 +2,162 +Total lease operating expenses +$ +18,447 +$ +19,208 +$ +27,795 +Realized prices +Natural gas ($/Mcf, including realized gains +(losses) on derivatives) +$ +4.78 +$ +9.99 +$ +8.01 +Natural gas ($/Mcf, excluding realized gains +(losses) on derivatives) +$ +4.45 +$ +10.10 +$ +7.40 +Oil ($/Bbl, including realized gains (losses) on +derivatives) +$ +73.00 +$ +88.07 +$ +67.63 +Oil ($/Bbl, excluding realized gains (losses) on +derivatives) +$ +55.84 +$ +97.37 +$ +67.10 +Operating costs per Mcfe — Total Consolidated +Production costs +$ +1.42 +$ +1.53 +$ +1.30 +Severance/production taxes +$ +0.04 +$ +0.05 +$ +0.07 +Gathering +$ +0.10 +$ +0.09 +$ +0.12 +DD&A +$ +2.83 +$ +5.57 +$ +3.89 +Interest +$ +1.62 +$ +2.09 +$ +1.83 +Total operating costs per Mcfe +$ +6.01 +$ +9.33 +$ +7.21 +10 +Table of Contents +Present Activities and Productive Wells +The following table sets forth the wells we have drilled and completed during the periods +indicated. All such wells were drilled in the continental United States primarily in federal and +state waters in the Gulf of Mexico. +Years Ended December 31, +2009 +2008 +2007 +Gross +Net +Gross +Net +Gross +Net +Development: +Oil +— +— +1 +0.15 +1 +0.25 +Gas +— +— +— +— +1 +0.12 +Non-productive +— +— +1 +0.50 +— +— +Total +— +— +2 +0.65 +2 +0.37 +Exploration: +Oil +— +— +— +— +— +— +Gas +— +— +— +— +2 +0.63 +Non-productive +— +— +2 +0.22 +3 +0.47 +Total +— +— +2 +0.22 +5 +1.10 +At December 31, 2009 we were not involved in the drilling of any wells. +The following table sets forth our productive wells as of December 31, 2009: +Wells +Gross +Net +Oil: +Working interest +32.00 +19.35 +Royalty interest +— +— +Total +32.00 +19.35 +Gas: +Working interest +19.00 +5.89 +Royalty interest +5.00 +0.13 +Total +24.00 +6.03 +A well is categorized as an oil well or a natural gas well based upon the ratio of oil to gas +reserves on a Mcfe basis. However, some of our wells produce both oil and gas. At December 31, +2009, we had no wells with multiple completions. +11 +Table of Contents +Leasehold Acreage +The following table shows our approximate developed and undeveloped (gross and net) leasehold +acreage as of December 31, 2009. +Leasehold Acreage +Developed +Undeveloped +Location +Gross +Net +Gross +Net +Louisiana +4,320 +1,964 +1,522 +973 +Texas +4,800 +3,167 +19,059 +9,136 +Federal waters +53,210 +18,387 +157,914 +99,841 +Total +62,330 +23,518 +178,495 +109,950 +Major Customers +Our production is sold generally on month-to-month contracts at prevailing prices. The following +table identifies customers to whom we sold a significant percentage of our total oil and gas +production during each of the 12-month periods ended: +December 31, +2009 +2008 +2007 +Shell Trading Company +45 +% +33 +% +25 +% +Plains Marketing, L.P. +23 +% +23 +% +10 +% +Louis Dreyfus Energy Services +15 +% +16 +% +20 +% +StatoilHydro +— +— +13 +% +Because alternative purchasers of oil and gas are readily available, we believe that the loss of +any of these purchasers would not result in a material adverse effect on our ability to market +future oil and gas production. +Title to Properties +We believe that the title to our oil and gas properties is good and defensible in accordance with +standards generally accepted in the oil and gas industry, subject to such exceptions which, in our +opinion, are not so material as to detract substantially from the use or value of such properties. +Our properties are typically subject, in one degree or another, to one or more of the following: +• +royalties and other burdens and obligations, express or implied, under oil and gas +leases; +• +overriding royalties and other burdens created by us or our predecessors in title; +• +a variety of contractual obligations (including, in some cases, development obligations) +arising under operating agreements, farmout agreements, production sales contracts and +other agreements that may affect the properties or their titles; +• +back-ins and reversionary interests existing under purchase agreements and leasehold +assignments; +• +liens that arise in the normal course of operations, such as those for unpaid taxes, +statutory liens securing obligations to unpaid suppliers and contractors and contractual +liens under operating agreements; +• +pooling, unitization and communitization agreements, declarations and orders; and +• +easements, restrictions, rights-of-way and other matters that commonly affect property. +12 +Table of Contents +To the extent that such burdens and obligations affect our rights to production revenues, they have +been taken into account in calculating our net revenue interests and in estimating the size and +value of our reserves. We believe that the burdens and obligations affecting our properties are +conventional in the industry for properties of the kind owned by us. +Corporate Offices +Our headquarters are located in Natchez, Mississippi, in approximately 51,500 square feet of owned +space. We also maintain a leased business office in Houston, Texas, and own or lease field offices +in the area of the major fields in which we operate properties or have a significant interest. +Replacement of any of our leased offices would not result in material expenditures by us as +alternative locations to our leased space are anticipated to be readily available . +Employees +We had 72 employees as of December 31, 2009, none of whom are currently represented by a union. We +believe that we have good relations with our employees. We employ seven petroleum engineers and +four petroleum geoscientists. +Regulations +General . The oil and gas industry is subject to regulation at the federal, state and local level, +and some of the laws, rules and regulations that govern our operations carry substantial penalties +for non-compliance. This regulatory burden increases our cost of doing business and, consequently, +affects our profitability. +Exploration and Production. Our operations are subject to federal, state and local regulations +that include requirements for permits to drill and to conduct other operations and for provision of +financial assurances (such as bonds and letters of credit) covering drilling and well operations. +Other activities subject to regulation are: +• +the location and spacing of wells, +• +the method of drilling and completing wells, +• +the rate and method of production, +• +the surface use and restoration of properties upon which wells are drilled and other +exploration activities, +• +the plugging and abandoning of wells, +• +the discharge of contaminants into water and the emission of contaminants into air, +• +the disposal of fluids used or other wastes obtained in connection with operations, +• +the marketing, transportation and reporting of production, and +• +the valuation and payment of royalties. +For instance, our outer continental shelf (“OCS”) leases in federal waters are administered by MMS, +and require compliance with detailed MMS regulations and orders. Lessees must obtain MMS approval +for exploration, exploitation and production plans prior to the commencement of such operations. +The MMS has promulgated regulations requiring offshore production facilities located on the OCS to +meet stringent engineering and construction specifications. The MMS also has regulations +restricting the flaring or venting of natural gas, and prohibiting the flaring of liquid +hydrocarbons and oil without prior authorization. MMS policies concerning the volume of production +that a lessee must have to maintain an offshore lease beyond its primary term also are applicable +to Callon. Similarly, the MMS has promulgated other regulations governing the plugging and +abandonment of wells located offshore and the installation and removal of production facilities. +To cover the various obligations of lessees on the OCS, the MMS generally requires that lessees +post bonds, letters of credit, or other acceptable assurances that such obligations will be met. +The cost of +13 +Table of Contents +these bonds or other surety can be substantial, and there is no assurance that bonds or other +surety can be obtained in all cases. Under some circumstances, the MMS may require any of our +operations on federal leases to be suspended or terminated. Any such suspension or termination +could materially adversely affect our financial conditions and results of operations. +Operations conducted on federal or state oil and natural gas leases must comply with numerous +regulatory restrictions, including various nondiscrimination statues, royalty and related valuation +requirements, and certain of these operations must be conducted pursuant to certain on-site +security regulations and other appropriate permits issued by the MMS or other appropriate federal +or state agencies. +Our sales of oil and natural gas are affected by the availability, terms and cost of pipeline +transportation. The price and terms for access to pipeline transportation remain subject to +extensive federal and state regulation. If these regulations change, we could face higher +transmission costs for our production and, possibly, reduced access to transmission capacity. +Various proposals and proceedings that might affect the petroleum industry are pending before +Congress, the Federal Energy Regulatory Commission, or FERC, various state legislatures, and the +courts. The industry historically has been heavily regulated and we can offer you no assurance +that the less stringent regulatory approach recently pursued by the FERC and Congress will continue +nor can we predict what effect such proposals or proceedings may have on our operations. +We do not currently anticipate that compliance with existing laws and regulations governing +exploration and production will have a significantly adverse effect upon our capital expenditures, +earnings or competitive position. +Environmental Regulation. Various federal, state and local laws and regulations concerning the +release of contaminants into the environment, including the discharge of contaminants into water +and the emission of contaminants into the air, the generation, storage, treatment, transportation +and disposal of wastes, and the protection of public health, welfare, and safety, and the +environment, including natural resources, affect our exploration, development and production +operations, including operations of our processing facilities. We must take into account the cost +of complying with environmental regulations in planning, designing, drilling, constructing, +operating and abandoning wells. Regulatory requirements relate to, among other things, the handling +and disposal of drilling and production waste products, the control of water and air pollution and +the removal, investigation, and remediation of petroleum-product contamination. In addition, our +operations may require us to obtain permits for, among other things, +• +air emissions, +• +discharges into surface waters, and +• +the construction and operations of underground injection wells or surface pits to +dispose of produced saltwater and other nonhazardous oilfield wastes. +In the event of an unauthorized discharge (e.g., to land or water), emission (e.g., to air) or +other activity, we may be liable for, among other things, penalties, costs and damages, and subject +to injunctive relief, and we could be required to cleanup or mitigate the environmental impacts of +those discharges, emissions or activities. Also, under federal, and certain state, laws, the +present and certain past owners and operators of a site, and persons that treated, disposed of or +arranged for the disposal of hazardous substances found at a site, may be liable, without regard to +fault or the legality of the original conduct, for the release of hazardous substances into the +environment. The Environmental Protection Agency, state environmental agencies and, in some cases +third parties are authorized to take actions in response to threats to human health or the +environment and to seek to recover from responsible classes of persons the costs of such actions. +We therefore could be required to remove or remediate previously disposed wastes and remediate +contamination, including contamination in surface water, soil or groundwater, caused by disposal of +that waste, irrespective +14 +Table of Contents +of whether disposal or release were authorized. We could be responsible for wastes disposed of or +released by us or prior owners or operators at properties owned or leased by us or at locations +where wastes have been taken for disposal also irrespective of whether disposal or release were +authorized. We could also be required to suspend or cease operations in contaminated areas, or to +perform remedial well plugging operations or cleanups to prevent future contamination. +Federal, and certain state, laws also impose duties and liabilities on certain “responsible +parties” related specifically to the prevention of oil spills and damages resulting from such +spills in or threatening United States waters or adjoining shorelines. A liable “responsible +party” includes the owner or operator of a facility, vessel or pipeline that is a source of an oil +discharge or that poses the substantial threat of discharge or, in the case of offshore facilities, +the lessee or permittee of the area in which a discharging facility is located. These laws assign +liability, which generally is joint and several, without regard to fault, to each liable party for +oil removal costs and a variety of public and private damages. Although defenses and limitations +exist to the liability imposed under these laws, they are limited. In the event of an oil +discharge or substantial threat of discharge, we could be liable for costs and damages. +The Environmental Protection Agency and various state agencies have limited the disposal options +for hazardous and nonhazardous wastes thereby increasing the costs of disposal. Furthermore, +certain wastes generated by our oil and natural gas operations that are currently exempt from +treatment as hazardous wastes may in the future be designated as hazardous wastes and, therefore, +be subject to considerably more rigorous and costly operating and disposal requirements. +Federal and state occupational safety and health laws require us to organize information about +hazardous materials used, released or produced in our operations. Certain portions of this +information must be provided to employees, state and local governmental authorities and local +citizens. We are also subject to the requirements and reporting set forth in federal workplace +standards. +There are federal and certain state laws that impose restrictions on activities adversely affecting +the habitat of certain plant and animal species. In the event of an unauthorized impact or taking +of a protected species or its habitat, we could be liable for penalties, costs and damages, and +subject to injunctive relief, and we could be required to mitigate those impacts. A critical +habitat or suitable habitat designation also could result in further material restrictions to land +use and may materially delay or prohibit land access for oil and natural gas development. +We have made and will continue to make expenditures to comply with environmental regulations and +requirements. These are necessary costs of doing business within the oil and gas industry. Although +we are not fully insured against all environmental risks, we maintain insurance coverage which we +believe is customary in the industry. Moreover, it is possible that other developments, such as +stricter and more comprehensive environmental laws and regulations, as well as claims for damages +to property or persons resulting from company operations, could result in substantial costs and +liabilities. We believe we are in compliance with existing environmental regulations, and that, +absent the occurrence of an extraordinary event the effect of which cannot be predicted, any +noncompliance will not have a material adverse effect on our operations or earnings. +Greenhouse Gas Legislation (“GHG”). On June 26, 2009, the U.S. House of Representatives passed the +“American Clean Energy and Security Act of 2009” which among other things, would enact a “cap and +trade” system to control GHGs. Under this cap and trade system, a cap on the amount of GHGs would +be established annually, which would be reduced annually. Each covered emission source would be +required to obtain GHG emission allowances corresponding to its annual emissions of GHGs. The +Senate has passed from committee its legislation proposing a similar cap and trade system to +regulate GHG emissions, but the +15 +Table of Contents +Senate legislation has not been voted upon by the full Senate. In the absence of a comprehensive +federal legislation on GHG emission control, the Environmental Protection Agency (“EPA”) has been +moving forward with rulemaking under the Clean Air Act (“CAA”) to regulate GHGs as pollutants under +the CAA. Should EPA regulate GHGs under the CAA, we could incur significant costs to control our +emissions and comply with regulatory requirements. In addition, EPA has adopted a mandatory GHG +emissions reporting program which imposes reporting and monitoring requirements on various +industries. We do not believe our operations will be subject to this program as currently +proposed, but there is no guarantee that EPA will not expand the program to include additional +industries. Should we be required to report GHG emissions, it could require us to incur costs to +monitor, keep records of, and report emissions of GHGs. +Because of the lack of any comprehensive legislative program addressing GHGs, there is a great deal +of uncertainty as to how and when federal regulation of GHGs might take place. In addition to +possible federal regulation, a number of states, individually and regionally, also are considering +or have implemented GHG regulatory programs. These potential regional and state initiatives may +result in so—called cap—and—trade programs, under which overall GHG emissions are limited and +GHG emissions are then allocated and sold, and possibly other regulatory requirements, that could +result in our incurring material expenses to comply, e.g., by being required to purchase or to +surrender allowances for GHGs resulting from our operations. The federal, regional and local +regulatory initiatives also could adversely affect the marketability of the oil and natural gas we +produce. The impact of such future programs cannot be predicted, but we do not expect our +operations to be affected any differently than other similarly situated domestic competitors. +Application of the Safe Drinking Water Act to Hydraulic Fracturing. The Safe Drinking Water Act +regulates, among other things, underground injection operations. Recent legislative activity has +occurred which, if successful, would impose additional regulation under the SDWA upon the use of +hydraulic fracturing fluids. The U.S. Senate and House of Representatives are considering two +companion bills entitled the “Fracturing Responsibility and Chemical Awareness Act of 2009.” If +enacted, the legislation would impose on our hydraulic fracturing operations permit and financial +assurance requirements, requirements that we adhere to construction specifications, fulfill +monitoring, reporting and recordkeeping obligations, and meet plugging and abandonment +requirements. In addition to subjecting the injection of hydraulic fracturing to the SDWA +regulatory and permitting requirements, the proposed legislation would require the disclosure of +the chemicals within the hydraulic fluids, which could make it easier for third parties opposing +hydraulic fracturing to initiate legal proceedings based on allegations that specific chemicals +used in the process could adversely affect ground water. Neither piece of legislation has been +passed. If this or similar legislation is enacted, we could incur substantial compliance costs, +and the requirements could negatively impact our ability to conduct fracturing activities on our +assets. +SDAs . In addition, eleven states have enacted surface damage statutes (“SDAs”). These laws are +designed to compensate for damage caused by mineral development. Most SDAs contain entry +notification and negotiation requirements to facilitate contact between operators and surface +owners/users. Most laws also contain bonding requirements and specific expenses for exploration and +operating activities. Costs and delays associated with SDAs could impair operational effectiveness +and increase development costs. +Other Regulations . If we conduct operations on federal, state or Indian oil and natural gas +leases, these operations must comply with numerous regulatory restrictions, including various +nondiscrimination statutes, royalty and related valuation requirements. Certain of these +operations must be conducted pursuant to certain on-site security regulations and other appropriate +permits issued by the Bureau of Land Management, Minerals Management Service or other appropriate +federal or state agencies. +16 +Table of Contents +Commitments and Contingencies +The Company’s activities are subject to federal, state and local laws and regulations governing +environmental quality and pollution control. Although no assurances can be made, the Company +believes that, absent the occurrence of an extraordinary event, compliance with existing federal, +state and local laws, rules and regulations governing the release of materials into the environment +or otherwise relating to the protection of the environment will not have a material effect upon the +capital expenditures, earnings or the competitive position of the Company with respect to its +existing assets and operations. The Company cannot predict what effect additional regulation or +legislation, enforcement polices thereunder, and claims for damages to property, employees, other +persons, and the environment resulting from the Company’s operations could have on its activities. +Availability of Reports +All of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form +8-K, and amendments to such reports as well as other filings we make pursuant to Section 13(a) and +15(d) of the Securities Exchange Act of 1934 are available free of charge on our Internet website. +The address of our Internet website is www.callon.com. Our SEC filings are available on our +website as soon as they are filed with the SEC. \ No newline at end of file diff --git a/raw/filings/0000928022/2009/0000950123-10-024025/item13.txt b/raw/filings/0000928022/2009/0000950123-10-024025/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..5040770679c6e33757176fe3dbd53400c0e22fdd --- /dev/null +++ b/raw/filings/0000928022/2009/0000950123-10-024025/item13.txt @@ -0,0 +1,4 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company +relating to the Annual Meeting of Stockholders to be held on May 4, 2010 which will be filed with +the Securities and Exchange Commission and is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000928022/2009/0000950123-10-024025/item9a.txt b/raw/filings/0000928022/2009/0000950123-10-024025/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..728f0ee99f3beedcb18f60447784d8c1085ae58c --- /dev/null +++ b/raw/filings/0000928022/2009/0000950123-10-024025/item9a.txt @@ -0,0 +1,79 @@ +ITEM 9A. CONTROLS AND PROCEDURES +The term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the +Securities Exchange Act of 1934, or the Exchange Act. This term refers to the controls and +procedures of a company that are designed to ensure that information required to be disclosed by a +company in the reports that it files or submits under the Exchange Act is recorded, processed, +summarized and reported within the time periods specified by the Securities and Exchange +Commission. Our management, including our Chief Executive Officer and Chief Financial Officer, has +evaluated the effectiveness of our disclosure controls and procedures as of the end of the period +covered by this annual report. Based upon that evaluation, our Chief Executive Officer and Chief +Financial Officer have concluded that our disclosure controls and procedures were effective as of +the end of the period covered by this annual report. There were no changes to our internal control +over financial reporting during our last fiscal quarter that have materially affected, or are +reasonable likely to materially affect, our internal control over financial reporting. +Management’s Report On Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over +financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the +supervision and with the participation of our management, including our principal executive and +financial officers, we conducted an evaluation of the effectiveness of our internal control over +financial reporting as of December 31, 2009 based on the frame work in the Internal +Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our evaluation under the framework in Internal Control-Integrated Framework, +our management concluded that our internal control over financial reporting was effective as of +December 31, 2009. +Ernst & Young LLP, our independent registered public accounting firm, has issued an attestation +report on the Company’s internal control over financial reporting as of December 31, 2009. +ITEM 9A (T). CONTROLS AND PROCEDURES +See Item 9A. +84 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited Callon Petroleum Company’s internal control over financial reporting as of December +31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the +Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Callon +Petroleum Company’s management is responsible for maintaining effective internal control over +financial reporting and for its assessment of the effectiveness of internal control over financial +reporting included in the accompanying Management’s Report on Internal Control over Financial +Reporting. Our responsibility is to express an opinion on the Company’s internal control over +financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight +Board (United States). Those standards require that we plan and perform the audit to obtain +reasonable assurance about whether effective internal control over financial reporting was +maintained in all material respects. Our audit included obtaining an understanding of internal +control over financial reporting, assessing the risk that a material weakness exists, testing and +evaluating the design and operating effectiveness of internal control based on the assessed risk, +and performing such other procedures as we considered necessary in the circumstances. We believe +that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable +assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A +company’s internal control over financial reporting includes those policies and procedures that (1) +pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the +transactions and dispositions of the assets of the company; (2) provide reasonable assurance that +transactions are recorded as necessary to permit preparation of financial statements in accordance +with generally accepted accounting principles, and that receipts and expenditures of the company +are being made only in accordance with authorizations of management and directors of the company; +and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the +financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or +detect misstatements. Also, projections of any evaluation of effectiveness to future periods are +subject to the risk that controls may become inadequate because of changes in conditions, or that +the degree of compliance with the policies or procedures may deteriorate. +In our opinion, Callon Petroleum Company maintained, in all material respects, effective internal +control over financial reporting as of December 31, 2009, based on the COSO criteria. +85 +Table of Contents +We also have audited, in accordance with the standards of the Public Company Accounting Oversight +Board (United States), the consolidated balance sheets of Callon Petroleum Company as of December +31, +2009 and 2008, and the related consolidated statements of operations, stockholders’ equity and cash +flows for each of the three years in the period ended December 31, 2009 and our report dated March +12, 2010, expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 12, 2010 +86 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0000928022/2009/0000950123-10-024025/rp_note.txt b/raw/filings/0000928022/2009/0000950123-10-024025/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2009/0000950123-10-024025/rpt_disclosure.txt b/raw/filings/0000928022/2009/0000950123-10-024025/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..275705ff94632205a1a2d716d3a265d07abc760c --- /dev/null +++ b/raw/filings/0000928022/2009/0000950123-10-024025/rpt_disclosure.txt @@ -0,0 +1,11 @@ +Certain Relationships and Related Party Transactions . Our Audit Committee charter provides +that the Company shall not enter into a related party transaction unless such transaction is +approved by the Audit Committee after a review of the transaction by the Audit Committee for +potential conflicts of interest. A transaction will be considered a “related party transaction” if +the transaction would be required to be disclosed under Item 404 of Regulation S-K. In addition, +our Code of Business Conduct and Ethics provides that an officer’s or a director’s conflict of +interest with the Company may only be waived if the Nominating and Governance Committee approves +the waiver and the full Board of Directors ratifies the waiver. The Committees have the authority +to hire legal, accounting, financial or other advisors as it may deem necessary or desirable and/or +to delegate responsibilities to executive officers of the Company in connection with discharging +their duties. As of December 31, 2009, we are not aware of any related party transactions with our \ No newline at end of file diff --git a/raw/filings/0000928022/2010/0000928022-11-000022/filing.txt b/raw/filings/0000928022/2010/0000928022-11-000022/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..7fc37b9b6c648847f6bf0ba96e66caead907c8cb --- /dev/null +++ b/raw/filings/0000928022/2010/0000928022-11-000022/filing.txt @@ -0,0 +1,4925 @@ +10-K +1 +form10k_2010.htm +CALLON PETROLEUM COMPANY FORM 10-K +form10k_2010.htm +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +Form 10-K +for the year ended +December 31, 2010 +[X] +Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2010 +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 001-14039 +CALLON PETROLEUM COMPANY +(Exact name of registrant as specified in its charter) +Delaware +( State or other jurisdiction of incorporation or organization) +64-0844345 +(I.R.S. Employer Identification No.) +200 North Canal Street +Natchez, Mississippi +(Address of principal executive offices) +39120 +(Zip Code) +601-442-1601 +(Registrant's telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class: +Name of each exchange on which registered: +Common Stock, $.01 par value +New York Stock Exchange +Securities registered pursuant to section 12 (g) of the Act: None +Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes [ ] +No [ X ] +Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. +Yes [ ] +No [ X ] +Indicate by check mark whether 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 [ ] +No [ ] +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] +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 definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one): +Large accelerated filer [ ] +Accelerated filer [ X ] +Non-accelerated filer [ ] +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 ] +The aggregate market value of the voting and non-voting common equity stock held by non-affiliates of the registrant was $165.3 million as of June 30, 2010. +As of March 3, 2011, 39,105,130 shares of the Registrant’s common stock, par value $.01 per share, were outstanding. +Documents Incorporated by Reference +Portions of the definitive Proxy Statement of Callon Petroleum Company (to be filed no later than 120 days after December 31, 2010) relating to the Annual Meeting of Stockholders to be held on May 12, 2011, which are incorporated into Part III of this Form 10-K. +TABLE OF CONTENTS +Part I +Special Note Regarding Forward-Looking Statements +3 +Definitions +4 +Item 1 & 2. +Business & Properties +5 +Our Business Strategy +5 +Our Strengths +5 +Recent Developments +6 +Exploration and Development Activities +6 +Acquisitions and Divestitures +6 +Oil and Gas Properties +6 +Onshore Properties +7 +Gulf of Mexico Deepwater Properties +8 +Gulf of Mexico Shelf and Other Properties +8 +Proved Reserves +9 +Proved Undeveloped Reserves +10 +Controls over Reserve Estimates +10 +Production Volumes, Average Sales Prices and Average Production Costs +11 +Present Activities and Productive Wells +12 +Leasehold Acreage +12 +Title to Properties +13 +Major Customers +13 +Corporate Offices +13 +Employees +13 +Regulations +13 +Commitments and Contingencies +16 +Available Information +16 +Item 1A. +Risk Factors +17 +Item 1B. +Unresolved Staff Comments +24 +Item 3. +Legal Proceedings +24 +Item 4. +Reserved +24 +Part II +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +24 +Performance Graph +25 +Item 6. +Selected Financial Data +26 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +27 +Overview and Outlook +27 +Liquidity and Capital Resources +29 +Results of Operations +31 +Off-Balance Sheet Arrangements +36 +Significant Accounting Policies and Critical Estimates +36 +Subsequent Events +38 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +39 +Commodity Price Risk +39 +Interest Rate Risk +39 +Item 8. +Financial Statements and Supplementary Data +40 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +69 +Item 9A. +Controls and Procedures +69 +Item 9A(T) +Controls and Procedures +69 +Item 9B. +Other Information +69 +Part III +Item 10. +Directors and Executive Officers of the Registrant +71 +Item 11. +Executive Compensation +71 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +71 +Item 13. +Certain Relationships and Related Transactions +71 +Item 14. +Principal Accountant Fees and Services +71 +Part IV +Item 15. +Exhibits +72 +Signatures +73 +2 +Special Note Regarding Forward Looking Statements +All statements, other than historical fact or present financial information, may be deemed to be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements that address activities, outcomes and other matters that should or may occur in the future, including, without limitation, statements regarding the financial position, business strategy, production and reserve growth and other plans and objectives for our future operations, are forward-looking statements. Although we believe the expectations expressed in such forward-looking statements are based on reasonable assumptions, such statements are not guarantees of future performance. We have no obligation and make no undertaking to publicly update or revise any forward-looking statements, except as may be required by law. +Forward-looking statements include the items identified in the preceding paragraph, information concerning possible or assumed future results of operations and other statements in this Form 10-Q identified by words such as “anticipate,” “project,” “intend,” “estimate,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “plan,” “forecast,” “target” or similar expressions. +You should not place undue reliance on forward-looking statements. They are subject to known and unknown risks, uncertainties and other factors that may affect our operations, markets, products, services and prices and cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. In addition to any assumptions and other factors referred to specifically in connection with forward-looking statements, risks, uncertainties and factors that could cause our actual results to differ materially from those indicated in any forward-looking statement include, but are not limited to: +· +the timing and extent of changes in market conditions and prices for commodities (including regional basis differentials); +· +our ability to transport our production to the most favorable markets or at all; +· +the timing and extent of our success in discovering, developing, producing and estimating reserves; +· +our ability to fund our planned capital investments; +· +the impact of government regulation, including any increase in severance or similar taxes, legislation relating to hydraulic fracturing, the climate and over-the-counter derivatives; +· +the costs and availability of oilfield personnel services and drilling supplies, raw materials, and equipment and services; +· +our future property acquisition or divestiture activities; +· +the effects of weather; +· +increased competition; +· +the financial impact of accounting regulations and critical accounting policies; +· +the comparative cost of alternative fuels; +· +conditions in capital markets, changes in interest rates and the ability of our lenders to provide us with funds as agreed; +· +credit risk relating to the risk of loss as a result of non-performance by our counterparties; and +· +any other factors listed in the reports we have filed and may file with the Securities and Exchange Commission (“SEC”). +We caution you that the forward-looking statements contained in this Form 10-K are subject to all of the risks and uncertainties, many of which are beyond our control, incident to the exploration for and development, production and sale of oil and natural gas. These risks include, but are not limited to, the risks described in Item 1A of this Annual Report on Form 10-K for the year ended December 31, 2010 (the “2010 Annual Report on Form 10-K”), and all quarterly reports on Form 10-Q filed subsequently thereto (“Form 10-Qs”). +Should one or more of the risks or uncertainties described above or elsewhere in this Form 10-K occur, or should underlying assumptions prove incorrect, our actual results and plans could differ materially from those expressed in any forward-looking statements. We specifically disclaim all responsibility to publicly update any information contained in a forward-looking statement or any forward-looking statement in its entirety and therefore disclaim any resulting liability for potentially related damages. +All forward-looking statements attributable to us are expressly qualified in their entirety by this cautionary statement. +3 +Table of Contents +DEFINITIONS +All defined terms under Rule 4-10(a) of Regulation S-X shall have their statutorily prescribed meanings when used in this report. As used in this document: +· +3-D : three-dimensional. +· +ARO : Asset Retirement Obligation +· +B/d : barrels of oil or natural gas liquids per day. +· +Bbl or Bbls : barrel or barrels of oil. +· +Bcf : billion cubic feet. +· +Boe : barrel of oil equivalent, determined by using the ratio of one Bbl of oil or NGLs to six Mcf of gas. +· +Boe/d : boe per day. +· +BOEMRE : Bureau of Ocean Energy Management, Regulation and Enforcement; formerly the Minerals Management Service ("MMS") +· +Btu : a British thermal unit, a measure of heating value, which is approximately equal to one Mcf. +· +LIBOR : London Interbank Offered Rate. +· +LNG : liquefied natural gas. +· +Mbbls : thousand barrels of oil. +· +Mboe : thousand boe. +· +Mboe/d : Mboe per day. +· +Mcfe : thousand cubic feet of natural gas. +· +Mcf/d : Mcf per day. +· +MMbbls : million barrels of oil. +· +MMboe : million boe. +· +MMBtu : million Btu. +· +MMBtu/d : MMBtu per day. +· +MMcf : million cubic feet of natural gas. +· +MMcf/d : MMcf per day. +· +NGL or NGLs : natural gas liquids, which are expressed in barrels. +· +NYMEX : New York Mercantile Exchange. +· +Oil : includes crude oil and condensate. +· +PDP : proved developed reserves. +· +PUD : proved undeveloped reserves. +· +SEC : United States Securities and Exchange Commission. +· +Section : land area containing 640 acres +· +US GAAP: Generally Accepted Accounting Principles in the United States +With respect to information relating to our working interest in wells or acreage, “net” oil and gas wells or acreage is determined by multiplying gross wells or acreage by our working interest therein. Unless otherwise specified, all references to wells and acres are gross. +4 +Table of Contents +PART I. +Items 1 and 2 - BUSINESS and PROPERTIES +Overview and Business Strategy +Callon Petroleum Company has been engaged in the exploration, development, acquisition and production of oil and gas properties since 1950. The Company was incorporated under the laws of the state of Delaware in 1994 and succeeded to the business of a publicly traded limited partnership, a joint venture with a consortium of European investors and an independent energy company partially owned by a member of current management. As used herein, the “Company,” “Callon,” “we,” “us,” and “our” refer to Callon Petroleum Company and its predecessors and subsidiaries unless the context requires otherwise. +Callon Petroleum Company is engaged in the development, production, exploration and acquisition of oil and gas properties. In late 2008, our management shifted our operational focus from exploration in the Gulf of Mexico to the acquisition and development of onshore properties located in the Wolfberry play of the Permian Basin in Texas and the Haynesville Shale area in Louisiana. As of December 31, 2010, we had estimated net proved reserves of 8.1 MMBbls and 33.0 Bcf, or 13.6 MMBOE. Of these reserves, approximately 50.0% were located onshore in the Permian Basin Wolfberry and Haynesville Shale plays, compared with 16.5% located onshore at December 31, 2009. +Our Business Strategy +Our goal is to increase stockholder value by: +· +Increasing reserves and production levels by using cash flows from, or monetization of, our Gulf of Mexico properties to acquire and develop lower risk, long-life onshore oil and gas properties; +· +Increasing our reserve life and predictability of production by focusing on acquisition and development of long-life onshore properties; +· +Diversifying risk by substantially increasing the number of productive wells we own; and +· +Strengthening our balance sheet by focusing on maintaining liquidity and a reduction of our average debt per barrel of oil equivalent (“Boe”) of proved reserves. +Our Strengths +We believe that we are well positioned to achieve our business objectives and to execute our strategy because of the following competitive strengths at year-end 2010 : +· +We have a substantial inventory of onshore drilling locations, with an estimated 132 net drilling locations on 40-acre spacing and an additional 166 net drilling locations on 20-acre spacing in the Wolfberry play of the Permian Basin and four net locations in the Haynesville area. +· +Our offshore properties generate substantial cash flow, which we can deploy in the acquisition, exploration and development of onshore properties. +· +Our management team is experienced in oil and gas acquisitions, exploration, development and production in the areas in which we are focusing our operations. +· +On December 31, 2010, our total liquidity position was approximately $47 million, including $17 million of available cash and $30 million of unused borrowing base available under our senior secured credit facility. The borrowing base was increased by 50.0% over its previous level at the last redetermination in the fourth quarter of 2010. The next redetermination is scheduled for April 2011. +5 +Table of Contents +Recent Developments +As discussed in Note 19 included in Part II, Item 8 of this filing, during February 2011, we received $73.7 million in net proceeds through the public offering of 10.1 million shares of our common stock, which included the issuance of 1.1 million shares pursuant to the underwriters’ over-allotment option. Immediately following the completion of the equity offering, we called for redemption $31.0 million principal amount of our 13% senior notes due 2016. We expect to complete the redemption of these notes by March 19, 2011, which will result in a gain on the early extinguishment of debt of approximately $2.0 million. We also completed an arbitration proceeding with our former joint interest partner in the Entrada project, which is more fully discussed in Note 19. +Exploration and Development Activities +During 2010, capital expenditures on an accrual basis for exploration and development costs related to oil and gas properties included these expenditures (in millions): +20 wells drilled, 11 wells producing, on the Permian Basin acreage +$ +32.0 +Natural gas well in the Haynesville Shale gas play and site development for future wells +10.9 +Leasehold acquisitions and seismic +4.0 +Costs incurred on legacy properties +1.6 +Plugging and abandonment costs in the Gulf of Mexico +2.4 +Capitalized interest ($2.0 million) and overhead ($11.8 million) allocable directly to exploration +and development projects. +13.8 +Total 2010 capital expenditures (a) +$ +64.7 +(a) +The above costs exclude approximately $6.6 million of capital costs incurred on legacy properties as a result of certain joint interest billings not being recovered from a joint interest partner. Under the full-cost method of accounting, these costs are capitalized to the Company’s full cost pool. Inclusive of this amount, 2010 capital expenditures totaled $71.2 million. See Note 19 included in Part II, Item 8 of this filing for additional information regarding the write-off of certain receivables. +As a result of the previously discussed shift in our operational focus from offshore in the Gulf of Mexico to onshore in the Wolfberry play of the Permian Basin and the Haynesville Shale play, we expect that substantially all of our 2011 capital expenditures will be focused on the development and acquisition of onshore properties in the United States, with only limited amounts of capital expended to maintain our offshore properties. Our projected 2011 capital expenditures budget is outlined within Management’s Discussion and Analysis and Results of Operations, which is included in Part II, Item 7 of this filing. +Acquisitions and Divestitures +The Company increased its interest in the East Bloxom Development Area of the Permian Basin, located in Upton County, from an average 47% working interest to 100% working interest through a number of acquisitions and farm-ins for which the Company paid approximately $1.0 million during 2010, of which $0.1 million was recorded acquisition expenses during 2010. As a result, Callon now controls the activity in three development areas encompassing 11 Sections. +Oil and Gas Properties +As of December 31, 2010, our estimated net proved reserves totaled 13.6 MMBoe and included 8.1 MMBbls and 33.0 Bcf, with a pre-tax present value, discounted at 10%, of $205.5 million. Pre-tax present value may be deemed to be a non-US GAAP financial measure, which we reconcile to the US GAAP standardized measure of $198.9 million in the proved reserves table presented later within this section of the filing. Oil constitutes approximately 60% on an equivalent basis of our total estimated net proved reserves, and approximately 49% of our total estimated proved reserves are proved developed reserves. +6 +Table of Contents +The following table sets forth certain information about our estimated proved reserves by our independent petroleum reserve engineers by major field and for all other properties combined at December 31, 2010: +Pre-tax +Discounted +Estimated Net Proved Reserves +Present +Oil +Gas +Total +Value +Operator +(MBbls) +(MMcf) +(MBoe) +($000) +(a) +(b)(c)(d) +Onshore: +Permian Basin +Callon +3,410 +6,247 +4,451 +$ +41,438 +Haynesville Shale +Callon +- +13,621 +2,270 +7,369 +Total Onshore +3,410 +19,868 +6,721 +48,807 +Gulf of Mexico Deepwater: +Mississippi Canyon 538/582 +“Medusa” +Murphy +4,020 +3,011 +4,522 +125,678 +Garden Banks Block 341 +“Habanero” +Shell +642 +4,592 +1,408 +28,411 +Total Gulf of Mexico Deepwater +4,662 +7,603 +5,930 +154,089 +Gulf of Mexico Shelf and Other: +West Cameron Block 295 +Mariner Energy +8 +1,466 +253 +4,714 +East Cameron Block 109 +Energy Partners LTD +13 +928 +167 +3,056 +East Cameron Block 2 +Apache +8 +770 +136 +2,572 +East Cameron Block 257 +SPN Resources +1 +899 +150 +1,906 +Other +Various +47 +1,423 +284 +(9,612 +) +Total Gulf of Mexico Shelf and Other +77 +5,486 +990 +2,636 +Total Net Proved Reserves +8,149 +32,957 +13,641 +$ +205,532 +(a) +We convert Mcf to Boe using a conversion ratio of six Mcf to one Boe. This ratio, which is typical in the industry and represents the approximate energy equivalent of an Mcf to a Boe, does not reflect to economic equivalency of an Mcf of gas compared with a Boe of oil or natural gas liquids. On an economic basis, a barrel of oil has a substantially higher price than six Mcf of natural gas. +(b) +Represents the present value of future net cash flows before deduction of federal income taxes, discounted at 10%, attributable to estimated net proved reserves as of December 31, 2010, as set forth in the Company’s reserve reports prepared by its independent petroleum reserve engineers, Huddleston & Co., Inc. +(c) +Includes a reduction for estimated plugging and abandonment costs that is reflected as a liability on our balance sheet at December 31, 2010, in accordance with accounting for asset retirement obligations rules. See the Oil and Gas Reserve table for the standardized measure of discounted future net cash flow in Note 15 of our consolidated financial statements. The negative Pre-Tax Present Value of the “Other” reflects plugging and abandonment obligations exceeding the future net cash flows, obligations of which most are estimated to occur within the next five years, +(d) +The Company uses the financial measure “Pre Tax Discounted Present Value” which is a non-US GAAP financial measure. The Company believes that Pre Tax Discounted Present Value, while not a financial measure in accordance with US GAAP, is an important financial measure used by investors and independent oil and gas producers for evaluating the relative value of oil and natural gas properties and acquisitions because the tax characteristics of comparable companies can differ materially. The total standardized measure calculated in accordance with the guidance issued by the FASB for disclosures about oil and gas producing activities for our proved reserves as of December 31, 2010 was $198.9 million inclusive of the $6.6 million discounted estimated future income taxes relating to such future net revenues. Year-end average pricing was $5.10 per Mcf for natural gas and $78.07 per Bbl for oil. +Onshore Properties +Onshore proved reserves accounted for approximately 50% of year-end 2010 proved reserves, demonstrating our progress toward our strategic goal of diversifying our reserve portfolio. +Permian Basin +During the fourth quarter of 2009, Callon acquired an interest in Permian Basin properties, which included 22 producing wells with associated proved reserves of 1.6 MMBoe. During 2010, the Company drilled an additional 20 wells targeting the Wolfberry trend, of which 11 were producing by year-end, thereby increasing total average daily production in the Permian Basin to approximately 550 boe/d as of December 31, 2010. The remaining 9 wells drilled during 2010 are scheduled to be fracture stimulated and brought online during the first and second quarters of 2011. Early in 2011, we entered into an agreement with our fracture stimulation service provider providing for a minimum of three well stimulations per month in 2011. During 2011, the Company plans to drill up to an additional 44 wells . +7 +Table of Contents +The Company’s primary target in the Permian Basin is the Wolfberry play, which is located in Crockett, Ector, Midland and Upton Counties, Texas. This play is a proven, low-permeability oil play and includes the Sprayberry, Dean, and Wolfcamp formations. The Company currently owns approximately 8,800 net acres within the Permian Basin, approximately 80% of which is prospective for the Wolfberry Play and provides a drilling inventory of 132 additional drilling locations based on a 40-acre spacing development. Approximately 33% of our 2010 proved reserves were attributable to our properties in the Wolfberry play of the Permian Basin. +Haynesville Shale +During the third quarter of 2009, Callon acquired a 69% working interest in a Haynesville Shale unit located in Southern Bossier Parish, Louisiana, and currently owns approximately 430 net acres in the Haynesville Shale. Initial production from the George R. Mills Well No. 1H, our first well completed since acquiring this property in 2009, commenced on September 3, 2010. To date as of March 2011, the well has produced 1.4 billion cubic feet of natural gas and is currently producing at a restricted rate of 5.0 MMcfe/d. We have an additional four net drilling locations on the 430-net acre unit in which we have a 69% working interest. The Company also performed some site development work for future wells and is awaiting improvement in natural gas prices before resuming development of the field. Approximately 17% of our year-end 2010 proved reserves were attributable to our Haynesville Shale property . +Gulf of Mexico Deepwater Properties +Medusa, Mississippi Canyon Blocks 538/582 +Our Medusa deepwater discovery that occurred during 1999, in which we own a 15% working interest, is located in 2,235 feet of water approximately 50 miles offshore Louisiana. Murphy Exploration & Production Company (“Murphy”), the operator, owns a 60% working interest and ENI Deepwater, LLC, owns the remaining 25% working interest. +During 2010 the Medusa field produced 593 MBoe net to us from eight wells which accounted for 35% of our total production. Most of the wells are still producing from their initial completions and have 2.4 MMBoe of proved developed non-producing reserves that will be accessed by recompletions in the existing wells. Another 1.2 MMBoe of proved undeveloped reserves will be developed by side tracking an existing well. These operations will occur as existing completions reach their economic limit, which as of December 31, 2010 is estimated to be in 2022. +In December 2003, we transferred our undivided 15% working interest in the spar production facilities to Medusa Spar LLC (“LLC”) in exchange for cash proceeds of approximately $25 million and a 10% ownership interest in the LLC. A discussion of this transaction is included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Off-Balance Sheet Arrangements.” +Habanero, Garden Banks Block 341 +The Habanero property, in which we own an 11.25% working interest in its wells, is located in 2,015 feet of water approximately 115 miles offshore Louisiana. Production from the Habanero 52 oil sand commenced in late November 2003 and from the Habanero 55 gas sand in January 2004. The well is operated by Shell Deepwater Development Inc., which owns a 55% working interest, with the remaining working interest owned by Murphy. +During 2010, Habanero produced 232 MBoe net to us from two wells which accounted for 14% of our total production. Future plans include sidetracks of both the wells to drain updip and partially fault-separated gas in the Habanero 52 sand when the existing completions reach their economic limit, which is estimated as of December 31, 2010 to be in 2012 for one well and 2013 for the other. +Gulf of Mexico Shelf and Other Properties +We own interests in 18 producing wells in twelve oil and gas fields in the shelf area of the Gulf of Mexico. These wells produced 616 MBOE net to our interest in 2010, which accounted for 37% of our total production. +8 +Table of Contents +Proved Reserves +In December 2008 the Securities and Exchange Commission (“SEC”) approved amendments to its oil and gas reserves estimation and disclosure requirements. The amendments, among other things: +· +allow the use of reliable technologies to estimate proved reserves if those technologies have been demonstrated to result in reliable conclusions about reserve volumes; +· +require disclosure of oil and gas proved reserves by significant geographic area; +· +permit the optional disclosure of probable and possible reserves; +· +modify the prices used to estimate reserves for SEC disclosure purposes to a 12-month average beginning-of-the-month price instead of a period-end price; and +· +require that if a third party is primarily responsible for preparing or auditing the reserve estimates, the company make disclosures relating to the independence and qualifications of the third party, including filing as an exhibit any report received from the third party. +The new requirements were effective for the Company’s year-end financial statements and Annual Report on Form 10-K for the year ended December 31, 2009, and as such the reserves and related information for 2009 and 2010 are presented consistent with the requirements of the new rule. The new rule does not require prior-year reserve information to be restated, and as such all information related to periods prior to 2009 is presented consistent with the prior SEC rules for the estimation of proved reserves. +Estimates of volumes of proved reserves, net to our interest, at year end are presented in MBbls for oil and in MMcf for natural gas at a pressure base of 15.025 pounds per square inch. Total volumes are presented in MBoe. For the MBoe computation, 6,000 cubic feet of gas are the equivalent of one barrel of oil. +The following table sets forth certain information about our estimated proved reserves. All of our proved reserves are located in the continental United States and in federal and state waters in the Gulf of Mexico. +Years Ended December 31, +2010 +2009 +2008 +Proved developed: +Oil (MBbls) +4,503 +4,346 +4,663 +Gas (MMcf) +12,715 +12,301 +13,463 +MBoe +6,622 +6,396 +6,907 +Proved undeveloped: +Oil (MBbls) +3,645 +2,133 +1,364 +Gas (MMcf) +20,241 +6,802 +5,189 +MBoe +7,019 +3,266 +2,229 +Total proved: +Oil (MBbls) +8,149 +6,479 +6,027 +Gas (MMcf) +32,957 +19,103 +18,652 +MBoe +13,641 +9,663 +9,136 +Estimated pre-tax future net cash flows (a) +$ +379,448 +$ +216,702 +$ +113,555 +Pre-tax discounted present value (a) (b) +$ +205,532 +$ +137,368 +$ +86,591 +Standardized measure of discounted future net cash flows (a) (b) +$ +198,916 +$ +135,921 +$ +86,305 +(a) Includes a reduction for estimated plugging and abandonment costs that is reflected as a liability on our balance sheet at December 31, 2010, in accordance with accounting for asset retirement obligations rules. +(b) The Company uses the financial measure “Pre Tax Present Value” which is a non-US GAAP financial measure. The Company believes that Pre Tax Present Value, while not a financial measure in accordance with US GAAP, is an important financial measure used by investors and independent oil and gas producers for evaluating the relative value of oil and natural gas properties and acquisitions because the tax characteristics of comparable companies can differ materially. The total standardized measure calculated in accordance with the guidance issued by the FASB for disclosures about oil and gas producing activities for our proved reserves as of December 31, 2010 was $198.9 million inclusive of the $6.6 million discounted estimated future income taxes relating to such future net revenues. Year-end average pricing was $5.10 per Mcf for natural gas and $78.07 per Bbl for oil. +See Note 15 of our Consolidated Financial Statements for the additional information regarding the Company’s reserves including its estimates of proved reserves, PDPs, PUDs and the Company’s estimates of future net cash flows and discounted future net cash flows from proved reserves. +9 +Table of Contents +Proved Undeveloped Reserves +The Company reviews annually its PUDs to ensure an appropriate plan exists for development. Generally, reserves for onshore properties are recognized as PUDs only if the Company has plans to convert the PUDs into PDPs within five years of the date they are first recorded as PUDs. The following table summarizes the Company’s recorded PUDs: +PUDs (in MBoe) at December 31, +2010 +2009 +2008 +Permian Basin +2,928 +932 +- +Haynesville Shale +1,757 +- +- +Total Onshore PUDs +4,685 +932 +- +Medusa +1,186 +1,186 +1,081 +Habanero +1,148 +1,148 +1,148 +Total Deepwater PUDs +2,334 +2,334 +2,229 +Total Shelf and other PUDs +- +- +- +Total PUDs +7,019 +3,266 +2,229 +Our plans are to develop our deepwater PUDS by side tracking existing wells when the zones currently being produced by the wells are depleted. The Company’s current plans forecast that the two producing zones in the Habanero field will be depleted one in 2012 and the other in 2013. In the Medusa field, the Company expects several recompletes to occur prior to 2012 with current producing reserves forecasted to reach their economic depletion point in 2022. Upon the depletion of currently producing reserves, the Company plans to develop its deepwater PUDs. During 2010, Callon did not convert any offshore PUDs to PDPs. The Company’s plans to develop its PUDs in the Permian Basin include a multi-year drilling program, which is expected to be completed on existing acreage within three to five years. Similarly, the Company plans to resume drilling on its Haynesville Shale property once gas prices improve, and expects to convert its existing PUDs within the next five years. +From December 31, 2009 to December 31, 2010, our PUDs increased 115% from 3,266 MBOE to 7,019 MBOE. As a result of acquisitions during 2009, we added 932 MBoe as compared to 2008. We then added 3,752 MBoe as a result of successful drilling during 2010 and commensurate PUDs associated with such drilling. None of these additions to our PUD reserves were offset by amounts no longer deemed to be economic PUDs at year-end. At January 1, 2010, we had 3,266 MBOE of proved undeveloped reserves. Of these PUD reserves, 23% were converted to proved developed producing reserves by year end 2010, at a total cost of $6.4 million, net. +We plan to develop our proved undeveloped reserves within a five-year time frame. The basis for our development plans are (i) allocation of capital to projects in our 2011 capital budget and (ii) in subsequent years, on the basis of capital allocation in our five-year business plan, each of which generally is governed by our expectations of internally generated cash flow. Reserve calculations at any end-of-year period are representative of our development plans at that time. Changes in commodity pricing, oilfield service costs and availability, and other economic factors may lead to changes in development plans. +Controls Over Reserve Estimates +Compliance as it relates to reporting the Company’s reserves is the responsibility of our Senior Vice President of Operations, who with over 30 years of industry experience including 25 years as a manager, is our principal engineer. In addition to his years of experience, our principal engineer holds a degree in petroleum engineering and asset evaluation and management. +Callon’s controls over reserve estimates included retaining Huddleston & Co., Inc., a Texas registered engineering firm, as our independent petroleum and geological firm. The Company provided to Huddleston information about our oil and gas properties, including production profiles, prices and costs, and Huddleston prepared its own estimates of the reserves attributable to the Company’s properties. All of the information regarding reserves in this annual report is derived from Huddleston’s report, which is included as an Exhibit to this annual report. The principal engineer at Huddleston responsible for preparing the Company’s reserve estimates has over 30 years of experience in the oil and gas industry and is a Texas Licensed Professional Engineer. Further professional qualifications include a degree in petroleum engineering and being a member of the Society of Petroleum Engineers. +The Audit Committee of our Board of Directors meets with management, including the Senior Vice President of Operations, to discuss matters and policies including those related to reserves. During our last fiscal year, we have not filed any reports with other federal agencies which contain an estimate of total proved net oil and gas reserves. +10 +Table of Contents +Production Volumes, Average Sales Prices and Average Production Costs +The following table sets forth certain information regarding the production volumes and average sales prices received for, and average production costs associated with, the Company’s sale of oil and natural gas for the periods indicated. +Years Ended December 31, +2010 +2009 +2008 +(in thousands, except per unit data) +Production +Natural gas (Mcf) +4,892 +5,740 +5,839 +Oil (MBbl) +859 +1,012 +942 +Total (MBoe) +1,674 +1,969 +1,915 +Revenues +Natural gas sales +$ +24,639 +$ +27,417 +58,349 +Oil sales +65,243 +73,842 +82,963 +Total revenues +$ +89,882 +$ +101,259 +$ +141,312 +Lease Operating Expenses +Production costs +$ +16,094 +$ +16,778 +$ +17,605 +Severance/production taxes +816 +528 +626 +Gathering +802 +1,141 +977 +Total lease operating expenses +$ +17,712 +$ +18,447 +$ +19,208 +Realized prices +Natural gas ($/Mcf, including realized gains (losses) on derivatives) +$ +5.04 +$ +4.78 +$ +9.99 +Natural gas ($/Mcf, excluding realized gains (losses) on derivatives) +4.91 +4.45 +10.10 +Oil ($/Bbl, including realized gains (losses) on derivatives) +75.97 +73.00 +88.07 +Oil ($/Bbl, excluding realized gains (losses) on derivatives) +75.97 +55.84 +97.37 +Operating costs per Boe - Total Consolidated +Production costs +$ +9.61 +$ +8.52 +$ +9.19 +Severance/production taxes +0.49 +0.27 +0.33 +Gathering +0.48 +0.58 +0.51 +DD&A +19.00 +16.99 +33.45 +Interest +7.95 +9.70 +12.52 +Total operating costs per Boe +$ +37.53 +$ +36.06 +$ +56.00 +11 +Table of Contents +Present Activities and Productive Wells +The following table sets forth the wells drilled and completed during the periods indicated. All such wells were drilled in the continental United States and in federal and state waters in the Gulf of Mexico. At December 31, 2010 we had nine oil wells awaiting fracture stimulation and were in the process of drilling two wells. +Years ended December 31, +2010 +2009 +2008 +Gross +Net +Gross +Net +Gross +Net +Development: +Oil +4 +3.69 +- +- +1 +0.15 +Gas +- +- +- +- +- +- +Non-productive +- +- +- +- +1 +0.50 +Total +4 +3.69 +- +- +2 +0.65 +Exploration: +Oil +16 +15.69 +- +- +- +- +Gas +1 +0.69 +- +- +- +- +Non-productive +- +- +- +- +2 +0.22 +Total +17 +16.38 +- +- +2 +0.22 +The following table sets forth productive wells as of December 31, 2010: +Oil Wells +Gas Wells +Gross +Net +Gross +Net +Working interest +45 +32.02 +21 +7.87 +Royalty interest +3 +0.10 +6 +0.15 +Total +48 +32.12 +27 +8.02 +A well is categorized as an oil well or a natural gas well based upon the ratio of oil to gas reserves on a Mcfe basis. However, some of our wells produce both oil and gas. At December 31, 2010, we had no wells with multiple completions. +Leasehold Acreage +The following table shows our approximate developed and undeveloped (gross and net) leasehold acreage as of December 31, 2010. A portion of our Texas acreage requires continued drilling to hold the acreage for which we have included in our development plans, though the r enewal of this acreage, if necessary, is not considered material. We have two federal blocks in offshore waters, 11,520 gross or 8,446 net acres, which will expire within the next two years for which we have a carrying value of $3.5 million. We are currently negotiating potential farm-outs of this acreage. In addition we have three other federal blocks in offshore waters, 16,706 gross or 6,489 net acres, scheduled to expire within the next two years which have no carrying value and for which we have no current development plans. +Developed +Undeveloped +Gross +Net +Gross +Net +Louisiana +4,848 +2,339 +931 +699 +Texas +6,160 +5,520 +3,634 +3,306 +Federal onshore +- +- +64,963 +64,963 +Federal waters +53,211 +18,386 +72,955 +41,919 +Total +64,219 +26,245 +142,483 +110,887 +12 +Table of Contents +Title to Properties +The Company believes that the title to its oil and gas properties is good and defensible in accordance with standards generally accepted in the oil and gas industry, subject to such exceptions which, in our opinion, are not so material as to detract substantially from the use or value of such properties. The Company’s properties are typically subject, in one degree or another, to one or more of the following: +· +royalties and other burdens and obligations, express or implied, under oil and gas leases; +· +overriding royalties and other burdens created by us or our predecessors in title; +· +a variety of contractual obligations (including, in some cases, development obligations) arising under operating agreements, farm-out agreements, production sales contracts and other agreements that may affect the properties or their titles; +· +back-ins and reversionary interests existing under purchase agreements and leasehold assignments; +· +liens that arise in the normal course of operations, such as those for unpaid taxes, statutory liens securing obligations to unpaid suppliers and contractors and contractual liens under operating agreements; +· +pooling, unitization and communitization agreements, declarations and orders; and +· +easements, restrictions, rights-of-way and other matters that commonly affect property. +To the extent that such burdens and obligations affect the Company’s rights to production revenues, the characteristic has been taken into account in calculating Callon’s net revenue interests and in estimating the size and value of its reserves. The Company believes that the burdens and obligations affecting our properties it’s conventional in the industry for properties of the kind owned by Callon. +Major Customers +Our production is sold generally on month-to-month contracts at prevailing prices. The following table identifies customers to whom we sold a significant percentage of our total oil and gas production during each of the 12-month periods ended: +Percentage of Total Revenue +for the year ended December 31, +2010 +2009 +2008 +Shell Trading Company +44% +45% +33% +Plains Marketing, L.P. +20% +23% +23% +Louis Dreyfus Energy Services +13% +15% +16% +Other +23% +17% +28% +Total +100% +100% +100% +Because alternative purchasers of oil and gas are readily available, the Company believes that the loss of any of these purchasers would not result in a material adverse effect on Callon’s ability to market future oil and gas production. We are not currently committed to provide a fixed and determinable quantity of oil or gas in the near future under our contracts. +Corporate Offices +The Company’s headquarters are located in Natchez, Mississippi, in approximately 51,500 square feet of owned space. We also maintain leased business offices in Houston and Midland, Texas, and own or lease field offices in the area of the major fields in which we operate properties or have a significant interest. Replacement of any of our leased offices would not result in material expenditures by us as alternative locations to our leased space are anticipated to be readily available . +Employees +Callon had 79 employees as of December 31, 2010, which included eight petroleum engineers and four petroleum geoscientists. None of the Company’s employees are currently represented by a union, and the Company believes that it has good relations with its employees. +Regulations +General . The oil and gas industry is subject to regulation at the federal, state and local level, and some of the laws, rules and regulations that govern our operations carry substantial penalties for non-compliance. This regulatory burden increases our cost of doing business and, consequently, affects our profitability. +13 +Table of Contents +Exploration and Production . Our operations are subject to federal, state and local regulations that include requirements for permits to drill and to conduct other operations and for provision of financial assurances (such as bonds and letters of credit) covering drilling and well operations. Other activities subject to regulation are: +· +the location and spacing of wells, +· +the method of drilling and completing wells, +· +the rate and method of production, +· +the surface use and restoration of properties upon which wells are drilled and other exploration activities, +· +the plugging and abandoning of wells, +· +the discharge of contaminants into water and the emission of contaminants into air, +· +the disposal of fluids used or other wastes obtained in connection with operations, +· +the marketing, transportation and reporting of production, and +· +the valuation and payment of royalties. +For instance, our outer continental shelf (“OCS”) leases in federal waters are administered by Bureau of Ocean Energy Management, Regulation and Enforcement (“BOEMRE”), and require compliance with detailed BOEMRE (a) regulations and orders. Lessees must obtain BOEMRE approval for exploration, exploitation and production plans and applications for permits to drill prior to the commencement of such operations. Since the April 20, 2010 blowout and oil spill at the BP Deepwater Horizon Macondo oil well, the BOEMRE has issued numerous Notices to Lessees and other guidance documents as well as an Interim Final Rule augmenting the existing regulations with more stringent safety, engineering and environmental requirements. The BOEMRE has also recently issued a rule requiring that all operators in the OCS formulate detailed Safety and Environmental Management Systems to improve the safety of their operations on the OCS. Current BOEMRE regulations restrict the flaring or venting of natural gas, and prohibit the flaring of liquid hydrocarbons and oil without prior authorization. The BOEMRE is considering whether to require flaring rather than venting, where practical, to reduce the potential effect of greenhouse gas emissions. +BOEMRE policies concerning the volume of production that a lessee must have to maintain an offshore lease beyond its primary term also are applicable to Callon. Similarly, the BOEMRE has promulgated other regulations and a Notice to Lessees governing the plugging and abandonment of wells located offshore and the installation and decommissioning of production facilities. To cover the various obligations of lessees on the OCS, BOEMRE generally requires that lessees post bonds, letters of credit, or other acceptable assurances that such obligations will be met. The cost of these bonds or other surety can be substantial, and there is no assurance that bonds or other surety can be obtained in all cases. Under some circumstances, BOEMRE may require any of our operations on federal leases to be suspended or terminated. Any such suspension or termination could materially adversely affect our financial conditions and results of operations. +As stated above, the April 20, 2010 blowout and oil spill at the BP Deepwater Horizon oil rig has prompted the federal government to impose heightened regulation of oil and gas exploration and production on the OCS. Especially with respect to deepwater operations, the BOEMRE has issued rules that are more stringent than the rules issued by the MMS, and has announced its intention to issue additional safety rules and be more scrupulous in implementing existing environmental requirements in the future. Legislation has been introduced in the United States Congress to toughen the regulation of oil and gas exploration and production on the OCS. In addition, the National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, whose members were appointed by President Obama, issued a report proposing, among other things, fundamental reform of the regulation of oil and gas exploration and production on the OCS. The tightening of regulation on the OCS could impose higher costs on, and render it more difficult to timely obtain regulatory approval of our proposed activities on the OCS, especially as to deepwater projects. +Operations conducted on federal or state oil and natural gas leases must comply with numerous regulatory restrictions, including various nondiscrimination statues, royalty and related valuation requirements, and certain of these operations must be conducted pursuant to certain on-site security regulations and other appropriate permits issued by the BOEMRE or other appropriate federal or state agencies. +Our sales of oil and natural gas are affected by the availability, terms and cost of pipeline transportation. The price and terms for access to pipeline transportation remain subject to extensive federal and state regulation. If these regulations change, we could face higher transmission costs for our production and, possibly, reduced access to transmission capacity. +Various proposals and proceedings that might affect the petroleum industry are pending before Congress, the Federal Energy Regulatory Commission, or FERC, various state legislatures, and the courts. The industry historically has been heavily regulated and we can offer you no assurance that the less stringent regulatory approach recently pursued by the FERC and Congress will continue nor can we predict what effect such proposals or proceedings may have on our operations. +We do not currently anticipate that compliance with existing laws and regulations governing exploration and production will have a significantly adverse effect upon our capital expenditures, earnings or competitive position. +14 +Table of Contents +In response to concerns that the former Minerals Management Service’s (“MMS”) revenue-generating and resource development functions were at odds with its safety and environmental regulatory functions, the Department of Interior plans to divide the BOEMRE into three separate agencies: the Bureau of Ocean Energy Management (“BOEM”), to be the resource manager for conventional and renewable energy and mineral resources on the OCS; the Bureau of Safety and Environmental Enforcement (“BSEE”), to promote and enforce safety in offshore energy exploration and production operations; and the Office of Natural Resources Revenue (“ONRR”), to collect and distribute royalties, rents, fees and other revenues, including the development of regulations with respect to revenue valuation and collection and enforcement activities. The ONRR began operations on October 1, 2010. The BOEM and the BSEE are scheduled to undergo a phased implementation program beginning in January 2011 and continuing for at least twelve months. +Environmental Regulation . Various federal, state and local laws and regulations concerning the release of contaminants into the environment, including the discharge of contaminants into water and the emission of contaminants into the air, the generation, storage, treatment, transportation and disposal of wastes, and the protection of public health, welfare, and safety, and the environment, including natural resources, affect our exploration, development and production operations, including operations of our processing facilities. We must take into account the cost of complying with environmental regulations in planning, designing, drilling, constructing, operating and abandoning wells. Regulatory requirements relate to, among other things, the handling and disposal of drilling and production waste products, the control of water and air pollution and the removal, investigation, and remediation of petroleum-product contamination. In addition, our operations may require us to obtain permits for, among other things, +· +air emissions, +· +discharges into surface waters, and +· +the construction and operations of underground injection wells or surface pits to dispose of produced saltwater and other nonhazardous oilfield wastes. +In the event of an unauthorized discharge (e.g., to land or water), emission (e.g., to air) or other activity, we may be liable for, among other things, penalties, costs and damages, and subject to injunctive relief, and we could be required to cleanup or mitigate the environmental impacts of those discharges, emissions or activities. Also, under federal, and certain state, laws, the present and certain past owners and operators of a site, and persons that treated, disposed of or arranged for the disposal of hazardous substances found at a site, may be liable, without regard to fault or the legality of the original conduct, for the release of hazardous substances into the environment. The Environmental Protection Agency, state environmental agencies and, in some cases third parties are authorized to take actions in response to threats to human health or the environment and to seek to recover from responsible classes of persons the costs of such actions. We therefore could be required to remove or remediate previously disposed wastes and remediate contamination, including contamination in surface water, soil or groundwater, caused by disposal of that waste, irrespective of whether disposal or release were authorized. We could be responsible for wastes disposed of or released by us or prior owners or operators at properties owned or leased by us or at locations where wastes have been taken for disposal also irrespective of whether disposal or release were authorized. We could also be required to suspend or cease operations in contaminated areas, or to perform remedial well plugging operations or cleanups to prevent future contamination. +Federal, and certain state, laws also impose duties and liabilities on certain “responsible parties” related specifically to the prevention of oil spills and damages resulting from such spills in or threatening United States waters or adjoining shorelines. A liable “responsible party” includes the owner or operator of a facility, vessel or pipeline that is a source of an oil discharge or that poses the substantial threat of discharge or, in the case of offshore facilities, the lessee or permittee of the area in which a discharging facility is located. These laws assign liability, which generally is joint and several, without regard to fault, to each liable party for oil removal costs and a variety of public and private damages. Although defenses and limitations exist to the liability imposed under these laws, they are limited. In the event of an oil discharge or substantial threat of discharge, we could be liable for costs and damages. +The Environmental Protection Agency and various state agencies have limited the disposal options for hazardous and nonhazardous wastes thereby increasing the costs of disposal. Furthermore, certain wastes generated by our oil and natural gas operations that are currently exempt from treatment as hazardous wastes may in the future be designated as hazardous wastes and, therefore, be subject to considerably more rigorous and costly operating and disposal requirements. +Federal and state occupational safety and health laws require us to organize information about hazardous materials used, released or produced in our operations. Certain portions of this information must be provided to employees, state and local governmental authorities and local citizens. We are also subject to the requirements and reporting set forth in federal workplace standards. +There are federal and certain state laws that impose restrictions on activities adversely affecting the habitat of certain plant and animal species. In the event of an unauthorized impact or taking of a protected species or its habitat, we could be liable for penalties, costs and damages, and subject to injunctive relief, and we could be required to mitigate those impacts. A critical habitat or suitable habitat designation also could result in further material restrictions to land use and may materially delay or prohibit land access for oil and natural gas development. +15 +Table of Contents +We have made and will continue to make expenditures to comply with environmental regulations and requirements. These are necessary costs of doing business within the oil and gas industry. Although we are not fully insured against all environmental risks, we maintain insurance coverage which we believe is customary in the industry. Moreover, it is possible that other developments, such as stricter and more comprehensive environmental laws and regulations, as well as claims for damages to property or persons resulting from company operations, could result in substantial costs and liabilities. We believe we are in compliance with existing environmental regulations, and that, absent the occurrence of an extraordinary event the effect of which cannot be predicted, any noncompliance will not have a material adverse effect on our operations or earnings. +Greenhouse Gas (“GHG”) Regulation. Although federal legislation regarding the control of greenhouse gasses or GHGs seems unlikely, the Environmental Protection Agency (“EPA”) has been moving forward with rulemaking to regulate GHGs as pollutants under the Clean Air Act (“CAA”). These GHG regulations could require us to incur increased operating costs and could have an adverse effect on demand for the oil and natural gas we produce. +On June 3, 2010, EPA published its so-called GHG tailoring rule that will phase in federal prevention of significant deterioration (PSD) permit requirements for new sources and modifications, and Title V operating permits for all sources, that have the potential to emit specific quantities of GHGs. Those permitting provisions, when they become applicable to our operations, could require controls or other measures to reduce GHG emissions from new or modified sources, and we could incur additional costs to satisfy those requirements. On November 30, 2010, EPA published a rule establishing GHG reporting requirements for sources in the petroleum and natural gas industry, requiring those sources to monitor, maintain records on, and annually report their GHG emissions, with the first annual report -- for 2010 -- being due in March of 2011. Although this rule does not limit the amount of GHGs that can be emitted, it could require us to incur costs to monitor, keep records of, and report GHG emissions associated with our operations. +In addition to federal regulation, a number of states, individually and regionally, also are considering or have implemented GHG regulatory programs. These potential regional and state initiatives may result in so–called cap–and–trade programs, under which overall GHG emissions are limited and GHG emissions are then allocated and sold, and possibly other regulatory requirements, that could result in our incurring material expenses to comply, e.g., by being required to purchase or to surrender allowances for GHGs resulting from our operations. The federal, regional and local regulatory initiatives also could adversely affect the marketability of the oil and natural gas we produce. The impact of such future programs cannot be predicted, but we do not expect our operations to be affected any differently than other similarly situated domestic competitors. +Application of the Safe Drinking Water Act to Hydraulic Fracturing. Congress is currently considering legislation to amend the federal Safe Drinking Water Act to remove the exemption for hydraulic fracturing operations and require reporting and disclosure of chemicals used by the oil and gas industry in the hydraulic fracturing process. Hydraulic fracturing involves the injection of water, sand and chemicals under pressure into rock formations to stimulate oil and natural gas production. Sponsors of bills pending before the Senate and House of Representatives have asserted that chemicals used in the fracturing process could adversely affect drinking water supplies. A number of states have or are considering hydraulic fracturing regulation. Potential federal as well as existing and potential state regulation could cause us to incur substantial compliance costs, and the requirement could negatively affect our ability to conduct fracturing activities on our assets. +Surface Damage Statues (“SDAs”) . In addition, eleven states have enacted SDAs. These laws are designed to compensate for damage caused by mineral development. Most SDAs contain entry notification and negotiation requirements to facilitate contact between operators and surface owners/users. Most laws also contain bonding requirements and specific expenses for exploration and operating activities. Costs and delays associated with SDAs could impair operational effectiveness and increase development costs. +Other Regulations . If we conduct operations on federal, state or Indian oil and natural gas leases, these operations must comply with numerous regulatory restrictions, including various nondiscrimination statutes, royalty and related valuation requirements. Certain of these operations must be conducted pursuant to certain on-site security regulations and other appropriate permits issued by the Bureau of Land Management, BOEMRE or other appropriate federal or state agencies. +Commitments and Contingencies +The Company’s activities are subject to federal, state and local laws and regulations governing environmental quality and pollution control. Although no assurances can be made, the Company believes that, absent the occurrence of an extraordinary event, compliance with existing federal, state and local laws, rules and regulations governing the release of materials into the environment or otherwise relating to the protection of the environment will not have a material effect upon the capital expenditures, earnings or the competitive position of the Company with respect to its existing assets and operations. The Company cannot predict what effect additional regulation or legislation, enforcement polices included, and claims for damages to property, employees, other persons, and the environment resulting from the Company’s operations could have on its activities. +Available Information +We make available free of charge on our Internet web site (www.callon.com) our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and other filings pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and amendments to such filings, as soon as reasonably practicable after each are electronically filed with, or furnished to, the Securities and Exchange Commission (the “SEC”). You may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE., Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers, like Callon, that file electronically with the SEC. +We also make available within the Investors section of our Internet web site our Code of Business Conduct and Ethics, Corporate Governance Guidelines, and Audit, Compensation and Nominating and Governance Committee Charters, which have been approved by our board of directors. We will make timely disclosure by a Current Report on Form 8-K and on our web site of any change to, or waiver from, the Code of Business Conduct and Ethics for our principal executive and senior financial officers. A copy of our Code of Business Conduct and Ethics is also available, free of charge by writing us at: Chief Financial Officer, Callon Petroleum Company, P.O. Box 1287, Natchez, MS 39121. +16 +Table of Contents +Item 1A. Risk Factors +Risk Factors +Future economic conditions in the U.S. and key international markets may materially adversely impact our operating results. The U.S. and other world economies are slowly recovering from a recession that began in 2008 and extended through 2010. While modest growth has resumed, there are likely to be significant long-term effects resulting from the recession and credit market crisis, including a future global economic growth rate that is slower than we have experienced in recent years. In addition, more volatility may occur before a sustainable growth rate is achieved. Global economic growth drives demand for energy from all sources, including fossil fuels. A lower future economic growth rate could result in decreased demand growth for our crude oil and natural gas production as well as lower commodity prices, which would reduce our cash flows from operations and our profitability. +Depressed oil and gas prices may adversely affect our results of operations and financial condition . Our success is highly dependent on prices for oil and gas, which are extremely volatile, and the oil and gas markets are cyclical. Extended periods of low prices for oil or gas will have a material adverse effect on us. The prices of oil and gas depend on factors we cannot control such as weather, economic conditions, and levels of production, actions by OPEC and other countries and government actions. Prices of oil and gas will affect the following aspects of our business: +· +our revenues, cash flows and earnings; +· +the amount of oil and gas that we are economically able to produce; +· +our ability to attract capital to finance our operations and the cost of the capital; +· +the amount we are allowed to borrow under our senior secured credit facility; +· +the profit or loss we incur in exploring for and developing our reserves; and +· +the value of our oil and gas properties. +Natural gas prices have been depressed for the last several years as a result of over-supply caused by, among other things, increased drilling in unconventional reservoirs, reduced economic activity associated with a recession and weather conditions. We expect natural gas prices to be depressed during the foreseeable future. Approximately 40% of our estimated net proved reserves are natural gas, and 49% of our production in 2010 was natural gas. A sustained reduction in natural gas prices could have an adverse effect on our results of operation and financial condition. +Our actual recovery of reserves may substantially differ from our proved reserve estimates. This Form 10-K contains estimates of our proved oil and gas reserves and the estimated future net cash flows from such reserves. These estimates are based upon various assumptions, including assumptions required by the SEC relating to oil and gas prices, drilling and operating expenses, capital expenditures, taxes and availability of funds. The process of estimating oil and natural gas reserves is complex. This process requires significant decisions and assumptions in the evaluation of available geological, geophysical, engineering and economic data for each reservoir and is therefore inherently imprecise. Additionally, our interpretations of the rules governing the estimation of proved reserves could differ from the interpretation of staff members of regulatory authorities resulting in estimates that could be challenged by these authorities. +Actual future production, oil and gas prices, revenues, taxes, development expenditures, operating expenses and quantities of recoverable oil and gas reserves most likely will vary from the estimates. Any significant variance could materially affect the estimated quantities and present value of reserves shown in this report. Additionally, reserves and future cash flows may be subject to material downward or upward revisions, based on production history, development drilling and exploration activities and prices of oil and natural gas. We incorporate many factors and assumptions into our estimates including: +· +Expected reservoir characteristics based on geological, geophysical and engineering assessments; +· +Future production rates based on historical performance and expected future operation investment activities; +· +Future oil and gas prices and quality and locational differences; and +· +Future development and operating costs. +Although we believe our assumptions are reasonable based on the information available to us at the time we prepare our estimates, our actual results could vary considerably from estimated quantities of proved natural gas and oil reserves (in the aggregate and for a particular geographic location), production, revenues, taxes and development and operating expenditures. Our policies and practices regarding internal controls over the recording of reserves are structured to objectively and accurately estimate our oil and gas reserve quantities and present values in compliance with the SEC’s regulations and US GAAP. We provide information about our oil and gas properties, including production profiles, prices and costs, to our independent reserve engineer and they prepare their own estimates of the reserve attributable to our properties. +You should not assume that any present value of future net cash flows from our producing reserves contained in this Form 10-K represents the market value of our estimated oil and natural gas reserves. We base the estimated discounted future net cash flows from our proved reserves at December 31, 2010 on average 12-month prices and costs as of the date of the estimate. Actual future prices and costs may be materially higher or lower. Further, actual future net revenues will be affected by factors such as the amount and timing of actual development expenditures, the rate and timing of production, and changes in governmental regulations or taxes. At December 31, 2010, approximately 21% of the discounted present value of our estimated net proved reserves consisted of PUDs. PUDs represented 51% of total proved reserves by volume, and approximately 33% of our PUDs were attributable to our deepwater properties. Recovery of undeveloped reserves generally requires significant capital expenditures and successful drilling operations. Our reserve estimates include the assumption that we will make significant capital expenditures to develop these undeveloped reserves and the actual costs, development schedule, and results associated with these properties may not be as estimated. In addition, the 10% discount factor that we use to calculate the net present value of future net revenues and cash flows may not necessarily be the most appropriate discount factor based on our cost of capital in effect from time to time and the risks associated with our business and the oil and gas industry in general. +Information about reserves constitutes forward-looking information. See “Forward-Looking Statements” for information regarding forward-looking information. +17 +Table of Contents +Unless we are able to replace reserves that we have produced, our cash flows and production will decrease over time. The high-rate production characteristics of our Gulf of Mexico properties subject us to high reserve replacement needs. In general, the volume of production from oil and gas properties declines as reserves are depleted. The decline rates depend on reservoir characteristics. Gulf of Mexico reservoirs tend to be recovered quickly through production with associated steep declines, while declines in other regions after initial flush production tend to be relatively low. Approximately 43% of our estimated proved reserves at December 31, 2010 and 49% of our production during 2010 were associated with our Gulf of Mexico, deep-water properties. Our reserves will decline as they are produced unless we acquire properties with proved reserves or conduct successful development and exploration drilling activities. Our future natural gas and oil production is highly dependent upon our level of success in finding or acquiring additional reserves at a unit cost that is sustainable at prevailing commodity prices. Without successful exploration or acquisition activities, our reserves, production and revenues will decline. +Exploring for, developing, or acquiring reserves is capital intensive and uncertain. We may not be able to economically find, develop, or acquire additional reserves, or may not be able to make the necessary capital investments if our cash flows from operations decline or external sources of capital become limited or unavailable. We cannot assure you that our future exploitation, exploration, development, and acquisition activities will result in additional proved reserves or that we will be able to drill productive wells at acceptable costs. We cannot assure you that we will be able to find and develop or acquire additional reserves at an acceptable cost. +A significant part of the value of our production and reserves is concentrated in a small number of offshore properties, and any production problems or inaccuracies in reserve estimates related to those properties would adversely impact our business. During 2010, approximately 62% of our daily production came from three of our properties in the Gulf of Mexico. Moreover, one property accounted for 35% of our production during this period. In addition, at December 31, 2010, approximately 43% of our total net proved reserves were located in two fields in the Gulf of Mexico. If mechanical problems, storms or other events curtailed a substantial portion of this production or if the actual reserves associated with any one of these producing properties are less than our estimated reserves, our results of operations and financial condition could be adversely affected. +Our exploration projects increase the risks inherent in our oil and gas activities. We may seek to replace reserves through exploration, where the risks are greater than in acquisitions and development drilling. Although we have been successful in exploration in the past, we cannot assure you that we will continue to increase reserves through exploration or at an acceptable cost. Additionally, we are often uncertain as to the future costs and timing of drilling, completing and producing wells. Our drilling operations may be curtailed, delayed or canceled as a result of a variety of factors, including: +· unexpected drilling conditions; +· overpressured formations and resultant blowouts or cratering; +· equipment failures or accidents; +· adverse weather conditions; +· governmental requirements; and +· shortages or delays in the availability of drilling rigs and the delivery of equipment. +Our decision to drill a prospect is subject to a number of factors, and we may decide to alter our drilling schedule or not drill at all. A prospect is a property on which we have identified what our geoscientists believe, based on available seismic and geological information, to be indications of hydrocarbons. Our prospects are in various stages of evaluation, ranging from a prospect which is ready to drill to a prospect that will require substantial additional seismic data processing and interpretation. Whether we ultimately drill a prospect may depend on the following factors: +· +receipt of additional seismic data or other geophysical data or the reprocessing of existing data; +· +material changes in oil or gas prices; +· +the costs and availability of drilling rigs; +· +the success or failure of wells drilled in similar formations or which would use the same production facilities; +· +availability and cost of capital; +· +changes in the estimates of the costs to drill or complete wells; +· +our ability to attract other industry partners to acquire a portion of the working interest to reduce exposure to costs and drilling risks; +· +decisions of our joint working interest owners; and +· +changes to governmental regulations. +We will continue to gather data about our prospects, and it is possible that additional information may cause us to alter our drilling schedule or determine that a prospect should not be pursued at all. You should understand that our plans regarding our prospects are subject to change. +Our exploration and development drilling efforts and the operation of our wells may not be profitable or achieve our targeted returns. Exploration, development, drilling and production activities are subject to many risks, including the risk that commercially productive reservoirs will not be discovered. We may invest in property, including undeveloped leasehold acreage, which we believe will result in projects that will add value over time. However, we cannot guarantee that any leasehold acreage acquired by us will be profitably developed, that new wells drilled by us will be productive or that we will recover all or any portion of our investment in such leasehold acreage or wells. Drilling for oil and natural gas may involve unprofitable efforts, not only from dry wells but also from wells that are productive but do not produce sufficient net reserves to return a profit after deducting operating and other costs. In addition, wells that are profitable may not achieve our targeted rate of return. Our ability to achieve our target results are dependent upon the current and future market prices for oil and natural gas, costs associated with producing oil and natural gas and our ability to add reserves at an acceptable cost. We rely to a significant extent on 3-D seismic data and other advanced technologies in identifying leasehold acreage prospects and in conducting our exploration activities. The 3-D seismic data and other technologies we use do not allow us to know conclusively whether oil or natural gas is present or may be produced economically. The use of 3-D seismic data and other technologies also requires greater pre-drilling expenditures than traditional drilling strategies. +In addition, we may not be successful in controlling our drilling and production costs to improve our overall return. The cost of drilling, completing and operating a well is often uncertain and cost factors can adversely affect the economics of a project. We cannot predict the cost of drilling, and we may be forced to limit, delay or cancel drilling operations as a result of a variety of factors, including: +· +unexpected drilling conditions; +· +pressure or irregularities in formations; +· +equipment failures or accidents and shortages or delays in the availability of drilling rigs and the delivery of equipment; and +· +compliance with governmental requirements. +18 +Table of Contents +We may be unable to integrate successfully the operations of future acquisitions with our operations, and we may not realize all the anticipated benefits of these acquisitions . We intend to focus on producing property acquisitions that would preferably include undeveloped acreage. Integration of acquisitions with our existing business and operations will be a complex, time consuming and costly process. We can offer no assurance that we will achieve the desired profitability from any acquisitions we may complete in the future. In addition, failure to assimilate recent and future acquisitions successfully could adversely affect our financial condition and results of operations. +Our acquisitions may involve numerous risks, including: +· +operating a larger combined organization and adding operations; +· +difficulties in the assimilation of the assets and operations of the acquired business, especially if the assets acquired are in a new business segment or geographic area; +· +risk that oil and natural gas reserves acquired may not be of the anticipated magnitude or may not be developed as anticipated; +· +loss of significant key employees from the acquired business: +· +diversion of management’s attention from other business concerns; +· +failure to realize expected profitability or growth; +· +failure to realize expected synergies and cost savings; +· +coordinating geographically disparate organizations, systems and facilities; and +· +coordinating or consolidating corporate and administrative functions. +Further, unexpected costs and challenges may arise whenever businesses with different operations or management are combined, and we may experience unanticipated delays in realizing the benefits of an acquisition. If we consummate any future acquisition, our capitalization and results of operation may change significantly, and you may not have the opportunity to evaluate the economic, financial and other relevant information that we will consider in evaluating future acquisitions. +We may fail to fully identify problems with any properties we acquire, and as such, assets we acquire may prove to be worth less than we paid because of uncertainties in evaluating recoverable reserves and potential liabilities. We are actively seeking to acquire additional acreage in Louisiana and Texas or other regions in the future. Although we conduct a review of properties we acquire which we believe is consistent with industry practices, we can give no assurance that we have identified or will identify all existing or potential problems associated with such properties or that we will be able to mitigate any problems we do identify. Our recent growth is due significantly to acquisitions of producing properties and undeveloped and unevaluated leaseholds. We expect acquisitions may also contribute to our future growth. Successful acquisitions require an assessment of a number of factors, including estimates of recoverable reserves, exploration potential, future oil and natural gas prices, operating and capital costs and potential environmental and other liabilities. Such assessments are inexact and their accuracy is inherently uncertain. In connection with our assessments, we perform a review of the acquired properties which we believe is generally consistent with industry practices. However, such a review will not reveal all existing or potential problems. In addition, our review may not permit us to become sufficiently familiar with the properties to fully assess their deficiencies and capabilities. We do not inspect every well. Even when we inspect a well, we do not always discover structural, subsurface and environmental problems that may exist or arise. We are generally not entitled to contractual indemnification for preclosing liabilities, including environmental liabilities. Normally, we acquire interests in properties on an “as is” basis with limited remedies for breaches of representations and warranties. As a result of these factors, we may not be able to acquire oil and natural gas properties that contain economically recoverable reserves or be able to complete such acquisitions on acceptable terms. +There is competition for available oil and gas properties. Our competitors include major oil and gas companies, independent oil and gas companies and financial buyers. Some of our competitors may have greater and more diverse resources than we do. High commodity prices and stiff competition for acquisitions have in the past, and may in the future, significantly increase the cost of available properties. The increased competition and rising prices for available properties could limit or impede our ability to identify acquisition opportunities that are economic for a company our size and that are necessary to grow our reserves or replace reserves produced. +We do not operate all of our properties, and have limited influence over the operations of some of these properties, particularly our two deepwater properties. Our lack of control could result in the following: +· +the operator may initiate exploration or development at a faster or slower pace than we prefer; +· +the operator may propose to drill more wells or build more facilities on a project than we have funds for or that we deem appropriate, which may mean that we are unable to participate in the project or share in the revenues generated by the project even though we paid our share of exploration costs; and +· +if an operator refuses to initiate a project, we may be unable to pursue the project. +Any of these events could materially reduce the value of our non-operated properties. +19 +Table of Contents +Weather, unexpected subsurface conditions, and other unforeseen operating hazards may adversely impact our ability to conduct business. There are many operating hazards in exploring for and producing oil and gas, including: +· +our drilling operations may encounter unexpected formations or pressures, which could cause damage to equipment or personal injury; +· +we may experience equipment failures which curtail or stop production; +· +we could experience blowouts or other damages to the productive formations that may require a well to be re-drilled or other corrective action to be taken; +· +hurricanes, storms and other weather conditions could cause damages to our production facilities or wells; and +· +because of these or other events, we could experience environmental hazards, including release of oil and gas from spills, gas leaks, and ruptures. +If we experience any of these problems, it could affect well bores, platforms, gathering systems and processing facilities, which could adversely affect our ability to conduct operations. We could also incur substantial losses in excess of our insurance coverage as a result of: +· +injury or loss of life; +· +severe damage to and destruction of property, natural resources and equipment; +· +pollution and other environmental damage; +· +clean-up responsibilities; +· +regulatory investigation and penalties; +· +suspension of our operations; and +· +repairs to resume operations. +Offshore operations are also subject to a variety of additional operating risks peculiar to the marine environment, such as capsizing, collisions and damage or loss from hurricanes or other adverse weather conditions. These conditions can cause substantial damage to facilities and interrupt production. As a result, we could incur substantial liabilities that could reduce or eliminate the funds available for development or leasehold acquisitions, or result in loss of equipment and properties. +We cannot assure you that we will be able to maintain adequate insurance at rates we consider reasonable to cover our possible losses from operating hazards. The occurrence of a significant event not fully insured or indemnified against could materially and adversely affect our financial condition and results of operations. +Factors beyond our control affect our ability to market production and our financial results. The ability to market oil and gas from our wells depends upon numerous factors beyond our control. These factors could negatively affect our ability to market all of the oil or gas we produce. In addition, we may be unable to obtain favorable prices for the oil and gas we produce. These factors include: +· +the extent of domestic production and imports of oil and gas; +· +the proximity of the gas production to gas pipelines; +· +the availability of pipeline capacity; +· +the demand for oil and gas by utilities and other end users; +· +the availability of alternative fuel sources; +· +the effects of inclement weather; +· +state and federal regulation of oil and gas marketing; and +· +federal regulation of gas sold or transported in interstate commerce. +In particular, in the Haynesville Shale and other nonconventional shale plays, capacity may be limited and it may be necessary for new interstate and intrastate pipelines and gathering systems to be built. +Part of our strategy involves drilling in new or emerging shale formations using horizontal drilling and completion techniques. The results of our planned drilling program in these formations may be subject to more uncertainties than conventional drilling programs in more established formations and may not meet our expectations for reserves or production. The results of our drilling in new or emerging formations, such as the Haynesville Shale, are generally more uncertain than drilling results in areas that are developed and have established production. Because new or emerging formations have limited or no production history, we are less able to use past drilling results in those areas to help predict our future drilling results. Further, part of our drilling strategy to maximize recoveries from the Haynesville Shale involves the drilling of horizontal wells using completion techniques that have proven to be successful in other shale formations. Our experience with horizontal drilling in these areas to date, as well as the industry’s drilling and production history, while growing, is limited. The ultimate success of these drilling and completion strategies and techniques will be better evaluated over time as more wells are drilled and production profiles are better established. Further, access to adequate gathering systems or pipeline takeaway capacity and the availability of drilling rigs and other services may be more challenging in new or emerging areas. If our drilling results are less than anticipated or we are unable to execute our drilling program because of capital constraints, access to gathering systems and takeaway capacity or otherwise, and/or natural gas and oil prices decline, our investment in these areas may not be as attractive as we anticipate and we could incur material writedowns of unevaluated properties and the value of our undeveloped acreage could decline in the future. +20 +Table of Contents +The loss of key personnel could adversely affect our ability to operate. We depend, and will continue to depend in the foreseeable future, on the services of our senior officers and other key employees, as well as other third-party consultants with extensive experience and expertise in evaluating and analyzing drilling prospects and producing oil and gas from proved properties and maximizing production from oil and natural gas properties. Our ability to retain our senior officers, other key employees and our third party consultants, none of whom are subject to employment agreements, is important to our future success and growth. The unexpected loss of the services of one or more of these individuals could have a detrimental effect on our business. +We may not be insured against all of the operating risks to which our business in exposed. In accordance with industry practice, we maintain insurance against some, but not all, of the operating risks to which our business is exposed. We cannot assure you that our insurance will be adequate to cover losses or liabilities. We experienced Gulf of Mexico production interruption in 2005, 2006 and 2007 from Hurricanes Katrina and Rita and in 2008 and 2009 from Hurricanes Gustav and Ike for which we had no production interruption insurance. Also, we cannot predict the continued availability of insurance at premium levels that justify its purchase. No assurance can be given that we will be able to maintain insurance in the future at rates we consider reasonable and may elect none or minimal insurance coverage. The occurrence of a significant event, not fully insured or indemnified against, could have a material adverse affect on our financial condition and operations. +Competitive industry conditions may negatively affect our ability to conduct operations. We compete with numerous other companies in virtually all facets of our business. Our competitors in development, exploration, acquisitions and production include major integrated oil and gas companies as well as numerous independents, including many that have significantly greater resources. Therefore, competitors may be able to pay more for desirable leases and evaluate, bid for and purchase a greater number of properties or prospects than the financial or personnel resources of the Company permit. We also compete for the materials, equipment and services that are necessary for the exploration, development and operation of our properties. Our ability to increase reserves in the future will be dependent on our ability to select and acquire suitable prospects for future exploration and development. Factors that affect our ability to compete in the marketplace include: +· +our access to the capital necessary to drill wells and acquire properties; +· +our ability to acquire and analyze seismic, geological and other information relating to a property; +· +our ability to retain the personnel necessary to properly evaluate seismic and other information relating to a property; +· +our ability to procure materials, equipment and services required to explore, develop and operate our properties, including the ability to procure fracture stimulation services on wells drilled; and +· +our ability to access pipelines, and the location of facilities used to produce and transport oil and natural gas production. +The adoption of derivatives legislation and regulations related to derivative contracts could have an adverse impact on our ability to hedge risks associated with our business. In 2009. the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. Among other things, the act requires the Commodity Futures Trading Commission and the SEC to enact regulations affecting derivative contracts, including the derivative contracts we use to hedge our exposure to price volatility. We cannot predict the content of these regulations or the effect that these regulations will have on our hedging activities. Of particular concern, the act does not explicitly exempt end users (such as us) from the requirements to post margin in connection with hedging activities. While several Senators have indicated that it was not the intent of the act to require margin from end users, the exemption is not in the act. If the regulations ultimately adopted were to require that we post margin for our hedging activities, our hedging would become more expensive and we may decide to alter our hedging strategy. Additionally, it is possible that regulations, when finally adopted, in addition to increasing the expenses related to our hedging program may cause us to alter our hedging strategy. +We may not have production to offset hedges; by hedging, we may not benefit from price increases. Part of our business strategy is to reduce our exposure to the volatility of oil and gas prices by hedging a portion of our production. In a typical hedge transaction, we will have the right to receive from the other parties to the hedge the excess of the fixed price specified in the hedge over a floating price based on a market index, multiplied by the quantity hedged. If the floating price exceeds the fixed price, we are required to pay the other parties this difference multiplied by the quantity hedged. Additionally, we are required to pay the difference between the floating price and the fixed price when the floating price exceeds the fixed price regardless of whether we have sufficient production to cover the quantities specified in the hedge. Significant reductions in production at times when the floating price exceeds the fixed price could require us to make payments under the hedge agreements even though such payments are not offset by sales of production. Hedging will also prevent us from receiving the full advantage of increases in oil or gas prices above the fixed amount specified in the hedge. +We also enter into price “collars” to reduce the risk of changes in oil and gas prices. Under a collar, no payments are due by either party so long as the market price is above a floor set in the collar and below a ceiling. If the price falls below the floor, the counter-party to the collar pays the difference to us and if the price is above the ceiling, we pay the counter-party the difference. Another type of hedging contract we have entered into is a put contract. Under a put, if the price falls below the set floor price, the counter-party to the contract pays the difference to us. See “Quantitative and Qualitative Disclosures About Market Risks” for a discussion of our hedging practices. +21 +Table of Contents +Compliance with environmental and other government regulations could be costly and could negatively impact production. Our operations are subject to numerous laws and regulations governing the operation and maintenance of our facilities and the discharge of materials into the environment or otherwise relating to environmental protection. For a discussion of the material regulations applicable to us, see “Regulations.” These laws and regulations may: +· +require that we acquire permits before commencing drilling; +· +impose operational, emissions control and other conditions on our activities; +· +restrict the substances that can be released into the environment in connection with drilling and production activities; +· +limit or prohibit drilling activities on protected areas such as wetlands, wilderness areas or coral reefs; and +· +require measures to remediate or mitigate pollution and environmental impacts from current and former operations, such as cleaning up spills or dismantling abandoned production facilities. +Under these laws and regulations, we could be liable for costs of investigation, removal and remediation, damages to and loss of use of natural resources, loss of profits or impairment of earning capacity, property damages, costs of and increased public services, as well as administrative, civil and criminal fines and penalties, and injunctive relief. We could also be affected by more stringent laws and regulations adopted in the future, including any related climate change and greenhouse gases. Under the common law, we could be liable for injuries to people and property. We maintain limited insurance coverage for sudden and accidental environmental damages. We do not believe that insurance coverage for environmental damages that occur over time is available at a reasonable cost. Also, we do not believe that insurance coverage for the full potential liability that could be caused by sudden and accidental environmental damages is available at a reasonable cost. Accordingly, we may be subject to liability or we may be required to cease production from properties in the event of environmental incidents. +Climate Change Legislation or regulations restricting emissions of “greenhouse gasses” could result in increased operating costs and reduced demand for the oil and gas we produce. On December 15, 2009, the U.S. Environmental Protection Agency (“EPA”) officially published its findings that emissions of carbon dioxide, methane and other “greenhouse gases” present an endangerment to public health and the environment because emissions of such gases are, according to the EPA, contributing to warming of the earth’s atmosphere and other climatic changes. These findings allow the EPA to adopt and implement regulations that would restrict emissions of greenhouse gases under existing provisions of the federal Clean Air Act. Accordingly, the EPA has proposed two sets of regulations that would require a reduction in emissions of greenhouse gases from motor vehicles and could trigger permit review for greenhouse gas emissions from certain stationary sources. +In addition, on October 30, 2009, the EPA published a final rule requiring the reporting of greenhouse gas emissions from specified large greenhouse gas emission sources in the United States beginning in 2011 for emissions occurring in 2010. On November 30, 2010, the EPA published its amendments to the greenhouse gas reporting rule to include onshore and offshore oil and natural gas production facilities and onshore oil and natural gas processing, transmission, storage and distribution facilities, which may include facilities we operate. Reporting of greenhouse gas emissions from such facilities will be required on an annual basis beginning in 2012 for emissions occurring in 2011. +Both houses of the United States Congress have actively considered legislation to reduce emissions of GHGs and almost one-half of the states have already taken legal measures to reduce GHG emission reduction levels that states sent out to achieve by specific time periods, often involving the planned development of GHG emission inventories and/or regional cap and trade programs. Most of these cap and trade programs work by requiring major sources of emissions or major producers of fuels to acquire and surrender emission allowances. The number of allowances available for purchase is reduced each year in an effort to achieve the overall GHG emission reduction goal. These allowances would be expected to escalate significantly in cost over time. The adoption and implementation of any legislation or regulatory programs imposing reporting obligations on, or limiting emissions of GHGs from, our equipment and operations could require us to incur costs to reduce emissions of GHGS associated with our operations or could adversely affect demand for the oil and natural gas that we produce. +Significant physical effects of climatic change have the potential to damage our facilities, disrupt our production activities and cause us to incur significant costs in preparing for or responding to those effects. In an interpretative guidance on climate change disclosures, the SEC indicates that climate change could have an effect on the severity of weather (including hurricanes and floods), sea levels, the arability of farmland, and water availability and quality. If such effects were to occur, our exploration and production operations have the potential to be adversely affected. Potential adverse effects could include damages to our facilities from powerful winds or rising waters in low-lying areas, disruption of our production activities either because of climate-related damages to our facilities in our costs of operation potentially arising from such climatic effects, less efficient or non-routine operating practices necessitated by climate effects or increased costs for insurance coverages in the aftermath of such effects. Significant physical effects of climate change could also have an indirect affect on our financing and operations by disrupting the transportation or process-related services provided by midstream companies, service companies or suppliers with whom we have a business relationship. We may not be able to recover through insurance some or any of the damages, losses or costs that may result from potential physical effects of climate change. +22 +Table of Contents +Federal legislation and state legislative and regulatory initiatives relating to hydraulic fracturing could result in increased costs and additional operating restrictions or delays. Hydraulic fracturing is used to stimulate production of hydrocarbons, particularly natural gas, from tight formations. The process involves the injection of water, sand and chemicals under pressure into formations to fracture the surrounding rock and stimulate production. The process is typically regulated by state oil and gas commissions but is not subject to regulation at the federal level. The EPA has commenced a study of the potential environmental impacts of hydraulic fracturing activities, with results of the study anticipated to be available by late 2012, and a committee of the U.S. House of Representatives is also conducting an investigation of hydraulic fracturing practices. Legislation has been introduced before Congress to provide for federal regulation of hydraulic fracturing and to require disclosure of the chemicals used in the fracturing process. In addition, some states have adopted, and other states are considering adopting, regulations that could restrict hydraulic fracturing in certain circumstances. For example, New York has imposed a de facto moratorium on the issuance of permits for high-volume, horizontal hydraulic fracturing until state-administered environmental studies are finalized, a draft of which must be published by June 1, 2011, followed by a 30-day comment period. Further, Pennsylvania has adopted a variety of regulations limiting how and where fracturing can be performed. If new laws or regulations that significantly restrict hydraulic fracturing are adopted, such legal requirements could make it more difficult or costly for us to perform hydraulic fracturing activities and thereby affect the determination of whether a well is commercially viable. In addition, if hydraulic fracturing is regulated at the federal level, our fracturing activities could become subject to additional permit requirements or operational restrictions and also to associated permitting delays and potential increases in costs. Such federal or state legislation could require the disclosure of chemical constituents used in the fracturing process to state or federal regulatory authorities who could then make such information publicly available. In addition, restrictions on hydraulic fracturing could reduce the amount of oil and natural gas that we are ultimately able to produce in commercial quantities. +Certain U.S. federal income tax preferences currently available with respect to oil and natural gas production may be eliminated as a result of future legislation. Among the changes contained in President Obama’s Budget Proposal for Fiscal Year 2012 is the elimination of certain key U.S. federal income tax incentives currently available to oil and gas exploration and production. The President’s budget proposes to eliminate certain tax preferences applicable to taxpayers engaged in the exploration or production of natural resources. Specifically, the budget proposes to repeal the deduction for percentage depletion with respect to wells, in which case only cost depletion would be available. It is unclear whether any such changes will be enacted or how soon any such changes could become effective. The passage of any legislation as a result of these proposals or any other similar changes in U.S. federal income tax laws could negatively affect our financial condition and results of operations. +There are inherent limitations in all control systems, and misstatements due to error or fraud that could seriously harm our business may occur and not be detected. Our management, including our Chief Executive Officer and Chief Financial Officer, do not expect that our internal controls and disclosure controls will prevent all possible error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. In addition, the design of a control system must reflect the fact that there are resource constraints and the benefit of controls must be relative to their costs. Because of the inherent limitations in all control systems, an evaluation of controls can only provide reasonable assurance that all material control issues and instances of fraud, if any, in our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Further, controls can be circumvented by the individual acts of some persons or by collusion of two or more persons. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. A failure of our controls and procedures to detect error or fraud could seriously harm our business and results of operations. +23 +Table of Contents +ITEM 1B. Unresolved Staff Comments +None. +ITEM 3. Legal Proceedings +We are a defendant in various legal proceedings and claims, which arise in the ordinary course of our business. We do not believe the ultimate resolution of any such actions will have a material effect on our financial position or results of operations. +ITEM 4. Reserved +PART II. +ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +The Company’s common stock trades on the New York Stock Exchange under the symbol "CPE". The following table sets forth the high and low sale prices per share as reported for the periods indicated. +Stock Price +2010 +High +Low +First quarter +ended +March 31, 2010 +$ +5.90 +$ +1.40 +Second quarter +ended +June 30, 2010 +8.80 +4.46 +Third quarter +ended +September 30, 2010 +6.72 +3.54 +Fourth quarter +ended +December 31, 2010 +6.39 +4.45 +2009 +First quarter +ended +March 31, 2010 +$ +3.50 +$ +0.93 +Second quarter +ended +June 30, 2010 +3.15 +1.01 +Third quarter +ended +September 30, 2010 +2.43 +1.37 +Fourth quarter +ended +December 31, 2010 +2.13 +1.36 +As of March 3, 2011 the Company had approximately 3,393 common stockholders of record. +The Company has never paid dividends on its common stock, and intends to retain its cash flow from operations for the future operation and development of its business. In addition, the Company’s primary credit facility and the terms of our outstanding debt prohibit the payment of cash dividends on our common stock. +During the fourth quarter of 2010, neither the Company nor any affiliated purchasers made repurchases of Callon’s equity securities. +Equity Compensation Plan Information +The following table summarizes information regarding the number of shares of our common stock that are available for issuance under all of our existing equity compensation plans as of December 31, 2010 (securities amounts are presented in thousands). +Plan Category +Number of securities to be issued upon exercise of outstanding options +Weighted-average exercise price of outstanding options, warrants and rights +Number of securities remaining available for future issuance under equity compensation plans +Equity compensation plans approved by security holders +124 +$ +11.46 +754 +Equity compensation plans not approved by security holders +74 +6.44 +27 +Total +198 +9.57 +781 +For additional information regarding the Company’s benefit plans and share-based compensation expense, see Notes 9 and 10 to the Consolidated Financial Statements. +24 +Table of Contents +Performance Graph +The following graph compares the yearly percentage change for the five years ended December 31, 2010, in the cumulative total shareholder return on the Company’s Common Stock against the cumulative total return for the following: +· +the Morningstar Group Index consisting of independent oil and gas drilling and exploration companies. Note that following Morningstar’s acquisition of Hemscott, the Morningstar Group Index is replacing the Hemscott Industry and Market Index of SIC Group 123 (the “Hemscott Group Index”), which was included in the Company’s performance graphs in prior filings. Consequently, both indexes have been included for comparative purposes during the transition to the Morningstar Group Index; and +· +the New York Stock Exchange Market Index. +Company/Market/Peer Group +12/31/2005 +12/31/2006 +12/31/2007 +12/31/2008 +12/31/2009 +12/31/2010 +Callon Petroleum Company +$ +100.00 +$ +85.16 +$ +93.20 +$ +14.73 +$ +8.50 +$ +33.54 +NYSE Composite Index +$ +100.00 +$ +120.47 +$ +131.15 +$ +79.67 +$ +102.20 +$ +115.88 +Morningstar Group Index +$ +100.00 +$ +94.73 +$ +126.71 +$ +47.87 +$ +72.96 +$ +68.36 +Hemscott Group Index +$ +100.00 +$ +118.43 +$ +186.25 +$ +83.39 +$ +158.52 +$ +149.20 +25 +Table of Contents +ITEM 6. Selected Financial Data +The following table sets forth, as of the dates and for the periods indicated, selected financial information about us. The financial information for each of the five years in the period ended December 31, 2010 has been derived from our audited Consolidated Financial Statements for such periods. The information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto. The following information is not necessarily indicative of our future results. +For the year ended December 31, +2010 +2009 +2008 +2007 +2006 +Statement of Operations Data: +(In thousands, except per share amounts) +Operating revenues: +Oil and gas sales +$ +89,882 +$ +101,259 +$ +141,312 +$ +170,768 +$ +182,268 +Medusa BOEMRE royalty recoupment +- +40,886 +- +- +- +Total operating revenues +$ +89,882 +$ +142,145 +$ +141,312 +$ +170,768 +$ +182,268 +Operating expenses: +Non-impairment related operating expenses +$ +68,703 +$ +68,692 +$ +97,497 +$ +114,418 +$ +107,865 +Impairment of oil and gas properties +- +- +485,498 +- +- +Total operating expenses +$ +68,703 +$ +68,692 +$ +582,995 +$ +114,418 +$ +107,865 +Income (loss) from continuing operations +21,179 +73,453 +(441,683 +) +56,350 +74,403 +Net income (loss) +8,386 +54,419 +(438,893 +) +15,194 +40,560 +Earnings (loss) per share ("EPS"): +Basic +$ +0.29 +$ +2.47 +$ +(20.68 +) +$ +0.73 +$ +1.43 +Diluted +$ +0.28 +$ +2.45 +$ +(20.68 +) +$ +0.71 +$ +1.28 +Weighted average number of shares outstanding for Basic EPS +28,817 +22,072 +21,222 +20,776 +20,270 +Weighted average number of shares outstanding for Diluted EPS +29,476 +22,200 +21,222 +21,290 +21,363 +Statement of Operations Data: +Net cash provided by operating activities +$ +99,942 +$ +19,698 +$ +89,054 +$ +109,283 +$ +135,484 +Net cash used in investing activities +(59,738 +) +(43,189 +) +(4,511 +) +(215,791 +) +(166,901 +) +Net cash provided by (used in) financing activities +(26,092 +) +10,000 +(120,667 +) +(157,862 +) +30,748 +Balance Sheet Data: +Oil and gas properties, net +$ +168,868 +$ +130,608 +$ +159,252 +$ +681,706 +$ +547,027 +Total assets +218,326 +227,991 +266,090 +792,482 +625,527 +Long-term debt (a) +165,504 +179,174 +272,855 +392,012 +225,521 +Stockholder' equity (deficit) +15,810 +(80,854 +) +(129,804 +) +287,075 +281,363 +Proved Reserves Data: +Total Oil (MMBbls) +8,148 +6,479 +6,027 +24,531 +13,265 +Total Gas (MMcf) +32,956 +19,103 +18,652 +116,454 +66,037 +Total proved reserves (MBoe) +13,641 +9,663 +9,136 +43,940 +24,271 +Present value of estimated future after-tax, net cash flows +$ +198,916 +$ +135,921 +$ +86,305 +$ +1,133,989 +$ +470,791 +(a) +Long-term debt includes a non-cash $27,543 deferred credit that will be amortized into earnings as a reduction to interest expense over the life of the 13% Senior Notes due 2016. See Note 6 for additional information. +We follow the full-cost method of accounting for oil and gas properties. Under this method of accounting, our net capitalized costs to acquire, explore and develop oil and gas properties may not exceed the sum of (1) the estimated future net revenues from proved reserves using a 12-month pricing average discounted at 10% and (2) the lower of cost or market of unevaluated properties, net of tax (the full-cost ceiling amount). If these capitalized costs exceed the full-cost ceiling amount, the excess is charged to expense. For the year ended December 31, 2008, the Company recorded a $485.5 million impairment of oil and gas properties as a result of the ceiling test. See Note 2 and 13 to the Consolidated Financial Statements for a description of the relevant accounting policy and the Company’s oil and gas properties disclosures, respectively. +26 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +General +The following management’s discussion and analysis is intended to assist in understanding the principal factors affecting the Company’s results of operations, liquidity, capital resources and contractual cash obligations. This discussion should be read in conjunction with the accompanying audited consolidated financial statements, information about our business practices, significant accounting policies, risk factors, and the transactions that underlie our financial results, which are included in various parts of this filing. +We have been engaged in the exploration, development, acquisition and production of oil and gas properties since 1950. Prior to 2009, our operations were focused on exploration and production in the Gulf of Mexico, and beginning in the latter part of 2008, we took steps to change our operational focus to lower risk, onshore exploration and development activities thereby reducing our reserve and production concentration in offshore properties. +Overview and Outlook +During 2010, Callon had net income and fully diluted earnings per share of $8.4 million and $0.28, respectively, compared to net income of $54.4 million and fully diluted earnings per share of $2.45, respectively for 2009. Prior year results included a $44.8 million royalty recoupment, plus $7.7 million interest, from the BOEMRE for royalties paid during 2009 and prior years. The Company’s earnings, and the drivers of these earnings, are discussed in greater detail within the “Results of Operations” section included below. +Also during 2010, Callon increased proved reserves by approximately 41%, increased Permian Basin oil production by 69%, brought online its first Haynesville gas well and diversified its net proved reserves with nearly 50% now being located onshore. +We made significant progress during 2010 towards our goal of strengthening our balance sheet and improving our liquidity, which better positions Callon for future growth. Significant financial achievements include: +· +Including principal and interest through the repayment date, we received $52.7 million for recoupment of deepwater royalty payments made to the BOEMRE. +· +The borrowing base of our Credit Facility was amended to provide for a $30 million borrowing base, representing a $10 million or 50% increase over the originally approved borrowing base. The underwriting bank approved the increase following its most recent borrowing base review based on the growth of the Company’s proved reserves, the collateral for the facility. +· +We completed the redemption of the remaining $16.1 million outstanding of 9.75% Senior Notes (“Old Notes”) held by those note holders who did not participate in an exchange offered in teh fourth quarter of 2009. The redemption and the exchange of our Old Notes with 13% Senior Notes reduced by 25% the principal balance of our notes and extended the restructured notes’ maturity from 2010 to 2016 in exchange for a 3.25% increase in the coupon rate and equity consideration. Principal outstanding under the 13% Senior Notes due 2016 is approximately $138.0 million, a significant decrease from the $200 million principal formerly outstanding under the Old Notes. (See Note 6 and discussion below highlighting the planned early redemption of $31 million of 13% Senior Notes during March 2011) +During February 2011, the Company received $73.7 million in net proceeds through the public offering of 10.1 million shares of its common stock, which included the issuance of 1.1 million shares pursuant to the underwriters’ over-allotment option. During March 2011, the Company intends to utilize approximately $35 million of the proceeds to redeem $31 million face value of its Senior Notes, plus the 13% call premium. The remaining proceeds from the offering are intended to fund a portion of our 2011 capital budget and for general corporate purposes, including possible future acquisitions. +Our success in these areas allows us to continue executing on our strategy to shift our operational focus from the offshore Gulf of Mexico to developing longer life, lower risk onshore properties. Our Permian Basin and Haynesville Shale onshore properties along with the cash flow from our Gulf of Mexico operations have already begun to re-shape our portfolio and outlook, and we believe that we are well positioned to continue diversifying our portfolio by building profitable growth opportunities onshore. During 2010, we began to develop the properties we acquired during late 2009. This 2010 development resulted in a 41% increase in total proved reserves, of which 50% were onshore. +27 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +· +Onshore – Permian Basin +During the fourth quarter of 2009, we acquired interests in properties producing from the Permian Basin’s Wolfberry and other formations in Crockett, Ector, Midland and Upton Counties, Texas. The acquisition included year-end proved reserves of 1.6 MMBoe, 22 existing wells producing approximately 325 Boe/d and upside from a multi-year inventory of drilling opportunities. We operate substantially all of the production and development of these properties. We currently own approximately 8,800 net acres in the Permian Basin with approximately 80% prospect for the Wolfberry. +During 2010, we drilled gross 20 wells in the Permian Basin targeting the Wolfberry, and placed on production 11 wells at a total cost of approximately $32.0 million. As a result of our 2010 development drilling activity, our net production has increased from 325 net Boe/d at the end of 2009 to 550 net Boe/d as of December 31, 2010, somewhat lower than our original expectations of 750 net Boe/d. The lower production relates primarily to delays in receiving fracture stimulation services, discussed below, for which there is increased demand in the area at the present time. Beyond 2010, and based on our current acreage holdings, our Permian acreage has the potential for an additional 132 wells based on 40-acre spacing. +As of December 31, 2010, we had nine wells awaiting fracture stimulation with the expectation that we will continue to build an inventory of wells waiting on fracture stimulation until the service organization builds additional capacity to handle industry requirements. As of March 1, 2011, three wells that were awaiting fracture stimulation as of December 31, 2010 have since been brought online. Early in 2011, we entered into an agreement with our fracture stimulation service provider providing for a minimum of three well stimulations per month in 2011. Either party to the agreement may cancel the agreement without penalty with at least 30 days notice. We expect to fracture stimulate three additional wells during the first quarter of 2011, and expect that our remaining year-end 2010 inventory of wells awaiting stimulation will be serviced by the second quarter of 2011. We plan to drill up to 44 gross wells during 2011, of which three had been drilled and two were in-process as of March 1, 2011. +In addition, during 2010 we have increased our interest in the East Bloxom Development Area, located in Upton County, from an average 47% working interest to a 100% working interest through a number of small acquisitions and farm-ins. As a result, we now control the activity in three development areas encompassing 11 sections. +· +Onshore – Shale Gas (Haynesville Shale) +Also during the late 2009, we acquired a 69% working interest in a 624-acre unit in the heart of the Haynesville Shale play in Bossier Parish, Louisiana. Our multi-year development plan for this property includes drilling and operating a total of seven gross or five net horizontal wells. The first of these wells was spud during June 2010, completed and placed on production in September 2010 and was producing, at a restricted rate, approximately 6,500 Mcfe/d as of December 31, 2010. The well cost approximately $10.9 million net to Callon, which included additional site development work for future wells. We have no remaining drilling obligations in our Haynesville Shale position, and currently plan to mobilize a rig to the area once natural gas prices warrant continued development of the remaining six planned horizontal wells. The Company currently owns approximately 430 net acres in the Haynesville Shale. +Also highlighting the continued successful execution of our long-term strategy and as a result of an increase in our market capitalization to an amount above the minimum required threshold, on April 23, 2010 the New York Stock Exchange (“NYSE”) removed Callon from its “Watch List” and affirmed that we are now considered a “company back in compliance” with the NYSE’s quantitative continued listing standards. +Our onshore properties along with the strong cash flow from our Gulf of Mexico operations have strengthened our portfolio and outlook. We believe we are well positioned to continue the pursuit of diversifying our portfolio by building profitable growth opportunities onshore. Factors potentially impacting our expected production profile include: +· +A reduced level of capital expenditures; +· +Allocation of capital expenditures to acquire producing properties; +· +Natural field decline in the deepwater Gulf of Mexico and Gulf Coast areas of our operations +· +Timing of well completions in the Permian Basin and Haynesville Shale development programs; +· +Potential hurricane-related downtime and volume curtailments in the Gulf of Mexico and Gulf Coast areas; and +· +Inflation of capital costs and operating expenses. +28 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +Deconsolidation of Callon Entrada +During 2010 we adopted the newly issued accounting standard issued by the FASB in September 2009, which significantly modified our consolidated financial statements. Upon adoption, we reevaluated our interest in Callon Entrada, and based on the evaluation performed, we concluded that a variable interest entity (“VIE”) reconsideration event had taken place. Our reconsideration analysis resulted in the determination that Callon Entrada is a VIE for which we are not the primary beneficiary. Consequently, effective January 1, 2010, Callon Entrada was deconsolidated from our consolidated financial statements. The deconsolidation of Callon Entrada resulted in the removal of approximately $1.8 million of current assets, $2.0 million of current liabilities, $30.3 million of deferred tax assets, $30.3 million of tax valuation allowance and approximately $84.8 million of non-recourse debt and the related obligation for the cumulative amount of interest. Retained earnings increased by $85.1 million as a cumulative effect of change related to this accounting standard. No gain was recognized in the statement of operations. For additional information regarding the deconsolidation of Callon Entrada, see Note 3, Deconsolidation of Callon Entrada, included in Item II, Part 8 of this filing. +Liquidity and Capital Resources +Historically, our primary sources of capital have been cash flows from operations, borrowings from financial institutions and the sale of debt and equity securities. Cash and cash equivalents increased by $13.8 million during 2010 to $17.4 million compared to $3.6 million at December 31, 2009. The increase is primarily attributable to an $80.2 million increase in cash flows from operations, which included production increases from our newly acquired properties and higher realized, average commodity prices on an equivalent basis, and the receipt of the previously discussed $52.7 million BOEMRE royalty recoupment and related interest. These increases were partially offset by production declines on some legacy properties, a $16.5 million increase in cash used in investing activities and a $36.1 million increase in cash used in financing activities. +During 2010, we amended our Senior Secured Credit Agreement to include Regions Bank as the sole arranger and administrative agent. The third amended and restated senior secured credit agreement (“the Credit Facility”), which matures on September 25, 2012, provides for a $100 million facility and has a current borrowing base of $30 million, which represents a $10 million or 50% increase over the original $20 million borrowing base. Regions Bank approved the increase following its fourth quarter 2010 redetermination review. The bank performs its redetermination reviews on a semi-annual basis. The Credit Facility bears interest at 4% above a defined base rate and in no event will the interest rate be less than 6%. As of December 31, 2010, the interest rate on the facility was 6%. In addition, a commitment fee of 0.5% per annum on the unused portion of the borrowing base, is payable quarterly. Simultaneously with the execution of the third amended and restated senior secured credit agreement, we repaid the $10 million then outstanding under the second amended and restated senior secured credit agreement. No amounts were outstanding under the amended facility as of December 31, 2010. +During the second quarter of 2010, we redeemed the remaining $16.1 million outstanding of our Old Notes, leaving only $138.0 million of the 13% Senior Notes outstanding at December 31, 2010. Following the previously discussed February 2011 equity offering from which the company received net proceeds of $73.7 million through the issuance of 10.1 million shares of its common stock, the Company intends to redeem during March 2011 $31 million of the 13% Senior Notes for approximately $35 million inclusive of the $4 million call premium. The remaining proceeds from the offering are to fund a portion of its 2011 capital budget and for general corporate purposes, including possible future acquisitions. +29 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +2011 Budget and Capital Expenditures +For 2011, we designed a flexible capital spending program that can be funded from cash on hand, including the proceeds from the recent equity offering, and cash flows from operations. We believe these resources along with our Credit Facility, if needed, will be adequate to meet our capital, interest payments, and operating requirements for 2011. However, depending on commodity prices and other economic conditions we experience in 2010, this base capital program may be adjusted up or down. Inflation has not had a material impact on us, nor is it expected to have a material impact on us in the immediate future. +Our preliminary base capital program includes further development of our Permian Basin crude oil assets, with plans to drill approximately 44 additional gross oil wells during 2011. Our 2011 capital budget approximates $107 million, of which 81% is dedicated to our growth strategy, and also includes plugging and abandonment, capitalized interest and certain overhead costs related to acquiring, exploring and developing our oil and gas properties. Components of the 2011 capital budget include: +Permian Basin / Wolfberry development +$ +77 +Leasehold related +10 +Gulf of Mexico plugging and abandonment and maintenance capital expenditures +8 +Capitalized interest and general and administrative costs +12 +Total projected 2011 capital expenditures budget +$ +107 +Should we identify an attractive strategic opportunity or acquisition, in addition to our available cash including the proceeds from the recent equity offering , we have a $30 million borrowing base available under our Credit Facility. +The following table includes the Company’s contractual obligations and purchase commitments as of December 31, 2010, at which date the Company had no product delivery commitments: +Payments due by Period +Contractual Obligation & Purchase Commitments +Total +< 1 Year +1 - 3 Years +3 - 5 Years +>5 Years +13% Senior Notes +$ +137,961 +- +- +$ +137,961 +- +Office space lease commitments +2,972 +26 +458 +684 +1,804 +Medusa Oil Pipeline Throughput Commitment +101 +39 +35 +27 +- +Total +$ +141,034 +$ +65 +$ +493 +$ +138,672 +$ +1,804 +Summary cash flow information is provided as follows: +Operating Activities. For the year ended December 31, 2010, net cash provided by operating activities was $99.9 million, an $80.2 million or 407% increase from net cash provided by operating activities of $19.7 million for the same period in 2009. The increase in net cash provided by operating activities was primarily attributable to receipt of the $52.7 million BOEMRE royalty recoupment including interest, production increases from our onshore properties and higher commodity prices on an equivalent basis, partially offset by production declines on some legacy properties. +Investing Activities. For the year ended December 31, 2010, net cash used in investing activities was $59.7 million as compared to $43.2 million for the same period in 2009. The $16.5 million increase, primarily attributable to an increase in capital expenditure spending, relates to drilling 20 wells in the Permian Basin properties and one well in the Haynesville Shale property. These increases were partially offset by the wind-down costs paid in 2009 for Callon Entrada with no similar costs paid during 2010. +Financing Activities . For the year ended December 31, 2010, net cash used in financing activities was $26.1 million compared to cash provided of $10.0 million for the same period in 2009. The 2010 expenditures related to the redemption of the $16.1 million remaining Old Notes and to the repayment of $10 million outstanding borrowings under the Credit Facility simultaneous with the amendment to include Regions Bank as the sole arranger and administrative agent. +30 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +Results of Operations +The following table sets forth certain unaudited operating information with respect to the Company's oil and gas operations for the periods indicated: +For the year ended December 31, +2010 +2009 +$ Change +% Change +2008 +$ Change +% Change +Net production: +Oil (MBbls) +859 +1,012 +(153 +) +(15 +)% +942 +70 +7 +% +Gas (MMcf) +4,892 +5,740 +(848 +) +(15 +)% +5,839 +(99 +) +(2 +)% +Total production (MBoe) +1,674 +1,969 +(295 +) +(15 +)% +1,915 +54 +3 +% +Average daily production (Boe) +4,587 +5,394 +(807 +) +(15 +)% +5,247 +147 +3 +% +Average realized sales price (a): +Oil (Bbl) +$ +75.97 +$ +73.00 +$ +2.97 +4 +% +$ +88.07 +$ +(15.07 +) +(17 +)% +Gas (Mcf) +5.04 +4.78 +0.26 +5 +% +9.99 +(5.21 +) +(52 +)% +Total (Boe) +53.69 +51.44 +2.25 +4 +% +73.79 +(22.35 +) +(30 +)% +Oil and gas revenues (in thousands): +Oil revenue +$ +65,243 +$ +73,842 +$ +(8,599 +) +(12 +)% +$ +82,963 +$ +(9,121 +) +(11 +)% +Gas revenue +24,639 +27,417 +(2,778 +) +(10 +)% +58,349 +(30,932 +) +(53 +)% +Total +$ +89,882 +$ +101,259 +$ +(11,377 +) +(11 +)% +$ +141,312 +$ +(40,053 +) +(28 +)% +Additional per Boe data: +Sales price +$ +53.69 +$ +51.44 +$ +2.25 +4 +% +$ +73.79 +$ +(22.35 +) +(30 +)% +Lease operating expense +(10.58 +) +(9.37 +) +(1.21 +) +13 +% +(10.03 +) +0.66 +(7 +)% +Operating margin +$ +43.11 +$ +42.07 +$ +1.04 +2 +% +$ +63.76 +$ +(21.69 +) +(34 +)% +(a) Below is a reconciliation of the average NYMEX price to the average realized sales price per barrel of oil: +Average NYMEX oil price +$ +79.52 +$ +61.80 +$ +17.72 +29 +% +$ +99.67 +$ +(37.87 +) +(38 +)% +Basis differential and quality adjustments +(2.39 +) +(4.64 +) +2.25 +(48 +)% +(1.15 +) +(3.49 +) +303 +% +Transportation +(1.16 +) +(1.32 +) +0.16 +(12 +)% +(1.15 +) +(0.17 +) +15 +% +Hedging +- +17.16 +(17.16 +) +(100 +)% +(9.30 +) +26.46 +(285 +)% +Average realized oil price +$ +75.97 +$ +73.00 +$ +2.97 +4 +% +$ +88.07 +$ +(15.07 +) +(17 +)% +Average NYMEX gas price +$ +4.40 +$ +4.17 +$ +0.23 +6 +% +$ +8.91 +$ +(4.74 +) +(53 +)% +Basis differential and quality adjustments +0.51 +0.28 +0.23 +82 +% +1.19 +(0.91 +) +(76 +)% +Hedging +0.13 +0.33 +(0.20 +) +(61 +)% +(0.11 +) +0.44 +(400 +)% +Average realized gas price +$ +5.04 +$ +4.78 +$ +0.26 +5 +% +$ +9.99 +$ +(5.21 +) +(52 +)% +31 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +Revenues +The following tables are intended to reconcile the change in crude oil, natural gas and total revenue by reflecting the effect of changes in volume, changes in the underlying commodity prices and the impact of our hedge program (in thousands): +Crude Oil +Natural Gas +Total +Revenues for the year ended December 31, 2007 +$ +71,891 +$ +98,877 +$ +170,768 +Volume decrease +(8,183 +) +(52,091 +) +(60,274 +) +Price increase +28,015 +12,213 +40,228 +Impact of hedges decrease +(8,760 +) +(650 +) +(9,410 +) +Net increase (decrease) in 2008 +11,072 +(40,528 +) +(29,456 +) +Revenues for the year ended December 31, 2008 +$ +82,963 +$ +58,349 +$ +141,312 +Volume increase (decrease) +6,165 +(989 +) +5,176 +Price decrease +(32,639 +) +(31,832 +) +(64,471 +) +Impact of hedges increase +17,353 +1,889 +19,242 +Net decrease in 2009 +(9,121 +) +(30,932 +) +(40,053 +) +Revenues for the year ended December 31, 2009 +$ +73,842 +$ +27,417 +$ +101,259 +Volume decrease +(11,164 +) +(4,050 +) +(15,214 +) +Price increase +2,556 +649 +3,205 +Impact of hedges increase +9 +623 +632 +Net decrease in 2010 +(8,599 +) +(2,778 +) +(11,377 +) +Revenues for the year ended December 31, 2010 +$ +65,243 +$ +24,639 +$ +89,882 +Total Revenue +Total oil and gas revenues of $89.9 million for the year ended December 31, 2010 were approximately $11.4 million, or 11%, less than $101.3 million for the same period of 2009. The largest contributors to the year-over-year decline included a 15% decline in production on an equivalent basis, partially offset by a 4% increase in average realized prices. Compared to 2009, the decline in production on an equivalent basis during 2010 was primarily driven by normal and expected declines from our legacy properties and damage to one of our Gulf of Mexico gas field production facilities. These declines were partially offset by new production from our Permian Basin and Haynesville Shale properties. +Total 2009 oil and gas revenues of $101.3 million decreased 28% or $40 million from $141.3 million in 2008 primarily due to lower oil and gas average realized sales prices. As reflected in the table above, hedge related revenues and a 3% increase in total production on an equivalent basis partially offset the decline in revenue for 2009 compared to 2008. +Oil Revenue +Crude oil revenues of $65.2 million for the year ended December 31, 2010 were approximately $8.6 million, or 12%, less than oil revenues of $73.8 million for the same period of 2009. The largest contributor to the decline was a 15% decrease in production, partially offset by a 4% increase in the average realized oil price. In addition to normal and expected production declines, volumes declined primarily due to our working interest in Habanero #1 decreasing from 25% to 11.25% in June 2009 following the payout of a sidetrack on this well. The payout was associated with a third quarter 2007 sidetrack of the #1 well for which the operator elected to non-consent. These declines were partially offset by production from our newly drilled and completed wells on the Permian Basin properties that we acquired during the fourth quarter of 2009. +Oil production during 2009 totaled 1.0 million barrels and generated $73.8 million in revenues compared to 0.9 million barrels and $83.0 million in revenues for the same period in 2008. Average oil prices realized in 2009 were $73.00 per barrel compared to $88.07 per barrel in 2008. See the Results of Operations table for a reconciliation of the realized oil prices to average NYMEX. The 7% increase in 2009 production was primarily due to the 2009 volumes associated with the BOEMRE royalty recoupment, described in Note 16, for the Medusa Field. +32 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +Gas Revenue +Natural gas revenues of $24.6 million for the year ended December 31, 2010 were approximately $2.8 million, or 10%, less when compared to gas revenues of $27.4 million for the same period of 2009. The largest contributor to the decline was a 15% decrease in production, partially offset by a 5% increase in the average realized sales price of gas. The largest contributor to the decline in production was the shut-in of the East Cameron #2 well, which was shut-in during January 2010 due to damage resulting from a fire. Production at the East Cameron #2 well was restored during the latter part of the fourth quarter of 2010 following the completion of the necessary repairs and BOEMRE inspections. Also contributing to the production decrease was the Habanero #1 well reversionary interest discussed above in the oil revenue analysis, while the remaining decrease in production was due to normal and expected declines from our legacy properties and production suspensions related to well recompletions and BOEMRE recompletion work approval such as at our Mobile Block 864 well. Offsetting these declines are increases from our Permian Basin properties discussed above, and production from our first Haynesville gas well, which was placed on production during September 2010. +Gas production during 2009 totaled 5.7 Bcf and generated $27.4 million in revenues compared to 5.8 Bcf and $58.3 million in revenues during the same period in 2008. Average gas prices realized for 2009 were $4.78 per Mcf compared to $9.99 per Mcf during the same period in 2008. The 2% decrease in 2009 production was primarily normal and expected declines from our legacy properties. +Operating Expenses +For the year ended December 31, +Year Change +2010 +Per Boe +2009 +Per Boe +$ +% +Lease operating expenses +17,712 +$ +10.58 +$ +18,447 +$ +9.37 +$ +(735 +) +(4 +)% +Depreciation, depletion and amortization +31,805 +19.00 +33,443 +16.99 +(1,638 +) +(5 +)% +General and administrative, net +16,507 +9.86 +13,355 +6.78 +3,152 +24 +% +Accretion expense +2,446 +1.46 +3,149 +1.60 +(703 +) +(22 +)% +Acquisition expense +233 +0.14 +298 +0.15 +(65 +) +(22 +)% +Total operating expenses +68,703 +$ +68,692 +For the year ended December 31, +Year Change +2009 +Per Boe +2008 +Per Boe +$ +% +Lease operating expenses +18,447 +$ +9.37 +$ +19,208 +$ +10.03 +$ +(761 +) +(4 +)% +Depreciation, depletion and amortization +33,443 +16.99 +64,054 +33.45 +(30,611 +) +(48 +)% +General and administrative, net +13,355 +6.78 +9,565 +4.99 +3,790 +40 +% +Accretion expense +3,149 +1.60 +4,172 +2.18 +(1,023 +) +(25 +)% +Acquisition expense +298 +0.15 +- +- +298 +100 +% +Derivative expense +- +- +498 +0.26 +(498 +) +(100 +)% +Impairment of oil and gas properties +- +- +485,498 +253.50 +(485,498 +) +(100 +)% +Total operating expenses +68,692 +$ +582,995 +Lease Operating Expenses +For the year ended December 31, 2010, lease operating expenses (“LOE”) decreased 4% to $17.7 million compared to $18.4 million for the same period in 2009. The primary contributor to the reduction in LOE was normal and expected declines in production in addition to, as previously discussed above in the oil revenue comparative analysis, the reduction in our working interest in Habanero #1 well following the payout of a sidetrack on this well. Partially offsetting these decreases, LOE increased related to our acquisition of the Permian Basin properties and a modest increase in insurance rates due to adding additional coverage to our program designed to better protect the Company from damage caused by severe weather. +33 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +Lease operating expenses for 2009 decreased by 4% to $18.4 million compared to $19.2 million for the same period in 2008. The decrease was primarily due to a lower number of producing wells in the Gulf of Mexico Shelf area. Four of our gas wells were shut-in during 2008 due to early water production and are plugged and abandoned or scheduled for plugging and abandonment. In addition, our High Island Block A-540 well was shut-in during the second quarter of 2008, due to a plugged flowline, which management determined uneconomic to repair. This well was plugged in the second half of 2009. +Depreciation, Depletion and Amortization +For the year ended December 31, 2010, DD&A decreased approximately $1.7 million or 5% to $31.8 million compared to $33.4 million for the same period of 2009. Production declines account for nearly all of the decrease, while a rate increase partially offset the production volume decreases. +Depreciation, depletion and amortization for 2009 and 2008 totaled $33.4 million and $64.1 million, respectively. The 48% decrease was due to a lower depletion rate resulting from the full-cost ceiling writedown, which was recorded in the fourth quarter of 2008 and the downward revision of plugging and abandonment cost for the Entrada field during 2009. +General and Administrative, net of amounts capitalized +For the year ended December 31, 2010, G&A expenses, net of amounts capitalized, increased $3.2 million or 24% to $16.5 million from $13.4 million for the same period of 2009. Our performance-based incentive program runs from April to March, and adjustments to our accruals are recorded during the first quarter upon completion of the program and evaluation by the Company’s Compensation Committee of the Board of Directors. During the first quarter of 2009, we recorded a 75% reduction in incentive-based compensation related to our actual 2008 results. These results, which were negatively affected by the decline in oil and gas prices, the abandonment of the Entrada project and worsening broader economic conditions, were lower than the performance goals set for fiscal year 2008. Conversely, the increase experienced during 2010 relates primarily to a 21% increase in incentive-based compensation related to exceeding performance goals set for fiscal year 2009. Also contributing to the increase are (1) a valuation adjustment to mark to fair value a portion of our share-based awards that will vest in the future which are accounted for as a liability, (2) additional employee-related costs, including non-recurring early retirement expenses, (3) costs associated with adding new employees, including relocation and related costs, and (4) higher legal costs and other charges related to an arbitration hearing involving a dispute with our joint interest partner in the Entrada development project. Partially offsetting the increases are $2.2 million of expenses related to staff reductions incurred during the second quarter of 2009 for which no similar charge was recorded during 2010. +General and administrative expenses for 2009, net of amounts capitalized, were $13.4 million compared to $9.6 million in 2008. The 43% increase was primarily due to the $2.2 million of nonrecurring expenses for staffing reductions and retirements and the result of overhead fees of approximately $2.6 million received during the second half of 2008 as operator of the Entrada Field, which was recorded as a reduction to general and administrative expenses in 2008. +Accretion Expense +For the year ended December 31, 2010, accretion expense decreased $0.7 million or 22% to $2.4 million from $3.1 million incurred during the same period of 2009. The Company’s accretion expense decreases as its ARO decreases. As of December 31, 2010, our average ARO liability for 2010 of $15.0 million was significantly lower than our average ARO liability of $27.0 million for the same period in 2009. Similarly, 2009 accretion expense of $3.1 million declined compared to 2008 accretion expense of $4.2 million, due to a lower average ARO liability in 2009 compared to the 2008 liability. For additional information regarding the company’s oil and gas properties and the related ARO, see Notes 13 and 14 included to the Consolidated Financial Statements. +Impairment of Oil and Gas Properties +No impairments of oil and gas properties were recorded during either 2010 or 2009. During the fourth quarter of 2008, capitalized costs of oil and gas properties, net of accumulated amortization and deferred taxes relating to oil and gas properties, exceeded the sum of (1) the estimated future net revenues from proved reserves at current prices discounted at 10% and (2) the lower of cost or market of unevaluated properties, net of tax effects. As a result, $485.5 million of excess costs was expensed as an impairment of oil and gas properties for the year ended December 31, 2008. For additional information, see Note 13 to the Consolidated Financial Statements. +34 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +Other (Income) Expense +For the year ended December 31, +Year Change +2010 +2009 +$ Change +% Change +2008 +$ (Dollars) +% (Percent) +Interest expense +$ +13,312 +$ +19,089 +$ +(5,777 +) +(30 +)% +$ +23,986 +$ +(4,897 +) +(20 +)% +Callon Entrada non-recourse credit facility interest expense (See Note 3) +- +7,072 +(7,072 +) +(100 +)% +2,719 +4,353 +160 +% +Loss on early extinguishment of debt +339 +- +339 +100 +% +11,871 +(11,871 +) +(100 +)% +9.75% Senior Notes restructuring expenses +- +1,024 +(1,024 +) +(100 +)% +- +1,024 +100 +% +Interest on BOEMRE royalty recoupment +(91 +) +(7,681 +) +7,590 +(99 +)% +- +(7,681 +) +(100 +)% +Other (income) expense +(166 +) +190 +(356 +) +(187 +)% +(1,379 +) +1,569 +(114 +)% +Total other (income) expenses +$ +13,394 +$ +19,694 +$ +37,197 +Income tax benefit +(174 +) +- +(174 +) +100 +% +$ +39,725 +$ +(39,725 +) +(100 +)% +Equity in earnings of Medusa Spar LLC +$ +427 +$ +660 +$ +(233 +) +(35 +)% +262 +(262 +) +152 +% +Interest Expense +For the year ended December 31, 2010, interest expense decreased $5.8 million or 30% to $13.3 million compared to $19.1 million for the same period of 2009. The decrease was primarily due to the $3.7 million amortization of our deferred credit related to the Senior Notes, which is recorded as a decrease to interest expense. Also reducing interest expense during 2010 was a decrease in the amount of discount amortization recognized related to our Old Notes, 92% of which were exchanged during 2009. Further, the remaining $16.1 million of outstanding Old Notes that did not participate in the exchange were later redeemed on April 30, 2010 resulting in approximately $1.1 million of interest expense savings during 2010 as compared to 2009. +Interest expense related to debt obligations decreased to $19.1 million in 2009 compared to $24.0 million in 2008. This 20% decrease was due to the retirement in April 2008 of the $200 million senior revolving credit facility associated with the Entrada acquisition. For additional information, see Note 6 to the Consolidated Financial Statement. +Callon Entrada Non-Recourse Credit Agreement Interest Expense +As discussed in Note 3 to the Consolidated Financial Statements and as a result of the deconsolidation of Callon Entrada effective January 1, 2010, during 2010 we incurred no expense related to this non-recourse credit facility. +For the years ended December 31, 2009 and 2008, we incurred interest expense under the Callon Entrada credit agreement of $7.1 million and $2.7 million, respectively. The increase was due to a larger outstanding loan balance for the twelve-month period ended December 31, 2009 and an increase in the interest rate due to the notice of default received from CIECO on April 2, 2009. Principal and related interest was payable from the assets of Callon Entrada, primarily production from the Entrada Field with no recourse to the assets of Callon. Accordingly, due to the abandonment of the Entrada project, no cash payments for principal or interest have been made by Callon Entrada except with proceeds from our 50% share of the sale of surplus equipment. +Loss on Early Extinguishment of Debt +For the year ended December 31, 2010, the loss on early extinguishment of debt was $0.34 million, though no similar expense was incurred during 2009. The $0.34 million related to the 1% call premium, equal to $0.16 million, paid to redeem the remaining $16.1 million of Old Notes not exchanged during the restructuring of the Old Notes, plus $0.18 million for the accelerated amortization of the Old Notes’ remaining discount and debt issuance costs. +Due to the early extinguishment of the $200 million senior revolving credit facility on April 8, 2008, we incurred expenses of $11.9 million consisting of $6.3 million in cash pre-payment penalties plus a non-cash charge of $5.6 million related to the amortization expense associated with the deferred financing costs related to the senior revolving credit facility. For additional information, see Note 6 to the Consolidated Financial Statements. +9.75% Senior Notes Restructuring Expense +During the fourth quarter of 2009 and following the successful exchange of our Old Note for the 13% Senior Notes, we incurred $1.0 million of financing cost related to consultant and legal expenses. For additional information, see Note 6 to the Consolidated Financial Statements. +35 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +Interest on BOEMRE Royalty Recoupment +Following a court ruling against the BOEMRE resulting from several royalty payment-related court cases brought by another oil and gas company, during 2009 we filed for a $44.8 million royalty recoupment for royalty payments previously made on inception-to-date our production from Medusa field. Consequently, the Company also recorded a related $7.7 million interest receivable for the interest owed on the amounts paid. During the first quarter of 2010, the Company received both the recoupment principal and interest. In addition, the Company is no longer required to make any future royalty payments to the BOEMRE related to its Medusa production. For additional information, see Note 16 included to the Consolidated Financial Statements. +Income Tax Expense +For the years ended December 31, 2010 and 2009, income tax expense was negligible despite earning pre-tax income of approximate $7.8 million and $53.8 million, respectively. Income tax expense remained immaterial due to adjustments made to our deferred tax asset valuation. During 2010, we recorded a $0.2 million tax benefit related to recovery of alternative minimum taxes paid during prior years. +For 2009, income tax expense was zero compared to an income tax benefit of $39.7 million in 2008. The income tax benefit in 2008 was primarily the result of expensing the impairment of oil and gas properties in the amount of $485.5 million. We established a valuation allowance of $128.1 million as of December 31, 2008. We revised the valuation allowance for the twelve-month period ended December 31, 2009 as a result of current year ordinary income, the impact of which is included in our effective tax rate. For additional information, see Note 12 to the Consolidated Financial Statements. +Off-Balance Sheet Arrangements +The Company holds a 10% ownership interest in Medusa Spar LLC (“LLC”), which is accounted for under the equity method of accounting for investments. The LLC owns a 75% undivided ownership interest in the deepwater spar production facilities at the Company’s Medusa Field in the Gulf of Mexico. The LLC earns a tariff based upon production volume throughput from the Medusa area. Callon is obligated to process through the spar production facilities its share of production from the Medusa Field and any future discoveries in the area. The balance of Medusa Spar LLC is owned by Oceaneering International, Inc. and Murphy Oil Corporation. +Summary of Significant Accounting Policies +Property and Equipment +The Company utilizes the full-cost method of accounting for its oil and gas properties whereby all costs incurred in connection with the acquisition, exploration and development of oil and gas reserves, including certain overhead costs, are capitalized into the “full-cost pool.” The amounts capitalized into the full-cost pool are depleted (charged against earnings) using the unit-of-production method. The full-cost method of accounting for our proved oil and gas properties requires that the Company makes estimates based on its assumptions of future events that could change. These estimates are described below. +Depreciation, Depletion and Amortization (DD&A) of Oil and Gas Properties +The Company calculates depletion by using the depletable base, equal to the net capitalized costs in our full-cost pool plus estimated future development costs, and the estimated net proved reserve quantities. Capitalized costs added to the full-cost pool include the following: +· +cost of drilling and equipping productive wells, dry hole costs, acquisition costs of properties with proved reserves, delay rentals and other costs related to exploration and development of our oil and gas properties; +· +payroll costs including the related fringe benefits paid to employees directly engaged in the acquisition, exploration and/or development of oil and gas properties as well as other directly identifiable general and administrative costs associated with such activities. Such capitalized costs do not include any costs related to the production of oil and gas or general corporate overhead; +36 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +· +costs associated with unevaluated properties, those lacking proved reserves, are excluded from the depletable base. These unevaluated property costs are added to the depletable base at such time as wells are completed on the properties, the properties are sold or the Company determines these costs have been impaired. The Company’s determination that a property has or has not been impaired (which is discussed below) requires assumptions about future events; +· +estimated costs to dismantle, abandon and restore properties that are capitalized to the full-cost pool when the related liabilities are incurred (see also the discussion below regarding Asset Retirement Obligations) ; and +· +estimated future costs to develop proved properties are added to the full-cost pool for purposes of the DD&A computation. The Company uses assumptions based on the latest geologic, engineering, regulatory and cost data available to us to estimate these amounts. However, the estimates made are subjective and may change over time. The Company’s estimates of future development costs are reviewed at least annually and as additional information becomes available. +Capitalized costs included in the full-cost pool plus estimated future development costs are depleted and charged against earnings using the unit-of-production method. Under this method, the Company estimates the proved reserves quantities at the beginning of each accounting period. For each Mcfe produced during the period, the Company records a depletion charge equal to the amount included in the depletable base (net of accumulated depreciation, depletion and amortization) divided by our estimated net proved reserve quantities. +Because the Company uses estimates and assumptions to calculate proved reserves (as discussed below) and the amounts included in the depletable base, our depletion rates may materially change if actual results differ from these estimates. +Ceiling Test +Under the full cost method of accounting, the Company compares, at the end of each financial reporting period, the present value of estimated future net cash flows from proved reserves (excluding cash flows related to estimated abandonment costs), to the net capitalized costs of proved oil and gas properties net of related deferred taxes. The Company refers to this comparison as a “ceiling test.” If the net capitalized costs of proved oil and gas properties exceed the estimated discounted (at 10%) future net cash flows from proved reserves, the Company is required to write-down the value of its oil and gas properties to the value of the discounted cash flows. Estimated future net cash flows from proved reserves are based on a twelve-month average pricing assumption. Given the volatility of oil and gas prices, it is reasonably possible that the Company’s estimates of discounted future net cash flows from proved oil and gas reserves could change in the near term. If oil and gas prices decline significantly, even if only for a short period of time, it is possible that write-downs of oil and gas properties could occur in the future. See Notes 2 and 13 for additional information regarding the Company’s oil and gas properties. +Estimating Reserves and Present Value of Estimated Future Net Cash Flows +Estimates of quantities of proved oil and gas reserves, including the discounted present value of estimated future net cash flows from such reserves at the end of each quarter, are based on numerous assumptions, which are likely to change over time. These assumptions include: +· +the prices at which the Company can sell its oil and gas production in the future. Oil and gas prices are volatile, but we are required to assume that they remain constant. In general, higher oil and gas prices will increase quantities of proved reserves and the present value of estimated future net cash flows from such reserves, while lower prices will decrease these amounts; and +· +the costs to develop and produce the Company’s reserves and the costs to dismantle its production facilities when reserves are depleted. These costs are likely to change over time, but the Company is required to assume that costs in effect at the end of the quarter will not change. Increases in costs will reduce estimated oil and gas quantities and the present value of estimated future net cash flows, while decreases in costs will increase such amounts. +Changes in these prices and/or costs will affect the present value of estimated future net cash flows more than the estimated quantities of oil and gas reserves for the Company’s properties that have relatively short productive lives. +In addition, the process of estimating proved oil and gas reserves requires that the Company’s independent and internal reserve engineers exercise judgment based on available geological, geophysical and technical information. We have described the risks associated with reserve estimation and the volatility of oil and gas prices under “Risk Factors.” +Sales of oil and gas properties are accounted for as adjustments to the net full cost pool with no gain or loss recognized unless the adjustment would significantly alter the relationship between capitalized costs and proved reserves. +37 +Table of Contents +Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) +Unproved Properties +Costs, including capitalized interest, associated with properties that do not have proved reserves are excluded from the depletable base, and are included in the line item “Unevaluated properties excluded from amortization.” Unproved property costs are transferred to the depletable base when wells are completed on the properties or the properties are sold. In addition, the Company is required to determine whether its unproved properties are impaired and, if so, include the costs of such properties in the depletable base. The Company determines whether an unproved property is impaired by periodically reviewing its exploration program on a property-by-property basis. This determination may require the exercise of substantial judgment by management. +Asset Retirement Obligations +The Company is required to record its estimate of the fair value of liabilities for obligations associated with the retirement of tangible long-life assets and the associated asset retirement costs. Interest is accreted on the present value of the asset retirement obligation and reported as accretion expense within operating expenses in the Consolidated Statements of Operations. See Note 14 for additional information. +Derivatives +To manage oil and gas price risk on a limited amount of its planned future production, the Company periodically uses derivative financial instruments. The Company does not use these instruments for trading purposes. Settlement of derivative contracts are generally based on the difference between the contract price and prices specified in the derivative instrument and a NYMEX price or other cash or futures index price. +The Company’s derivative contracts, all of which are accounted for as cash flow hedges, are recorded at fair market value on its consolidated balance sheet under the caption “Fair Market Value of Derivatives”. The estimated fair value of these contracts is based upon closing exchange prices on NYMEX and in the case of collars and floors, the time value of options. Changes in fair value recorded through other comprehensive income (loss), net of tax, in stockholders’ equity. The cash settlements on these contracts are recorded in the Statement of Operations as an increase or decrease in oil and gas sales. The changes in fair value related to ineffective derivative contracts are recognized as derivative expense (income). The cash settlement on these contracts is also recorded within derivative expense (income). For additional information regarding derivatives and their fair values, see Notes 7 and 8 to the Consolidated Financial Statements. +Subsequent Events. +For additional information regarding subsequent events, see Note 19 included in Part II, Item 8 of this filing. +Equity Offering and Announced Senior Notes Redemption +As previously discussed above in the Results of Operations and Liquidity discussions, during February 2011, the Company received $73.7 million in net proceeds through the public offering of 10.1 million shares of its common stock, which included the issuance of 1.1 million shares pursuant to the underwriters’ over-allotment option. Immediately following the completion of the equity offering, the Company provided the public notice required by the terms of the Senior Notes to call $31.0 million of face value of the Notes. The Company expects to complete the redemption of these notes by March 19, 2011, which will result in a gain on the early extinguishment of debt of approximately $2.0 million. The gain represents the difference between the $35.0 million paid for $37.0 million carrying value of the Notes, which included the $31.0 million face value of the notes plus $6.0 million of accelerated deferred credit amortization, offset by the $4.0 million 13% call premium required by the terms of the call option. +Arbitration Results +Prior to abandonment of the Entrada project, the Company’s joint interest owner in the Entrada Project failed to fund two loan requests totaling $40 million under the Callon Entrada credit agreement. These loan requests were to cover Callon Entrada’s share of the costs incurred to develop the Entrada field up to the suspension of the project. Following its partner’s failure to fund these requests, the amounts were subsequently funded by the Company to Callon Entrada, and were included as part of the Company’s full-cost pool impairment adjustment recorded in the fourth quarter of 2008. The joint interest partner also failed to fund its working interest share of a settlement payment to terminate a drilling contract for the Entrada Project. The Company and its joint interest partner in the Entrada project arbitrated the matter during 2010. During February, 2011, the arbitration panel reviewing the Company’s claims against the joint interest owner delivered its final decision in which it ruled that the company was not entitled to recover any damages. The Company determination that the arbitration ruling represented a recognizable subsequent event, and as such, recorded a charge as of December 31, 2010 to write off its $6.6 receivable related to certain joint interest billings not being recovered from a joint interest partner. Under the full cost method of accounting, these costs are capitalized to the Company’s full cost pool. +Recent Accounting Standards +For a discussion of recently issued accounting standards, see Note 2 to the Consolidated Financial Statements. +38 +Table of Contents +ITEM 7A. Quantitative and Qualitative Disclosures about Market Risks +The primary objective of the following information is to provide forward-looking quantitative and qualitative information about our exposure to market risk. The term market risk relates to the risk of loss arising from adverse changes in oil and natural gas prices and interest rates. The disclosures are not meant to be precise indicators of expected future losses, but rather indicators of reasonably possible losses. The forward-looking information provides indicators of how the Company views and manages its ongoing market risk exposures. +Commodity Price Risk +The Company’s revenues, earnings, cash flow, capital investments and, ultimately, future rate of growth are highly dependent on the prices we receive for our crude oil and natural gas, which have historically been very volatile due to unpredictable events such as economical growth or retraction, weather and climate, changes in supply and government actions. Oil and natural gas price declines and volatility could adversely affect the Company’s revenues, cash flows and profitability. Price volatility is expected to continue. Based on projected annual sales volumes for 2011, excluding production from 2011 exploratory drilling and the effects of the Company’s hedging program, a 10% decline in the prices we receive for our crude oil and natural gas production would result in an approximate $10.6 million reduction of our revenues. +While the Company does not enter into derivative transactions for speculative purposes, in order to limit its exposure to this risk, the Company most often utilizes price "collars" to reduce the risk of changes in oil and gas prices. Under these arrangements, no payments are due by either party as long as the market price is above the floor price and below the ceiling price set in the collar. If the price falls below the floor, the counter-party to the collar pays the difference to Callon, and if the price rises above the ceiling, Callon pays the difference to the counter-party. +The Company may also enter into derivative financial instruments including fixed price “swaps.” These swaps reduce our exposure to decreases in commodity prices, while simultaneously limiting the benefit the Company might otherwise have received from any increases in commodity prices. Similarly, the Company’s derivatives policy also allows Callon to, at its discretion, purchase “puts,” which reduce our exposure to decreases in oil and gas prices while allowing realization of the full benefit from any increases in oil and gas prices. If the price falls below the floor, the counter-party pays the difference to the Callon. +During 2010, all of the Company’s derivative positions were designated as hedges for accounting purposes, though the Company has the discretion not to designate its hedges as such. For additional information, see Note 7 to the Consolidated Financial Statements for a description of our hedged position at December 31, 2010. +Interest Rate Risk +On December 31, 2010, all of the Company’s debt, consisting entirely of its 13% Senior Notes, had fixed interest rates. The Company’s revolving credit facility with Regions Bank includes a variable interest rate, and as such fluctuates based on short-term interest rates. Although the Company had no borrowings outstanding at December 31, 2010 under its revolving credit facility, were the Company to fully draw its available $30 million borrowing base at the beginning of the year, a 100 basis point change in the variable interest rate would increase the Company’s annual interest expense by $0.3 million. For additional information, see Note 6 to the Consolidated Financial Statements additional information regarding the Company’s credit facility and other borrowings at December 31, 2010. +39 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +Report of Independent Registered Public Accounting Firm +41 +Consolidated Balance Sheets as of December 31, 2010 and 2009 +42 +Consolidated Statements of Operations for Each of the Three Years in the Period Ended December 31, 2010 +43 +Consolidated Statements of Stockholders' Equity (Deficit) for Each of the Three Years in the Period Ended December 31, 2010 +44 +Consolidated Statements of Cash Flows for Each of the Three Years in the Period Ended December 31, 2010 +45 +Notes to Consolidated Financial Statements +46 +40 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited the accompanying consolidated balance sheets of Callon Petroleum Company as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Callon Petroleum Company as of December 31, 2010 and 2009, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. +As discussed in Note 2 to the financial statements, effective January 1, 2010, the Company changed its accounting for its subsidiary, Callon Entrada Company, as a result of adopting the amended accounting pronouncement related to the consolidation of variable interest entities. In 2009, the Company changed its reserve estimates and related disclosures as a result of adopting new oil and gas reserve estimation and disclosure requirements. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Callon Petroleum Company’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2011, expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 14, 2011 +41 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(In thousands, except share data) +December, 31 +2010 +2009 +ASSETS +Current assets: +Cash and cash equivalents +$ +17,436 +$ +3,635 +Accounts receivable +10,728 +20,798 +Accounts receivable - BOEMRE royalty recoupment +- +51,534 +Fair market value of derivatives +- +145 +Other current assets +2,180 +1,572 +Total current assets +30,344 +77,684 +Oil and gas properties, full-cost accounting method: +Evaluated properties +1,316,677 +1,593,884 +Less accumulated depreciation, depletion and amortization +(1,155,915 +) +(1,488,718 +) +Net oil and gas properties +160,762 +105,166 +Unevaluated properties excluded from amortization +8,106 +25,442 +Total oil and gas properties +168,868 +130,608 +Other property and equipment, net +3,370 +2,508 +Restricted investments +4,044 +4,065 +Investment in Medusa Spar LLC +10,424 +11,537 +Other assets, net +1,276 +1,589 +Total assets +$ +218,326 +$ +227,991 +LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) +Current liabilities: +Accounts payable and accrued liabilities +$ +17,702 +$ +12,887 +Asset retirement obligations +2,822 +4,002 +Fair market value of derivatives +937 +- +9.75% Senior Notes, net of $0 and $232 discount, respectively +- +15,820 +Subtotal +21,461 +32,709 +Callon Entrada non-recourse credit facility (See Note 3) +- +84,847 +Total current liabilities +21,461 +117,556 +13% Senior Notes +Principal outstanding +137,961 +137,961 +Deferred credit, net of accumulated amortization of $3,964 and $294, respectively +27,543 +31,213 +Total 13% Senior Notes (See Note 6) +165,504 +169,174 +Senior secured revolving credit facility +- +10,000 +Asset retirement obligations +13,103 +10,648 +Other long-term liabilities +2,448 +1,467 +Total liabilities +202,516 +308,845 +Stockholders' equity (deficit): +Preferred Stock, $.01 par value, 2,500,000 shares authorized; +- +- +Common Stock, $.01 par value, 60,000,000 shares authorized; 28,984,125 and 28,742,926 +shares outstanding at December 31, 2010 and December 31, 2009, respectively +290 +287 +Capital in excess of par value +248,160 +243,898 +Other comprehensive loss +(8,560 +) +(7,478 +) +Retained earnings (deficit) +(224,080 +) +(317,561 +) +Total stockholders' equity (deficit) +15,810 +(80,854 +) +Total liabilities and stockholders' equity (deficit) +$ +218,326 +$ +227,991 +The accompanying notes are an integral part of these financial statements. +42 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF OPERATIONS +(In thousands, except per share amounts) +For the year ended December 31, +2010 +2009 +2008 +Operating revenues: +Oil sales +$ +65,243 +$ +73,842 +$ +82,963 +Gas sales +24,639 +27,417 +58,349 +BOEMRE royalty recoupment +- +40,886 +- +Total operating revenues +89,882 +142,145 +141,312 +Operating expenses: +Lease operating expenses +17,712 +18,447 +19,208 +Depreciation, depletion and amortization +31,805 +33,443 +64,054 +General and administrative +16,507 +13,355 +9,565 +Accretion expense +2,446 +3,149 +4,172 +Acquisition expense +233 +298 +- +Derivative expense +- +- +498 +Impairment of oil and gas properties +- +- +485,498 +Total operating expenses +68,703 +68,692 +582,995 +Income (loss) from operations +21,179 +73,453 +(441,683 +) +Other (income) expenses: +Interest expense +13,312 +19,089 +23,986 +Callon Entrada non-recourse credit facility interest expense (See Note 3) +- +7,072 +2,719 +Loss on early extinguishment of debt +339 +- +11,871 +9.75% Senior Notes restructuring expenses +- +1,024 +- +Interest on BOEMRE royalty recoupment +(91 +) +(7,681 +) +- +Other (income) expense +(166 +) +190 +(1,379 +) +Total other expenses +13,394 +19,694 +37,197 +Income (loss) before income taxes +7,785 +53,759 +(478,880 +) +Income tax benefit +(174 +) +- +(39,725 +) +Income (loss) before equity in earnings of Medusa Spar LLC +7,959 +53,759 +(439,155 +) +Equity in earnings of Medusa Spar LLC +427 +660 +262 +Net income (loss) available to common shares +$ +8,386 +$ +54,419 +$ +(438,893 +) +Net income (loss) per common share: +Basic +$ +0.29 +$ +2.47 +$ +(20.68 +) +Diluted +$ +0.28 +$ +2.45 +$ +(20.68 +) +Shares used in computing net income per common share: +Basic +28,817 +22,072 +21,222 +Diluted +29,476 +22,200 +21,222 +The accompanying notes are an integral part of these financial statements. +43 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) +(In thousands) +Preferred Stock +Common Stock +Capital in Excess of Par +Accumulated Other Comprehensive Income (Loss) +Retained Earnings (Deficit) +Total Stockholders' Equity (Deficit) +Balances at December 31, 2007 +$ +- +$ +209 +$ +223,336 +$ +(3,383 +) +$ +66,913 +$ +287,075 +Comprehensive income (loss): +Net loss +- +- +- +- +(438,893 +) +Other comprehensive income +- +- +- +17,540 +- +Total comprehensive loss +(421,353 +) +Shares issued pursuant to employee benefit plans +- +1 +(1,153 +) +- +- +(1,152 +) +Tax benefits related to share-based compensation plans +- +- +2,050 +- +- +2,050 +Restricted stock +- +1 +3,575 +- +- +3,576 +Warrants +- +5 +(5 +) +- +- +- +Balances at December 31, 2008 +$ +- +$ +216 +$ +227,803 +$ +14,157 +$ +(371,980 +) +$ +(129,804 +) +Comprehensive income: +Net income +- +- +- +- +54,419 +Other comprehensive loss +- +- +- +(21,635 +) +- +Total comprehensive income +32,784 +Shares issued pursuant to employee benefit plans +- +1 +205 +- +- +206 +Restricted stock +- +1 +4,432 +- +- +4,433 +Common stock issued for Note exchange +- +69 +11,458 +- +- +11,527 +Balances at December 31, 2009 +$ +- +$ +287 +$ +243,898 +$ +(7,478 +) +$ +(317,561 +) +$ +(80,854 +) +Deconsolidation of subsidiary (See Note 3) +- +- +- +- +85,095 +85,095 +Comprehensive income: +Net income +- +- +- +- +8,386 +Other comprehensive loss +- +- +- +(1,082 +) +- +Total comprehensive income +7,304 +Shares issued pursuant to employee benefit plans +- +1 +192 +- +- +193 +Restricted stock +- +2 +4,070 +- +- +4,072 +Balances at December 31, 2010 +$ +- +$ +290 +$ +248,160 +$ +(8,560 +) +$ +(224,080 +) +$ +15,810 +The accompanying notes are an integral part of these financial statements. +44 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In thousands) +For the year ended December 31, +2010 +2009 +2008 +Cash flows from operating activities: +Net income +$ +8,386 +$ +54,419 +$ +(438,893 +) +Adjustments to reconcile net income to +cash provided by operating activities: +Depreciation, depletion and amortization +32,629 +34,274 +64,862 +Impairment of oil and gas properties +- +- +485,498 +Accretion expense +2,446 +3,149 +4,172 +Amortization of non-cash debt related items +397 +2,816 +4,185 +Amortization of deferred credit +(3,670 +) +(294 +) +- +Equity in earnings of Medusa Spar LLC +(427 +) +(660 +) +(262 +) +Deferred income tax expense +1,503 +18,816 +(167,848 +) +Valuation allowance +(1,503 +) +(18,816 +) +128,123 +Non-cash interest expense for Callon Entrada non-recourse credit agreement +- +3,693 +- +Non-cash charge for early debt extinguishment +179 +- +5,598 +Non-cash charge related to compensation plans +3,107 +2,335 +1,550 +Excess tax benefits from share-based payment arrangements +- +- +(2,050 +) +Payments to settle asset retirement obligations +(2,486 +) +(6,657 +) +(4,178 +) +Changes in current assets and liabilities: +Accounts receivable +59,527 +(45,573 +) +(22,215 +) +Other current assets +(209 +) +(468 +) +5,489 +Current liabilities +907 +(27,260 +) +22,987 +Change in gas balancing receivable +347 +279 +630 +Change in gas balancing payable +(300 +) +(312 +) +156 +Change in other long-term liabilities +(115 +) +(12 +) +2,708 +Change in other assets, net +(776 +) +(31 +) +(1,458 +) +Cash provided by operating activities +99,942 +19,698 +89,054 +Cash flows from investing activities: +Capital expenditures +(59,908 +) +(29,133 +) +(172,358 +) +Acquisitions +(995 +) +(15,756 +) +- +Proceeds from sale of mineral interests +- +- +167,349 +Investment in restricted assets related to plugging and abandonment +(375 +) +- +- +Distribution from Medusa Spar LLC +1,540 +1,700 +498 +Cash used in investing activities +(59,738 +) +(43,189 +) +(4,511 +) +Cash flows from financing activities: +Increases in debt +- +20,337 +94,435 +Payments on debt +(10,000 +) +(10,337 +) +(216,000 +) +Redemption of remaining 9.75% senior notes +(16,052 +) +- +- +Equity issued related to employee stock plans +- +- +(1,152 +) +Excess tax benefits from share-based payment arrangements +- +- +2,050 +Proceeds from exercise of employee stock options +(40 +) +- +- +Cash (used in) provided by financing activities +(26,092 +) +10,000 +(120,667 +) +Net change in cash and cash equivalents +14,112 +(13,491 +) +(36,124 +) +Cash and cash equivalents: +Balance, beginning of period +3,635 +17,126 +53,250 +Less: Cash held by subsidiary deconsolidated at January 1, 2010 +(311 +) +- +- +Balance, end of period +$ +17,436 +$ +3,635 +$ +17,126 +The accompanying notes are an integral part of these financial statements. +45 +Table of Contents +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Note +Description +Note +Description +1. +Description of Business and Basis of Presentation +11. +Equity Transactions +2. +Summary of Significant Accounting Policies +12. +Income Taxes +3. +Deconsolidation of Callon Entrada +13. +Oil and Gas Properties +4. +Earnings per Share +14. +Asset Retirement Obligations +5. +Other Comprehensive Income (Loss) +15. +Supplemental Oil and Gas Reserve Data (unaudited) +6. +Borrowings +16. +BOEMRE Royalty Recoupment +7. +Derivative Instruments and Hedging Activities +17. +Commitments and Contingencies +8. +Fair Value Measurements +18. +Summarized Quarterly Financial Information (unaudited) +9. +Employee Benefit Plans +19. +Subsequent Events +10. +Share-Based Compensation +NOTE 1 – Description of Business and Presentation +Callon Petroleum Company has been engaged in the exploration, development, acquisition and production of oil and gas properties since 1950. The Company was incorporated under the laws of the state of Delaware in 1994 and succeeded to the business of a publicly traded limited partnership, a joint venture with a consortium of European investors and an independent energy company partially owned by a member of current management. As used herein, the “Company,” “Callon,” “we,” “us,” and “our” refer to Callon Petroleum Company and its predecessors and subsidiaries unless the context requires otherwise. The Company's properties are geographically concentrated onshore in Louisiana and Texas and the offshore waters of the Gulf of Mexico. +The Consolidated Financial Statements include the accounts of the Company, and its subsidiary, Callon Petroleum Operating Company (“CPOC”). CPOC also has subsidiaries, namely Callon Offshore Production, Inc. and Mississippi Marketing, Inc. Fiscal years prior to 2010, CPOC also included Callon Entrada Company (“Callon Entrada”), which as discussed in Note 3 was deconsolidated from the Company’s Consolidated Financial Statements effective January 1, 2010. All intercompany accounts and transactions have been eliminated. Certain prior year amounts have been reclassified to conform to presentation in the current year. To the extent these amounts are material, we have either footnoted them within the Company's disclosures or have noted the items within this footnote. The Company reclassified on its 2009 and 2008 Consolidated Statements of Cash Flow $6,657 and $4,178, respectively, between “Payments to settle asset retirement obligations” and “Capital expenditures.” +NOTE 2 – Summary of Significant Accounting Policies +A. +Use of Estimates +The preparation of financial statements in conformity with United States generally accepted accounting principles (“US GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. +B. +Cash and Cash Equivalents +The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. +C. +Accounts Receivable +Accounts receivable consists primarily of accrued oil and gas production receivables. The balance in the reserve for doubtful accounts netted within accounts receivable was $339 and $65 at December 31, 2010 and 2009, respectively. During 2010, the Company recorded $274 of bad debt expense in general and administrative expenses. For 2009 and 2008, the Company recorded no provisions for bad debt to expense. +46 +Table of Contents +D. +Revenue Recognition and Gas Balancing +The Company recognizes revenue under the entitlement method of accounting. Under the method, revenue is deferred for deliveries in excess of the Company’s net revenue interest, while revenue is accrued for the undelivered volumes. Production imbalances are generally recorded at the estimated sale price in effect at the time of production. Gas balancing receivables were $396 and $743 as of December 31, 2010 and 2009, respectively. Gas balancing payables were $870 and $1,171 as of December 31, 2010 and 2009, respectively. +E. +Major Customers +The Company’s production is generally sold on month-to-month contracts at prevailing prices. The following table identifies customers to whom it sold a significant percentage of its total oil and gas production during each of the years ended: +December 31, +2010 +2009 +2008 +Shell Trading Company +44% +45% +33% +Plains Marketing, L.P. +20% +23% +23% +Louis Dreyfus Energy Services +13% +15% +16% +Other +23% +17% +28% +Total +100% +100% +100% +Because alternative purchasers of oil and gas are readily available, the Company believes that the loss of any of these purchasers would not result in a material adverse effect on its ability to market future oil and gas production. +F. +Oil and Gas Properties +The Company uses the full-cost method of accounting for its exploration and development activities. Under this method of accounting, the cost of both successful and unsuccessful exploration and development activities are capitalized as property and equipment. Such amounts include the cost of drilling and equipping productive wells, dry hole costs, lease acquisition costs, delay rentals, interest capitalized on unevaluated leases, other costs related to exploration and development activities, and site restoration, dismantlement and abandonment costs capitalized in accordance with asset retirement obligation accounting guidance. Costs capitalized also include any internal costs that are directly related to exploration and development activities, including salaries and benefits, but do not include any costs related to production, general corporate overhead or similar activities. The Company capitalized $11,829, $10,107 and $12,623 of these internal costs during 2010, 2009 and 2008, respectively. +When applicable, proceeds from the sale or disposition of oil and gas properties are accounted for as a reduction to capitalized costs unless a significant portion (greater than 25 percent) of the Company’s reserve quantities in a particular country are sold, in which case a gain or loss is recognized in income. +Costs of oil and gas properties, including future development costs, which have proved reserves and properties which have been determined to be worthless, are depleted using the unit-of-production method based on proved reserves. Excluded from this amortization are costs associated with unevaluated properties, including capitalized interest on such costs. Unevaluated property costs are transferred to evaluated property costs at such time as wells are completed on the properties or management determines that these costs have been impaired. +Under the full cost method of accounting, the Company compares, at the end of each financial reporting period, the present value of estimated future net cash flows from proved reserves (excluding cash flows related to estimated abandonment costs), to the net capitalized costs of proved oil and gas properties net of related deferred taxes. The Company refers to this comparison as a “ceiling test.” If the net capitalized costs of proved oil and gas properties exceed the estimated discounted (at 10%) future net cash flows from proved reserves, the Company is required to write-down the value of its oil and gas properties to the value of the discounted cash flows. Historically, estimated future net cash flows from proved reserves were calculated based on period-end hedge adjusted commodity prices, and the impact of price increases subsequent to the period end could be considered. In December 2008, the Securities and Exchange Commission (“SEC”) issued a final rule, “Modernization of Oil and Gas Reporting,” which adopted revisions to the SEC’s oil and gas reporting requirements. The revisions , which became effective for the Company’s financial statements as of December 31, 2009, replaced the single-day year-end pricing with a twelve-month average pricing assumption. Additionally, consideration of the impact of subsequent price increases after period end is no longer allowed. The changes to prices used in the reserves calculation under the new rule are used in both disclosures and accounting impairment tests. In January 2010, the Financial Accounting Standards Board (“FASB”) issued its final standard on oil and gas reserve estimation and disclosures aligning its requirements with the SEC’s final rule. The new rules were considered a change in accounting principle that is inseparable from a change in accounting estimate, which did not require retroactive revision. See Note 13 for additional information regarding the Company’s oil and gas properties. +47 +Table of Contents +Upon the acquisition or discovery of oil and gas properties, the Company estimates by using available geological, engineering and regulatory data the future net costs to dismantle, abandon and restore the property. Such cost estimates are periodically updated for changes in conditions and requirements. In accordance with asset retirement obligation guidance issued by the Financial Accounting Standards Board (“FASB”), such costs are capitalized to the full-cost pool when the related liabilities are incurred. In accordance with Securities and Exchange Commission (“SEC”) rules, assets recorded in connection with the recognition of an asset retirement obligation are included as part of the costs subject to the full-cost ceiling limitation. The future cash outflows associated with settling the recorded asset retirement obligations are excluded from the computation of the present value of estimated future net revenues used in determining the full-cost ceiling amount. +Sales of oil and gas properties are accounted for as adjustments to the net full cost pool with no gain or loss recognized, unless the adjustment would significantly alter the relationship between capitalized costs and proved reserves. +G. +Amendments to Oil and Gas Reserves Estimation and Disclosure Requirements +In December 2008 the SEC approved amendments to its oil and gas reserves estimation and disclosure requirements. The amendments, among other things: +· +allow the use of reliable technologies to estimate proved reserves if those technologies have been demonstrated to result in reliable conclusions about reserve volumes; +· +require disclosure of oil and gas proved reserves by significant geographic area; +· +permit the optional disclosure of probable and possible reserves; +· +modify the prices used to estimate reserves for SEC disclosure purposes to a 12-month average beginning-of-the-month price instead of a period-end price; and +· +require that if a third party is primarily responsible for preparing or auditing the reserve estimates, the company make disclosures relating to the independence and qualifications of the third party, including filing as an exhibit any report received from the third party. +Additionally, during January 2010, the FASB issued accounting guidance to align the reserve calculation and disclosure requirements of US GAAP with the new SEC oil and gas reserve estimation and disclosure rules. The Company adopted the new requirements effective for its year-end financial statements and our Annual Report on Form 10-K for the year ended December 31, 2009. The adoption had no material impact on the Company’s financial statements. +H. +Other Property and Equipment +The Company depreciates its other property and equipment using the straight-line method over estimated useful lives of three to 20 years. Depreciation expense of $446, $423 and $437 relating to other property and equipment was included in general and administrative expenses in the Company’s consolidated statements of operations for the years ended December 31, 2010, 2009 and 2008, respectively. The accumulated depreciation on other property and equipment was $12,047 and $11,828 as of December 31, 2010 and 2009, respectively. +I. +Asset Retirement Obligations +The Company is required to record its estimate of the fair value of liabilities for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. Interest is accreted on the present value of the asset retirement obligations and reported as accretion expense within operating expenses in the consolidated statements of operations. See Note 14 for additional information. +J. +Derivatives +Settlements of oil and gas derivative contracts are generally based on the difference between the contract price or prices specified in the derivative instrument and a New York Mercantile Exchange (“NYMEX”) price or other cash or futures index price. The current and non-current portion of derivative contracts are carried at fair value in the consolidated balance sheet under the caption “Fair Market Value of Derivatives” and “Other Assets, net / Other long-term liabilities” respectively. The oil and gas derivative contracts are settled based upon reported prices on NYMEX. The estimated fair value of these contracts is based upon closing exchange prices on NYMEX and in the case of collars and floors, the time value of options. The Company’s derivative contracts are designated as cash flow hedges, and are recorded at fair market value with the changes in fair value recorded net of tax through other comprehensive income (loss) (“OCI”) in stockholders’ equity (deficit). The cash settlements on contracts for future production are recorded as an increase or decrease in oil and gas sales. Both changes in fair value and cash settlements of ineffective derivative contracts are recognized as derivative expense (income). See Notes 7 and 8 for additional information. +48 +Table of Contents +K. +Income Taxes +Provisions for income taxes include deferred taxes resulting primarily from temporary differences due to different reporting methods for oil and gas properties for financial reporting purposes and income tax purposes. US GAAP requires the recognition of a deferred tax asset for net operating loss carryforwards, statutory depletion carryforward and tax credit carryforwards, net of a valuation allowance. The valuation allowance is provided for that portion of the asset for which it is deemed more likely than not will not be realized. See Note 12 for additional information. +L. +Share-Based Compensation +Share-based compensation requires the cash flows from tax benefits resulting from tax deductions in excess of compensation cost recognized for stock options exercised (excess tax benefits) to be classified as financing cash flows. The $2,050 of excess tax benefits classified as a financing cash inflow for the year ended December 31, 2008 would have been classified as an operating cash flow had the Company not adopted the guidance issued by the FASB for share-based compensation. There were no stock option exercises in the year ended December 31, 2009, and no cash proceeds from the exercise of stock options for the years ended December 31, 2010 or 2008 due to the fact that all options were exercised through net-share settlements. See Note 10 for additional information. +M. +Statements of Cash Flows +During the three year period ended December 31, 2010, the Company paid no federal income taxes. During the years ended December 31, 2010, 2009 and 2008, the company made cash interest payments of $18,579, $19,811 and $26,970, respectively. +N. +Off-Balance Sheet Investment in Medusa Spar LLC +The Company holds a 10% ownership interest in Medusa Spar LLC (“LLC”), which is accounted for under the equity method of accounting for investments. The LLC owns a 75% undivided ownership interest in the deepwater spar production facilities at the Company’s Medusa Field in the Gulf of Mexico. The LLC earns a tariff based upon production volume throughput from the Medusa area. Callon is obligated to process through the spar production facilities its share of production from the Medusa Field and any future discoveries in the area. The balance of Medusa Spar LLC is owned by Oceaneering International, Inc. and Murphy Oil Corporation. +O. +Consolidation of Variable Interest Entities (“VIE”) +In June 2009, the Financial Accounting Standards Board (“FASB”) issued an accounting standard which became effective for the Company on January 1, 20101, and which amended US GAAP as follows: +· +to require an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a Variable Interest Entity (“VIE”), identifying the primary beneficiary of a VIE; +· +to require ongoing reassessment of whether an enterprise is the primary beneficiary of a VIE, rather than only when specific events occur; +· +to eliminate the quantitative approach previously required for determining the primary beneficiary of a VIE; +· +to amend certain guidance for determining whether an entity is a VIE; +· +to add an additional reconsideration event when changes in facts and circumstances pertinent to a VIE occur; +· +to eliminate the exception for troubled debt restructuring regarding VIE reconsideration; and +· +to require advanced disclosures that will provide users of financial statements with more transparent information about an enterprise’s involvement in a VIE. +The Company adopted the pronouncement for consolidation of variable interest entities on January 1, 2010. Upon adoption, the Company reevaluated its interest in its subsidiary, Callon Entrada. Based on the evaluation performed, management has concluded that a VIE reconsideration event had taken place resulting in the determination that Callon Entrada is a VIE, for which the Company is not the primary beneficiary. Therefore, effective January 1, 2010, Callon Entrada was deconsolidated from the consolidated financial statements of the Company. For additional information, see Note 3 “Deconsolidation of Callon Entrada.” +49 +Table of Contents +P. +Earnings per Share (“EPS”) +The Company’s basic EPS amounts have been computed based on the weighted-average number of shares of common stock outstanding for the period. Diluted EPS reflects the potential dilution, using the treasury-stock method, which assumes that options were exercised and restricted stock was fully vested. Diluted EPS also includes the impact of unvested share appreciation plans. For awards in which the share price goals have already been achieved, shares are included in diluted EPS using the treasury-stock method. For those awards in which the share price goals have not been achieved, the number of contingently issuable shares included in the diluted EPS is based on the number of shares, if any, using the treasury-stock method, that would be issuable if the market price of the Company’s stock at the end of the reporting period exceeded the share price goals under the terms of the plan. +Q. +Treasury Stock +The Company applies the weighted-average-cost method of accounting for treasury stock transactions and held 29 treasury shares as of December 31, 2010. +R. +Recent Accounting Pronouncements +In January 2010, the Financial Accounting Standards Board issued guidance which added new requirements for fair value disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances and settlements relating to Level 3 measurements. The guidance also clarified existing requirements regarding the level of disaggregation as well as inputs and valuation techniques used to measure fair value. The guidance is effective for the first reporting period beginning after December 31, 2009, except for the requirement to provide the Level 3 activity of purchases, sales, issuances, and settlements on a gross basis, which are effective for fiscal years beginning after December 31, 2010. The adoption of this guidance had no material impact on the Company’s fair value disclosures. See Note 8 for additional information. +NOTE 3 - Deconsolidation of Callon Entrada +In April 2008, Callon completed the sale of a 50% working interest in the Entrada Field to CIECO Energy (US) Limited (“CIECO”) effective January 1, 2008. At closing, CIECO paid Callon $155,000, and reimbursed the Company $12,600 for 50% of Entrada capital expenditures incurred prior to the closing date. In addition, as part of the purchase and sale agreement, CIECO agreed to loan Callon Entrada, a wholly owned subsidiary of the Company, up to $150,000 plus interest expense incurred up to $12,000, for its share of the development costs for the Entrada project. Based on the terms of the credit agreement with CIECO Energy (Entrada) LLC (“CIECO Entrada”), the debt was to be repaid solely from assets, primarily production, from the Entrada field. All assets of Callon Entrada, and its stock, are pledged to CIECO Entrada under the Callon Entrada credit agreement, and neither Callon nor its subsidiaries (other than Callon Entrada) guaranteed the Callon Entrada credit facility. +Prior to January 1, 2010 and prior to the issuance of revised accounting rules regarding the consolidating of VIEs, the Company was required to consolidate the financial statements and results of operations of Callon Entrada, and as such, Callon Entrada’s non-recourse principal and interest due under the credit facility was reflected in a separate line item in Callon’s 2009 consolidated financial statements. +Based on the Company’s re-evaluation under the revised accounting rules, which are detailed in Note 2, the Company concluded that a VIE reconsideration event had taken place resulting in the determination that Callon Entrada is a VIE, for which the Company is not the primary beneficiary and, as a result, Callon Entrada was deconsolidated from the Company’s consolidated financial statements as of January 1, 2010. Key events considered in this analysis include the following: +Default on non-recourse debt and CIECO’s acceleration rights exercised : As a result of abandoning the Entrada project in November 2008, prior to completion, Callon Entrada’s only source of payment is the proceeds from the sale of equipment purchased but not used for the Entrada project. On April 2, 2009, Callon Entrada received a notice from CIECO Entrada advising Callon Entrada that certain alleged events of default occurred under the credit agreement relating to failure to pay interest when due and the breach of various other covenants related to the decision to abandon the Entrada project. The notice of default received from CIECO Entrada invoked CIECO Entrada’s rights under the Callon Entrada credit agreement to accelerate payment of the principal and interest due, and to invoke its rights to the surplus equipment related to the Entrada project, including the proceeds from the sale of the equipment and the ability to control the decisions related to the sale of the equipment. Based on the advice of legal counsel, Callon believes that it and its other subsidiaries are not otherwise obligated to repay the principal, accrued interest or any other amounts which may become due under the Callon Entrada credit facility. The agreement bears interest at six-month LIBOR (as in effect on the first day of each interest period) plus 375 basis points and is subject to customary representations, warranties, covenants and events of default. The interest rate increased by 400 basis points as of April 2, 2009 due to a notice of default received from CIECO Entrada, which is discussed above. While as of January 1, 2010 Callon Entrada had been deconsolidated from these financial statements such that no principal or interest were recorded as outstanding on the Consolidated Balance Sheet at December 31,2010 under this facility, at December 31, 2009, $78,435 of principal and $6,412 of interest were outstanding under this facility. +50 +Table of Contents +Abandonment obligations satisfied: Callon guaranteed Callon Entrada’s payment of all amounts to plug and abandon the wells and related facilities and for a breach of law, rule or regulation (including environmental laws) and for any losses of CIECO Entrada attributable to gross negligence of Callon Entrada. The well for which Callon Entrada was responsible was plugged and abandoned in the fourth of quarter of 2008, and the Bureau of Ocean Energy Management, Regulation and Enforcement (“BOEMRE,” formerly the Minerals Management Service) confirmed to Callon during September 2009 that Callon had satisfied all if its abandonment obligations related to this project. +No ability to control future actions of Callon Entrada : As of December 31, 2009, the wind down of the Entrada project was complete, all of the costs related to the Entrada project were paid, and subsequent to the lease expiration June 1, 2009, control of the property reverted to the BOEMRE. The sale of remaining equipment purchased for the Entrada project remains ongoing. The Company believes that the amount of future operating costs of Callon Entrada, for which the Company would be responsible for, is insignificant and is limited to minimal storage fees for the surplus equipment while the equipment is being liquidated. As of December 2010, Callon Entrada has collected $4,235 in sales proceeds from the sale of equipment, net to its interest, which has been applied to unpaid interest expense as required under the Callon Entrada credit facility. +As a result of the events described above, the Company lost its power to direct the only remaining activities that affect Callon Entrada’s future economic performance. Below is a condensed balance sheet of Callon presented to demonstrate the effect of deconsolidation on the financial statements at January 1, 2010: +Callon +Callon +Callon +Consolidated +Entrada +Consolidated +at 12/31/09 +Deconsolidated +at 1/1/2010 +Total current assets +$ +77,684 +$ +(1,767 +) +$ +75,917 +Total oil and gas properties +130,608 +- +130,608 +Other property and equipment +2,508 +- +2,508 +Other assets +17,191 +- +17,191 +Total assets +$ +227,991 +$ +(1,767 +) +$ +226,224 +Other current liabilities +$ +16,889 +$ +(2,015 +) +$ +14,874 +9.75% Senior Notes, due December 2010 +15,820 +- +15,820 +Callon Entrada non-recourse credit facility +84,847 +(84,847 +) +- +Total current liabilities +$ +117,556 +$ +(86,862 +) +$ +30,694 +Total long-term debt +179,174 +- +179,174 +Total other long-term liabilities +12,115 +- +12,115 +Total stockholders’ equity (deficit) +(80,854 +) +85,095 +4,241 +Total liabilities and stockholders’ equity (deficit) +$ +227,991 +$ +(1,767 +) +$ +226,224 +See Note 19 for subsequent information regarding Callon Entrada. +51 +Table of Contents +NOTE 4 - Earnings per Share +Basic net income per common share was computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted net income per common share was determined on a weighted average basis using common shares issued and outstanding adjusted for the effect of stock options and restricted stock considered common stock equivalents computed using the treasury stock method. +A reconciliation of the basic and diluted net income per share computation is as follows (in thousands, except per share amounts): +For the year ended December 31, +2010 +2009 +2008 +(a) Net income +$ +8,386 +$ +54,419 +$ +(438,893 +) +(b) Weighted average shares outstanding (1) +28,817 +22,072 +21,222 +Dilutive impact of stock options +108 +- +- +Dilutive impact of restricted stock +551 +128 +- +(c) Weighted average shares outstanding +for diluted net income per share (1) +29,476 +22,200 +21,222 +Basic net income per share (a ¸ b) +$ +0.29 +$ +2.47 +$ +(20.68 +) +Diluted net income per share (a ¸ c) +$ +0.28 +$ +2.45 +$ +(20.68 +) +(1) During February 2011, the Company completed an equity offering of an addition 10,100 share of common stock, which have been excluded from the above shares outstanding as of December 31, 2010. See Note 19. +The following were excluded from the diluted EPS calculation because their effect would be anti-dilutive: +Stock options +122 +978 +161 +Because the Company reported a loss for the year ended December 31, 2008, the following were excluded from the dilution calculation: 161, 328 and 129 for stock options, warrants and restricted stock, respectively. +NOTE 5 – Other Comprehensive Income (Loss) +A summary of the Company’s comprehensive income (loss) is detailed below (in thousands, net of tax): +For the year ended December 31, +2010 +2009 +2008 +Net income +$ +8,386 +$ +54,419 +$ +(438,893 +) +Other comprehensive income (loss): +Change in fair value of derivatives +(1,082 +) +(21,635 +) +17,540 +Total comprehensive income (loss) +$ +7,304 +$ +32,784 +$ +(421,353 +) +52 +Table of Contents +NOTE 6 - Borrowings +The Company's borrowings consisted of the following at: +December 31, +2010 +2009 +Principal components: +Credit Facility +$ +- +$ +10,000 +9.75% Senior Notes due 2010, principal +- +16,052 +13% Senior Notes due 2016, principal +137,961 +137,961 +Callon Entrada Credit Facility; non-recourse (1) +- +84,847 +Total principal outstanding +137,961 +248,860 +Non-cash components: +9.75% Senior Notes, due 2010 Unamortized discount +- +(232 +) +13% Senior Notes due 2016 Unamortized deferred credit +27,543 +31,213 +Total carrying value of borrowings +$ +165,504 +$ +279,841 +(1) Liability was eliminated as part of the deconsolidation of Callon Entrada. See Note 3 for additional information. +Senior Secured Revolving Credit Facility (the “Credit Facility”) +In January 2010, the Company amended its Credit Facility agreement to include Regions Bank as the sole arranger and administrative agent. The third amended and restated Credit Facility, which matures on September 25, 2012, provides for a $100,000 facility and had an initial borrowing base of $20,000, which is reviewed and re-determined on a semi-annual basis during the second and fourth quarters. The Credit Facility bears interest at 4% above a defined base rate, and in no event will the interest rate be less than 6%. As of December 31, 2010, the interest rate on the facility was 6%. In addition, a commitment fee of 0.5% per annum on the unused portion of the borrowing base, is payable quarterly. During October 2010, Regions Bank approved a $30,000 borrowing base, which represents a $10,000 or 50% increase over the Company’s previous $20,000 borrowing base with Regions Bank, and is secured by mortgages covering the Company’s major oil fields. The next borrowing base review is scheduled for the second quarter of 2011. +Simultaneously with the January 2010 execution of the third amended and restated Credit Facility, the Company repaid the $10,000 outstanding draw under the second amended and restated Credit Facility, which was outstanding as of December 31, 2009. No balance on this facility was outstanding at December 31, 2010. +9.75% Senior Notes (“Old Notes”) (Due December 2010) +During the fourth quarter of 2009, Callon commenced an exchange offer for any and all of its outstanding Old Notes. Holders of approximately 92% of the Old Notes tendered their Notes in the exchange offer. During March 2010, the Company announced its intention to redeem all remaining Old Notes by April 30, 2010 (the “Redemption Date”) at a redemption price of 101% of their principal amount, plus accrued and unpaid interest to the Redemption Date. +On April 30, 2010, the Company completed its publically announced plans to redeem for 101% of the face value the remaining $16,052 outstanding Old Notes for $16,343, which included the 1% call premium and $130 of accrued interest through the repurchase date. The Company also recognized $179 of additional interest expense related to the accelerated amortization of the Old Notes’ remaining discount and debt issuance costs, which when added to the $160 call premium resulted in a $339 loss on early extinguishment of this debt. Since the April 30, 2010 redemption date, no Old Notes remain outstanding. +53 +Table of Contents +13% Senior Notes due 2016 (“Senior Notes”) and Deferred Credit +As described above, during the fourth quarter of 2009, the Company exchanged approximately 92% of the principal amount, or $183,948, of the Old Notes for $137,961 of Senior Notes. The exchange resulted in a 25% reduction in the principal amount of the Old Notes tendered, and included a 3.25% increase in the coupon rate from 9.75% to 13%. In addition, holders of the tendered notes received 3,794 shares of common stock and 311 shares of Convertible Preferred Stock which was valued on November 24, 2009 in the amount of $11,527 and recorded as an increase to stockholders’ equity. On December 31, 2009, each share of the Convertible Preferred Stock was automatically converted by the Company into 10 shares of common stock following shareholder approval and the filing of an amendment to the Company’s charter increasing the number of authorized shares of common stock as necessary to accommodate such conversion. The Senior Notes’ 13% interest coupon is payable on the last day of each quarter. +Upon issuing the Senior Notes during November 2009, the Company reduced the carrying amount of the Old Notes by the fair value of the common and preferred stock issued in the amount of $11,527. The $31,507 difference between the adjusted carrying amount of the Old Notes and the face value of the Senior Notes was recorded as a deferred credit, which is being amortized as a reduction in interest expense over the life of the Senior Notes at an 8.5% effective interest rate. The following table summarizes the Company’s deferred credit balance at December 31, 2010: +Gross Carrying Amount +Accumulated Amortization at December 31, 2010 +Carrying Value at December 31, 2010 +Amortization Recorded during 2010 as a Reduction of Interest Expense +Estimated Amortization +Expected to be Recorded during 2011 (1) +$ +31,507 +$ +3,964 +$ +27,543 +$ +3,670 +$ +9,162 +(1) +As discussed below, the Company initiated the redemption of $31,000 face value of its 13% Senior Notes, which is expected to be completed on March 19, 2011. As a result of the early redemption of this debt, the Company will recognize accelerated amortization of $6,004 for a proportionate share of the deferred credit, thereby increasing the full-year expected amortization to the amount reflected in the table. Deferred credit amortization expected to be recorded as a reduction in interest expense during 2012, 2013, 2014, 2015 and thereafter is $3,350, $3,647, $3,971, $4,323 and $3,098, respectively. +Following the completion of an equity offering during February, 2011, the Company provided the formal notice to holders of its Senior Notes, as required by the terms of the Senior Notes, to call $31,000 of face value of the Notes. See Note 19 for additional information. +Certain of the Company’s subsidiaries guarantee the Company’s obligations under the Senior Notes. The subsidiary guarantors are 100% owned, all of the guarantees are full and unconditional and joint and several, the parent company has no independent assets or operations and any subsidiaries of the parent company other than the subsidiary guarantors are minor. +Restrictive Covenants +The Indenture governing our Senior Notes and the Company’s Credit Facility contains various covenants including restrictions on additional indebtedness and payment of cash dividends. In addition, Callon’s Credit Facility contains covenants for maintenance of certain financial ratios. The Company was in compliance with these covenants at December 31, 2010. +54 +Table of Contents +NOTE 7 – Derivative Instruments and Hedging Activities +Objectives and Strategies for Using Derivative Instruments +The Company is exposed to fluctuations in crude oil and natural gas prices on the majority of its production. Consequently, the Company believes it is prudent to manage the variability in cash flows on a portion of its crude oil and natural gas production. The Company utilizes primarily collars and swap derivative financial instruments to manage fluctuations in cash flows resulting from changes in commodity prices. The Company does not use these instruments for trading purposes. +Counterparty Risk +The use of derivative transactions exposes the Company to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments. To reduce the Company’s risk in this area, counterparties to the Company’s commodity derivative instruments predominantly include a large, well-known financial institution and a large, well-known oil and gas company. The Company monitors counterparty creditworthiness on an ongoing basis; however, it cannot predict sudden changes in counterparties’ creditworthiness. In addition, even if such changes are not sudden, the Company may be limited in its ability to mitigate an increase in counterparty credit risk. Should one of these counterparties not perform, the Company may not realize the benefit of some of its derivative instruments under lower commodity prices. +The Company executes commodity derivative transactions under master agreements that have netting provisions that provide for offsetting payables against receivables. In general, if a party to a derivative transaction incurs an event of default, as defined in the applicable agreement, the other party will have the right to demand the posting of collateral, demand a transfer or terminate the arrangement. +Settlements and Financial Statement Presentation +Settlements of oil and gas derivative contracts are generally based on the difference between the contract price or prices specified in the derivative instrument and a New York Mercantile Exchange (“NYMEX”) price or other cash or futures index price. The estimated fair value of these contracts is based upon closing exchange prices on NYMEX and in the case of collars and floors, the time value of options. For additional information, including the balance sheet presentation of derivative instrument asset and liability balances, See Note 8 for additional information. +The Company’s derivative contracts are designated as cash flow hedges, and are recorded at fair market value with the changes in fair value recorded net of tax through other comprehensive income (loss) (“OCI”) in stockholders’ equity (deficit). The cash settlements on contracts for future production are recorded as an increase or decrease in oil and gas sales. Both changes in fair value and cash settlements of ineffective derivative contracts are recognized as derivative expense (income). +Listed in the table below are the outstanding oil and gas derivative contracts, consisting entirely of collars, as of December 31, 2010: +Product +Volumes per Month +Quantity Type +Average Floor Price per Hedge +Average Ceiling Price per Hedge +Period +Oil +10 +Bbls +$ +75.00 +$ +101.85 +Jan11 - Dec11 +Oil +5 +Bbls +$ +80.00 +$ +102.00 +Jan11 - Dec11 +Oil +10 +Bbls +$ +75.00 +$ +94.50 +Jan11 - Dec11 +The tables below present the effect of the Company’s derivative financial instruments on the consolidated statements of operations as an increase (decrease) to oil and gas sales: +For the year ended December 31, +2010 +2009 +2008 +Amount of Gain (Loss) Reclassified from OCI into Income (1) +$ +632 +$ +19,242 +$ +(9,909 +) +Amount of Gain Recognized in Income (2) +- +- +498 +(1) Effective portion +(2) Ineffective Portion and amount Excluded from Effectiveness Testing +55 +Table of Contents +NOTE 8 – Fair Value Measurements +Fair value is defined within the accounting rules as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The rules established a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. As presented in the tables below, this hierarchy consists of three broad levels: +Level 1 +Valuations consist of unadjusted quoted prices in active markets for identical assets and liabilities and has the highest priority; +Level 2 +Valuations rely on quoted prices in markets that are not active or observable inputs over the full term of the asset or liability; +Level 3 +Valuations are based on prices or third party or internal valuation models that require inputs that are significant to the fair value measurement and are less observable and thus have the lowest priority. +Fair Value of Financial Instruments +Cash, Cash Equivalents, and Short-Term Investments. The carrying amounts for these instruments approximate fair value due to the short-term nature or maturity of the instruments. +Debt. The Company’s debt is recorded at the carrying amount on its Consolidated Balance Sheet. The fair value of Callon’s fixed-rate debt is based upon estimates provided by an independent investment banking firm. The carrying amount of floating-rate debt approximates fair value because the interest rates are variable and reflective of market rates. +The following table summarizes the respective carrying and fair values at: +December 31, +2010 +2009 +Carrying Value +Fair Value +Carrying Value +Fair Value +Credit Facility +$ +- +$ +- +$ +10,000 +$ +10,000 +9.75% Senior Notes due 2010, net of unamortized discount +- +- +15,820 +15,249 +13% Senior Notes due 2016 (a) +165,504 +140,030 +169,174 +103,471 +Callon Entrada Credit Facility; non-recourse +- +- +84,847 +- +Total +$ +165,504 +$ +140,030 +$ +279,841 +$ +128,720 +(a) 2010 Fair value is calculated only in relation to the $137,961 face value outstanding of the 13% Senior Notes. The remaining $27,543, which the Company has recorded as a deferred credit, is excluded from the +fair value calculation, and will be recognized in earnings as a reduction of interest expense over the remaining amortization period. See Note 6 for additional information. +Assets and Liabilities Measured at Fair Value on a Recurring Basis +Certain assets and liabilities are reported at fair value on a recurring basis (unless otherwise noted below) in Callon’s Consolidated Balance Sheet. The following methods and assumptions were used to estimate the fair values: +Commodity Derivative Instruments. Callon’s derivative policy allows for commodity derivative instruments to consist of collars and natural gas and crude oil basis swaps, though at December 31, 2010 the Company’s portfolio included only collars. The fair value of these derivatives is derived using a valuation model that utilizes market-corroborated inputs that are observable over the term of the derivative contract, and the values are corroborated by quotes obtained from counterparties to the agreements. The Company’s fair value calculations also incorporate an estimate of the counterparties’ default risk for derivative assets and an estimate of the Company’s default risk for derivative liabilities. Prior to the fourth quarter of 2010, the Company considered many of the inputs to fall with Level 3 of the accounting guidance. During its year-end review of the valuation calculation, the Company determined that the inputs now primarily fall within Level 2 of the fair-value hierarchy based on the wide availability of quoted market prices for similar commodity derivative contracts. This transfer from a Level 3 classification to a Level 2 classification is reflected in the reconciliation performed below. See Note 7 for additional information regarding the Company’s derivative instruments. +56 +Table of Contents +The following tables present the Company’s assets and liabilities measured at fair value on a recurring basis for each hierarchy level: +As of December 31, 2010 +Balance Sheet Presentation +Level 1 +Level 2 +Level 3 +Total +Assets +Derivative financial instruments - current Portion +Fair market value of derivatives +$ +- +$ +- +$ +- +$ +- +Derivative financial instruments - non-current +Other assets, net +- +- +- +- +Liabilities +Derivative financial instruments - current Portion +Fair market value of derivatives +$ +- +$ +937 +$ +- +$ +937 +Derivative financial instruments - non-current +Other long-term liabilities +- +- +- +- +Total +$ +- +$ +(937 +) +$ +- +$ +(937 +) +The derivative fair values above are based on analysis of each contract. Derivative assets and liabilities with the same counterparty are presented here on a gross basis, even where the legal right of offset exists. See Note 7 for a discussion of net amounts recorded in the Consolidated Balance Sheet at December 31, 2010. +The following table presents the Company’s Level 3 assets and liabilities measured at fair value on a recurring basis using significant, unobservable inputs: +Derivatives +Balance at January 1, 2010 +$ +145 +Total gains or losses (realized or unrealized): +Included in earnings +632 +Included in other comprehensive (income) loss +(1,082 +) +Purchases, issuances and settlements +(632 +) +Transfers (in) and out of Level 3 (a) +937 +Balance at December 31, 2010 +$ +- +Change in unrealized gains (losses) included in earnings relating to derivatives still held as of December 31, 2010 +$ +- +(a) +As discussed above, during its year-end review of its commodity derivatives instrument valuation calculation, the Company determined that the inputs now primarily fall within Level 2 of the fair-value hierarchy based on the wide availability of quoted market prices for similar commodity derivative contracts. +Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis +Certain assets and liabilities are reported at fair value on a nonrecurring basis in Callon’s Consolidated Balance Sheet. The following methods and assumptions were used to estimate the fair values: +Asset Retirement Obligations Incurred in Current Period. Callon estimates the fair value of AROs based on discounted cash flow projections using numerous estimates, assumptions and judgments regarding such factors as (1) the existence of a legal obligation for an ARO, (2) amounts and timing of settlements, (3) the credit-adjusted risk-free rate to be used and (4) inflation rates. AROs incurred for the year ended December 31, 2010 and resulting in fair value measurement, including upward revisions to ARO liabilities of $1,608, were Level 3 fair value measurements. See Note 14 for a summary of changes in the Company’s ARO liability. +57 +Table of Contents +NOTE 9 – Employee Benefit Plans +The Company has adopted a series of incentive compensation plans designed to align the interest of the executives and employees with those of its stockholders. The following is a brief description of each plan: +Savings and Protection Plan +The Savings and Protection Plan (“401-K Plan”) provides employees with the option to defer receipt of a portion of their compensation, and the Company may, at its discretion, match a portion of the employee's deferral with cash. The Company may also elect, at its discretion, to contribute a non-matching amount in cash and Company Common Stock to employees. The amounts held under the 401-K Plan are invested in various funds maintained by a third party in accordance with the directions of each employee. An employee is fully vested, including Company discretionary contributions, immediately upon participation in the 401-K Plan. The total amounts contributed by the Company, including the value of the common stock contributed, were $690, $640 and $747 in the years 2010, 2009 and 2008, respectively. +1996 Stock Incentive Plan (the “1996 Plan”) +The 1996 Plan, first adopted by the Board of Directors on August 23, 1996 and approved by the shareholders during 1997 and as amended, authorized and reserved for issuance 2,200 shares of common stock for issuance upon exercise of vested stock options and vesting of other share-based equity awards. Unvested options under this plan are subject to various accelerated vesting and forfeiture provisions subject to the occurrence of certain events, and unexercised, vested options expire 10 years from the date of grant. Equity awards under the plan generally vest over time or subject to attaining a specified metric, but vesting of awards may be immediate or cliff vest at a specified date. The Company recognizes expense on the grant date for all immediately vesting awards, while it recognizes expense ratably over the requisite service (i.e. vesting) period for both cliff and ratably vesting awards. For performance-based awards, the Company recognizes expense based on its analysis of the performance criteria, and records or reverses expense as necessary based on its analysis. +During 2010, the Company awarded 120 restricted stock units to non-employee members of the Board of Directors of the Company, which cliff vest on May 7, 2011. Other activity within the 1996 Plan during 2010 included the expiration of 278 vested, unexercised stock options, the forfeiture of 4.3 restricted stock units due to an employee departure from the Company, and the vesting of 152.5 restricted stock units awarded in prior years. As of December 31, 2010, the 1996 Plan had 329.5 shares remaining and eligible for future issuance. +2002 Stock Incentive Plan (the “2002 Plan”) +The 2002 Plan, adopted by the Board of Directors on February 14, 2002, authorized and reserved for issuance 350 shares of common stock for issuance upon exercise of vested stock options and vesting of other share-based equity awards. The 2002 Plan is considered a “broadly-based plan” and did not require shareholder approval. Unvested options under this plan are subject to various accelerated vesting and forfeiture provisions subject to the occurrence of certain events, and unexercised, vested options expire 10 years from the date of grant. Equity awards under the plan generally vest over time or subject to attaining a specified metric, but vesting of awards may be immediate or cliff vest at a specified date. The Company recognizes expense on the grant date for all immediately vesting awards, while it recognizes expense ratably over the requisite service (i.e. vesting) period for both cliff and ratably vesting awards. For performance-based awards, the Company recognizes expense based on its analysis of the performance criteria, and records or reverses expense as necessary based on its analysis. +During 2010, the Company awarded 10 restricted stock units which vest one-third on each anniversary date following the award date. Other activity within the 2002 Plan during 2010 included the exercise of 1.3 stock options and the vesting of 3.5 restricted stock units awarded in prior years. As of December 31, 2010, the 2002 Plan had 27.5 shares remaining and available for future issuance. +2006 Stock Incentive Plan (the “2006 Plan”) +The 2006 Plan, adopted by the Board of Directors on March 9, 2006 and approved by the shareholders at the May 4, 2006 annual meeting, authorized and reserved for issuance 500 shares of common stock for issuance upon exercise of vested stock options and vesting of other share-based equity awards. Unvested options under this plan are subject to various accelerated vesting and forfeiture provisions subject to the occurrence of certain events, and unexercised, vested options expire 10 years from the date of grant. Equity awards under the plan generally vest over time or subject to attaining a specified metric, but vesting of awards may be immediate or cliff vest at a specified date. The Company recognizes expense on the grant date for all immediately vesting awards, while it recognizes expense ratably over the requisite service (i.e. vesting) period for both cliff and ratably vesting awards. For performance-based awards, the Company recognizes expense based on its analysis of the performance criteria, and records or reverses expense as necessary based on its analysis. +During 2010, the Company did not grant any new awards under this plan. Other activity during 2010 included the forfeiture of 64 restricted stock units for failure to reach the minimum performance metric, forfeiture of 5.5 restricted stock units due to an employee departure from the Company and the vesting 21.3 restricted stock units awarded in prior years. As of December 31, 2010, the 2006 Plan had 110.5 shares remaining and available for future issuance. +58 +Table of Contents +2009 Stock Incentive Plan (the “2009 Plan”) +The 2009 Plan, adopted by the Board of Directors on March 5, 2009 and approved by shareholders on April 30, 2009, authorizes and reserves for issuance 1,250 shares of common stock for issuance upon exercise of vested stock options and vesting of other share-based equity awards. Unvested options under this plan are subject to various accelerated vesting and forfeiture provisions subject to the occurrence of certain events, and unexercised, vested options expire 10 years from the date of grant. Equity awards under the plan generally vest over time or subject to attaining a specified metric, but vesting of awards may be immediate or cliff vest at a specified date. The Company recognizes expense on the grant date for all immediately vesting awards, while it recognizes expense ratably over the requisite service (i.e. vesting) period for both cliff and ratably vesting awards. For performance-based awards, the Company recognizes expense based on its analysis of the performance criteria, and records or reverses expense as necessary based on its analysis. +During 2010, the Company awarded 49.5 restricted stock units which vest one-third on each anniversary date following the award date and 805.5 restricted stock units which cliff vest on May 7, 2013. Other activity during 2010 included the forfeiture of 90 restricted stock units due to an employee departure from the Company. As of December 31, 2010, the 2009 Plan had 313.2 shares remaining and available for future issuance. +Stock Incentive Award for Inducement of Employment +On June 1, 2009, under an exception available by the New York Stock Exchange as an inducement of employment, the Company awarded to its new Executive Vice President and Chief Operating Officer (“COO”) 200 restricted stock units of which one-half were to vest on June 1, 2012 based on achieving certain metrics and one-half was to vest on June 1, 2013 subject to the COO being employed by the Company on that date. The vesting of the portion of the award subject to achieving a specified metric was contingent upon the Company’s relative ranking amongst a Company-selected peer group of other public oil and gas companies, and was subject to a 0% - 150% adjustment. The Company also awarded the COO 500 stock options with vesting determined by the Company’s stock price achieving certain levels. These stock options were approved to cliff vest in one-third increments upon the stock price reaching specified levels. Following the COO’s resignation from Callon during September 2010 to join another oil and gas company as its Chief Executive Officer, the COO forfeited all of his restricted and performance-based shares and 333 of the unvested performance-based stock options. Prior to his departure, the Company achieved the first of three performance metrics specified in the performance-based stock options agreement resulting in the vesting of these 167 options, for which the Company recorded approximately $180 of compensation expense. +On April 1, 2010, under an exception available by the New York Stock Exchange as an inducement of employment, the Company awarded 50 shares of restricted stock to its new Senior Vice President of Operations. The restricted stock was approved to cliff vest on January 1, 2011, and had been fully expensed at December 31, 2010. +Other Incentive Awards +During 2009, the Company awarded 121.5 restricted stock units that cliff vest in August, 2012 and allow for automatic early vesting upon a qualifying retirement. Vesting units under this award will be settled in cash based on the closing price of the Company’s common stock on the date of vesting. This award is accounted for as a liability award, and is recorded on the Company’s consolidated balance sheet at its fair value, with changes in fair value of the award recorded as adjustment to compensation expense. +During 2010, the Company awarded 94.5 restricted stock units that cliff vest in May, 2012. Subsequent to the issuance, 15 of these restricted stock units were forfeited following an employee departure from the Company. Upon vesting, these units will be paid in cash based on the closing stock price of the Company’s common stock on the vesting date. This award is accounted for as a liability award, and is recorded on the Company’s consolidated balance sheet for the ratable portion of its fair value, with changes in fair value of the award recorded as adjustment to compensation expense. +During 2010, the Company awarded 400 restricted stock units that cliff vest in December, 2012, which will ultimately be settled in cash. Subsequent to the issuance, 50 of these performance-based restricted stock units were forfeited following an employee departure from the Company. The number of units that will ultimately vest will be based on a calculation that compares the Company’s total shareholder return the same calculated return of a group of peer companies as selected by the Company, and the number of units that vest can range between 0% and 150% of the remaining 350 restricted stock units. Because this award is payable in cash, the entire award is accounting for as a liability, and is recorded on the Company’s consolidated balance sheet for the ratable portion of its fair value, which changes in fair value of the award recorded as adjustments to compensation expense. +Tabular disclosures related to the share-based awards are presented below in Note 10. +59 +Table of Contents +NOTE 10 - Share-Based Compensation +As discussed in Note 9, “Employee Benefit Plans,” the Company has various stock plans (“Plans”) under which employees of the Company and its subsidiaries and non-employee members of the Board of Directors of the Company have been or may be granted certain share-based compensation. Shares available for future stock option or restricted stock grants to employees and directors under existing plans were 781 at December 31, 2010. The Company recorded non-cash share-based compensation expense of $5,701, $4,821 and $4,699 during the years ended December 31, 2010, 2009 and 2008, respectively. The portion of this non-cash share-based compensation expense that was included in general and administrative expense totaled $3,107, $2,335 and $2,633 for the same years respectively, and the portion capitalized to oil and gas properties was $2,594, $2,486 and $2,066, respectively. Non-cash share-based compensation included: +For the year ended December 31, +2010 +2009 +2008 +Non-cash compensation expense for options +$ +206 +$ +144 +$ +93 +Non-cash compensation expense for restricted stock +3,898 +4,302 +4,389 +Non-cash compensation expense for share-based units +1,396 +182 +- +Non-cash compensation expense for 401(k) contributions in shares +201 +193 +217 +Total non-cash compensation expense +$ +5,701 +$ +4,821 +$ +4,699 +The following table presents unrecognized compensation expense expected to be recognized in future periods: +As of December 31, +2010 +2009 +2008 +Unrecognized compensation costs related to unvested options +$ +57 +$ +649 +$ +179 +Unrecognized compensation costs related to equity-based unvested restricted stock units +3,353 +3,201 +6,869 +Unrecognized compensation costs related to liability-based unvested restricted stock units +2,676 +- +- +2011 +2012 +2013 +2014 +Thereafter +Total +Future share-based compensation expense expected to be recognized for options +$ +57 +$ +- +$ +- +$ +- +$ +- +$ +57 +Future share-based compensation expense expected to be recognized for equity-based unvested restricted stock units +1,751 +1,193 +409 +- +- +3,353 +Future share-based compensation expense expected to be recognized for liability-based unvested restricted stock units +1,311 +1,311 +54 +- +- +2,676 +Liability-based restricted stock unit awards accounted are recorded on the Company’s consolidated balance sheet at December 31, 2010, 2009 and 2008 for $1,578, $182 and $0, respectively. This liability is marked to fair value each reporting period with changes in the fair value recognized in compensation expense. +60 +Table of Contents +Stock Options +The Company uses the Black-Scholes option pricing model to estimate the fair value of stock option awards with the following weighted-average assumptions for the indicated periods. There were no stock options issued during either 2010 or 2008. +For the year ended December 31, +2010 +2009 +2008 +Dividend yield +n/a +0.0 +% +n/a +Expected volatility +n/a +136.0 +% +n/a +Risk-free interest rate +n/a +3.9 +% +n/a +Expected life of option (in years) +n/a +9 +n/a +Weighted-average grant-date fair value +n/a +$ +1.23 +n/a +Forfeiture rate +n/a +0.0 +% +n/a +The assumptions above are based on multiple factors, including historical exercise patterns of employees with respect to exercise and post-vesting employment termination behaviors, expected future exercising patterns and the historical volatility of the Company’s stock price. The following table represents stock option activity: +For the year-ended December 31, +2010 +2009 +2008 +Shares +Wtd Avg Ex Price per Option +Shares +Wtd Avg Ex Price per Option +Shares +Wtd Avg Ex Price per Option +Outstanding, beginning of year +978 +$ +6.37 +513 +$ +10.27 +755 +$ +10.00 +Granted (at market) +- +- +500 +2.76 +- +- +Exercised +(168 +) +2.77 +- +- +(239 +) +9.34 +Forfeited +(335 +) +2.78 +(15 +) +14.44 +(3 +) +15.97 +Expired +(278 +) +10.61 +(20 +) +9.99 +- +- +Outstanding, end of year +198 +$ +9.57 +978 +$ +6.37 +513 +$ +10.27 +Exercisable, end of year +184 +$ +8.99 +465 +$ +9.93 +488 +$ +9.91 +Weighted-average remaining contract life per unit: +Outstanding options at end of period in years +3.06 +5.75 +2.92 +Outstanding exercisable at end of period in years +2.86 +1.78 +2.68 +As of December 31, +2010 +2009 +2008 +Aggregate intrinsic value of options outstanding & exercisable +$ +- +$ +- +$ - +Aggregate intrinsic value of options exercised during the year +175 +- +4,100 +Fair value of shares vesting during the year +207 +58 +145 +Restricted Stock Units +The following table represents unvested restricted stock activity for the year ended December 31, 2010: +Weighted average +Number of Shares +Grant-Date Fair Value per Share +Period over which expense is expected to be recognized +Outstanding at the beginning of the period +927 +$ +7.01 +Granted +1,430 +5.21 +Vested +(177 +) +8.62 +Forfeited +(409 +) +6.75 +Outstanding at the end of the period +1,771 +$ +5.46 +1.9 years +61 +Table of Contents +NOTE 11 – Equity Transactions +During the fourth quarter of 2009, the Company commenced an exchange offer for any and all of its outstanding 9.75% Senior Notes. For each $1,000 principal amount of outstanding Senior Notes tendered in accordance with the terms and conditions of the exchange offer, each tendering holder of the Senior Notes received $750 principal amount of 13% Senior Secured Notes due 2016 (“Exchange Notes), 20.625 shares of common stock and 1.6875 shares of Convertible Preferred Stock. On December 31, 2009, each share of the Convertible Preferred Stock was automatically converted by the Company into 10 shares of common stock following shareholder approval and the filing of an amendment to the Company’s charter increasing the number of authorized shares of common stock as necessary to accommodate such conversion. Holders of approximately 92% of the Senior Notes tendered their notes in the exchange offer, and 6,902 shares of common stock were issued to the tendering notes holders after the Convertible Preferred Stock was converted into common shares. +During February 2011, the Company received $73,720 in net proceeds through the public offering of 10,100 shares of its common stock, which included the issuance of 1,100 shares pursuant to the underwriters’ over-allotment option. See Note 19 for additional information. +NOTE 12 – Income Taxes +The following table presents Callon’s net unrecognized tax benefits relating to its reported net losses and other temporary differences from operations: +For the year ended December 31 +2010 +2009 +Deferred tax asset: +Federal net operating loss carryforward +$ +79,680 +$ +94,125 +Statutory depletion carryforward +6,140 +4,895 +Alternative minimum tax credit carryforward +208 +383 +Asset retirement obligations +4,018 +3,704 +Other +16,807 +34,170 +Deferred tax asset before valuation allowance +106,853 +137,277 +Less: Valuation allowance +(85,222 +) +(116,676 +) +Total deferred tax asset +21,631 +20,601 +Deferred tax liability: +Oil and gas properties +21,631 +9,555 +Other +- +11,046 +Total deferred tax liability +21,631 +20,601 +Net deferred tax asset +$ +- +$ +- +As of January 1, 2010 and as previously disclosed in Note 3, Callon Entrada has been deconsolidated from the Company’s consolidated financial statements, resulting in a $30,330 decrease in deferred tax assets and a corresponding reduction in the valuation allowance. +For the years ended December 31, 2010 and 2009, the Company recorded a full valuation allowance against its net deferred tax assets. Consequently, the Company’s effective tax rate will be affected in future periods to the extent these deferred tax assets are recognized. The Company continues to assess whether or not deferred tax assets can be recognized based on current and expected future operating results and other factors. +If not utilized, the Company’s federal net operating loss carryforwards of $227,657 will expire in 2012 through 2030, of which $20,919 is scheduled to expire over the next five-years including $1,422 and $19,497 in 2012 and 2014, respectively. To the extent the Company experiences a Section 382 Ownership Change as a result of the equity offering completed in February 2011 (discussed in Note 19) or any other potential triggering event, the Company’s ability to utilize these potential NOL carrybacks and realize this potential refund, as well as certain of its other tax attributes, may be limited. +62 +Table of Contents +The Company’s state net operating loss carryforwards in the amount of $171,380 as of December 31, 2010 will expire in 2011 through 2030 of which $55,748 is scheduled to expire over the next five-years including $1,415, $1,599, $23,792, $16,327 and $12,615 from 2011 through 2015, respectively. The Company has limited state taxable income as primarily all of its revenue is generated in federal waters and is not subject to state income taxes. Accordingly, the Company has established a full valuation allowance on the tax benefit associated with these state net operating loss carryforwards as the Company does not anticipate generating taxable state income in the states in which these carryforwards apply. +The Company had no significant unrecognized tax benefits at December 31, 2010. Accordingly, the Company does not have any interest or penalties related to uncertain tax positions. However, if interest or penalties were to be incurred related to uncertain tax positions, such amounts would be recognized in income tax expense. Tax periods for years 1999 through 2009 remain open to examination by the federal and state taxing jurisdictions to which the Company is subject. +In addition, the net operating loss (“NOL”) carryback provision of the Internal Revenue Code was amended on November 6, 2009, as part of The Worker, Homeownership and Business Assistance Act of 2009 (the “WHB Act”). The WHB Act allows businesses with net operating losses (“NOLs”) for 2008 and 2009 to carry back losses for up to five years and suspends the 90% limitation on the use of any alternative minimum tax NOL deduction attributable to carrybacks of the applicable NOL. There would be no limit on the NOL carrybacks for the first four preceding years of the carryback period, but for the fifth preceding year, the NOL carryback would be limited to fifty percent of a company’s taxable income in that year. In applying the new five-year NOL carryback rule, the Company was able to file for a refund claim to recover approximately $174. +Below is a reconciliation of the reported amount of income tax expense attributable to continuing operations for the year to the amount of income tax expense that would result from applying domestic federal statutory tax rates to pretax income from continuing operations. +For the years ended December 31, +Component of Income Tax Rate Reconciliation +2010 +2009 +2008 +Income tax expense computed at the statutory federal income tax rate +35 +% +35 +% +(35 +)% +Change in valuation allowance +(21 +)% +(34 +)% +27 +% +Percentage depletion carryforward +(15 +)% +0 +% +0 +% +Other +3 +% +(1 +)% +0 +% +Effective income tax rate +2 +% +0 +% +(8 +)% +For the years ended December 31, +Components of Income Tax Expense +2010 +2009 +2008 +Current income tax expense (benefit) +$ +(174 +) +$ +- +$ +- +Deferred income tax (benefit) expense +1,503 +18,816 +(167,848 +) +Valuation allowance +(1,503 +) +(18,816 +) +128,123 +Total income tax (benefit) expenses +$ +(174 +) +$ +- +$ +(39,725 +) +During 2010, the Company reduced the valuation allowance by the amount of estimated taxable income generated for the year. +63 +Table of Contents +NOTE 13 – Oil and Gas Properties +The following table discloses certain financial data relating to the Company's oil and gas activities, all of which are located in the United States. +For the year ended December 31, +2010 +2009 +2008 +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance +$ +1,593,884 +$ +1,581,698 +$ +1,349,904 +Deconsolidation of Subsidiary January 1, 2010 +(364,589 +) +- +- +Property acquisition costs +10,676 +23,748 +6,126 +Exploration costs +14,739 +- +2,578 +Development costs +61,967 +(11,562 +) +223,090 +End of period balance +$ +1,316,677 +$ +1,593,884 +$ +1,581,698 +Unevaluated Properties (excluded from amortization): +Beginning of period balance +$ +25,442 +$ +32,829 +$ +70,176 +Additions +3,561 +6,140 +6,409 +Capitalized interest +2,000 +3,213 +6,496 +Transfers to evaluated +(22,897 +) +(16,740 +) +(50,252 +) +End of period balance +$ +8,106 +$ +25,442 +$ +32,829 +Accumulated depreciation, depletion and amortization: +Beginning of period balance +$ +1,488,718 +$ +1,455,275 +$ +738,374 +Provision charged to expense +31,786 +33,443 +549,552 +Deconsolidation of Subsidiary January 1, 2010 +(364,589 +) +- +- +Sale of mineral interests +- +- +167,349 +End of period balance +$ +1,155,915 +$ +1,488,718 +$ +1,455,275 +Unevaluated property costs, primarily including lease acquisition costs incurred at federal and state lease sales, unevaluated drilling costs, seismic, capitalized interest and certain overhead costs related to exploration and development being excluded from the amortizable evaluated property base, consisted of $3,331 incurred in 2010, $1,621 in 2009, and $3,154 incurred in 2008 and prior. These costs are directly related to the acquisition and evaluation of unproved properties and major development projects. The excluded costs and related reserves are included in the amortization base as the properties are evaluated and proved reserves are established or impairment is determined. The Company expects that the majority of these costs will be evaluated over the next three to five years. The Company’s unevaluated property balance of $8,106 at December 31, 2010 reflects a $17,336 decline compared to the December 31, 2009, and primarily relates to the evaluation of the Company’s Gulf of Mexico shelf prospect lease inventory following the Company’s continued shift away from offshore exploration to onshore activities. +Depletion per unit-of-production (Boe) amounted to $19.00, $16.99 and $33.45 for the years ended December 31, 2010, 2009, and 2008, respectively. Lease operating expense, or production costs, per unit-of-production (Boe) amounted to $10.58, $9.37, and $10.03 for the years ended December 31, 2010, 2009, and 2008, respectively. +Under the full-cost accounting rules of the SEC, the Company reviews the carrying value of its proved oil and gas properties each quarter. Under these rules, capitalized costs of oil and gas properties, net of accumulated depreciation, depletion and amortization and deferred income taxes, may not exceed the present value of estimated future net cash flows from proved oil and gas reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of related tax effects (the full-cost ceiling amount). These rules generally require pricing based on the preceding 12-months’ average oil and gas prices based on closing prices on the first day of each month and require a write-down if the “ceiling” is exceeded. Given the volatility of oil and gas prices, it is reasonably possible that the Company’s estimate of discounted future net cash flows from proved oil and gas reserves could change in the near term. If oil and gas prices decline significantly, even if only for a short period of time, it is possible that write-downs of oil and gas properties could occur in the future. For the year ended December 31, 2008, the Company recorded a $485,498 impairment of oil and gas properties as a result of the ceiling test calculation. +NOTE 14 – Asset Retirement Obligations +The following table summarizes the activity for the Company’s asset retirement obligations: +For the year ended December 31, +2010 +2009 +Asset retirement obligations at beginning of the period +$ +14,650 +$ +42,194 +Accretion expense +2,446 +3,149 +Liabilities incurred +608 +9 +Liabilities settled +(3,035 +) +(8,194 +) +Revisions to estimate +1,256 +(22,508 +) +Asset retirement obligations at end of period +15,925 +14,650 +Less: current asset retirement obligations +(2,822 +) +(4,002 +) +Long-term asset retirement obligations at the end of the period +$ +13,103 +$ +10,648 +At December 31, 2010, the Company had $4,443 restricted investment assets, including $399 and $4,044 recorded as current and non-current, respectively. These assets, which primarily include short-term U.S. Government securities, are held in abandonment trusts dedicated to pay future abandonment costs for several of the Company’s oil and gas properties. +64 +Table of Contents +NOTE 15 – Supplemental Oil and Gas Reserve Data (unaudited) +The Company's proved oil and gas reserves at December 31, 2010, 2009 and 2008 have been estimated by Huddleston & Co., Inc., the Company’s independent petroleum engineers. The reserves were prepared in accordance with guidelines established by the SEC. Accordingly, the following reserve estimates are based upon existing economic and operating conditions. +There are numerous uncertainties inherent in establishing quantities of proved reserves. The following reserve data represents estimates only and should not be construed as being exact. In addition, the standardized measure of discounted future net cash flows should not be construed as the current market value of the Company's oil and gas properties or the cost that would be incurred to obtain equivalent reserves. +Estimated Reserves +Changes in the estimated net quantities of crude oil and natural gas reserves, all of which are located onshore within the continental United States and offshore within the Gulf of Mexico, are as follows: +Reserve Quantities +For the year ended December 31, +2010 +2009 +2008 +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period +6,479 +6,027 +24,531 +Revisions to previous estimates +423 +(356) +(9,026) +Change in ownership +- +563 +- +Purchase of reserves in place +- +1,257 +- +Sale of reserves in place +- +- +(8,536) +Extensions and discoveries +2,106 +- +- +Production +(859) +(1,012) +(942) +End of period +8,149 +6,479 +6,027 +Natural Gas (MMcf): +Beginning of period +19,103 +18,651 +116,454 +Revisions to previous estimates +354 +3,632 +(49,526) +Change in ownership +- +420 +- +Purchase of reserves in place +- +2,140 +- +Sale of reserves in place +- +- +(42,542) +Extensions and discoveries +18,392 +- +105 +Production +(4,892) +(5,740) +(5,840) +End of period +32,957 +19,103 +18,651 +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period +4,346 +4,663 +4,723 +End of period +4,503 +4,346 +4,663 +Natural Gas (MMcf): +Beginning of period +12,301 +13,463 +22,340 +End of period +12,715 +12,301 +13,463 +Proved undeveloped reserves: +Crude Oil (MBbls): +Beginning of period +2,133 +1,364 +19,808 +End of period +3,645 +2,133 +1,364 +Natural Gas (MMcf): +Beginning of period +6,802 +5,188 +94,114 +End of period +20,241 +6,802 +5,189 +65 +Table of Contents +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share, per note, per-hedge and per unit data) +Standardized Measure +The following tables present the standardized measure of future net cash flows related to estimated proved oil and gas reserves together with changes therein, including a reduction for estimated plugging and abandonment costs that are also reflected as a liability on the balance sheet at December 31, 2010. You should not assume that the future net cash flows or the discounted future net cash flows, referred to in the tables below, represent the fair value of our estimated oil and gas reserves. Prior to December 31, 2009, the Company was required to determine estimated future net cash flows using period-end market prices for oil and gas without considering hedge contracts in place at the end of the period. Effective December 31, 2009, the SEC issued a final rule which changed prices used in reserves calculations. Prices are no longer based on a single-day, period-end price. Rather, they are based on either the preceding 12-months’ average price based on closing prices on the first day of each month, or prices defined by existing contractual arrangements. The 2010 average 12-month oil and gas prices net of differentials were $78.07 per barrel of oil and $5.10 per Mcf of gas. The 2009 average 12-month oil and gas prices net of differentials were $57.40 per barrel of oil and $4.75 per Mcf of gas. The 2008 year-end oil and gas prices net of differentials were $36.80 per barrel of oil and $6.36 per Mcf of gas. Future production and development costs are based on current costs with no escalations. Estimated future cash flows net of future income taxes have been discounted to their present values based on a 10% annual discount rate. +Gas production from our deepwater and Permian Basin properties has a high BTU content of separator gas. The natural gas Mcf price of $5.10 used in the 2010 reserve estimate reflects estimated revenues from our natural gas and associated natural gas liquids. +Standardized Measure +For the year ended December 31, +2010 +2009 +2008 +Future cash inflows +$ +804,111 +$ +462,607 +$ +340,485 +Future costs - +Production +(277,793 +) +(195,735 +) +(192,819 +) +Development and net abandonment +(146,870 +) +(50,170 +) +(34,111 +) +Future net inflows before income taxes +379,448 +216,702 +113,555 +Future income taxes +(24,719 +) +(2,809 +) +(565 +) +Future net cash flows +354,729 +213,893 +112,990 +10% discount factor +(155,813 +) +(77,972 +) +(26,685 +) +Standardized measure of discounted future net cash flows +$ +198,916 +$ +135,921 +$ +86,305 +Changes in Standardized Measure +For the year ended December 31, +2010 +2009 +2008 +(1) +Standardized measure at the beginning of the period +$ +135,921 +$ +86,305 +$ +1,133,989 +Sales and transfers, net of production costs +(72,171 +) +(82,674 +) +(122,104 +) +Net change in sales and transfer prices, net of production costs +126,571 +94,435 +(111,140 +) +Net change due to purchases and sales of in place reserves +621 +45,009 +(558,652 +) +Extensions, discoveries, and improved recovery, net of future production and development costs incurred +23,739 +-- +162,566 +Changes in future development cost +(68,960 +) +6,194 +33,652 +Revisions of quantity estimates +23,295 +39,242 +(786,001 +) +Accretion of discount +10,597 +5,797 +159,147 +Net change in income taxes +(5,170 +) +(2,368 +) +457,483 +Changes in production rates, timing and other +24,473 +(56,019 +) +(282,635 +) +Aggregate change +62,995 +49,616 +(1,047,684 +) +Standardized measure at the end of period +$ +198,916 +$ +135,921 +$ +86,305 +(1) At year-end 2008, the Company had a reduction in reserves due to the sale to CIECO of a 50% interest in the Entrada field and the abandonment of the Entrada project. +The Company ended 2010 with estimated net proved reserves of 13,642 MBoe, representing a 41% increase over 2009 year-end estimated net proved reserves of 9,663 MBoe. The increase is primarily due to the Company’s development of a portion of its Permian Basin and Haynesville Shale properties, on which it drilled a total of 20 oil wells and one natural gas well, respectively. +The Company annually reviews its proved undeveloped reserves (“PUDs”) to ensure an appropriate plan for development exists. Generally, reserves for the Company’s onshore properties are booked as PUDs only if the Company has plans to convert the PUDs into proved developed reserves within five years of the date they are first booked as PUDs. Callon had 7,019 MBoe of PUDs at December 31, 2010, representing a 115% increase over the 3,266 MBoe of PUDs at December 31, 2009. Of its 2010 PUDs, 1,186 MBoe and 1,148 MBoe were attributable to the Company’s offshore properties in the Medusa and Habanero fields in the Gulf of Mexico, respectively. Callon plans are to develop these PUDs by side tracking existing wells when the zones currently being produced by the wells are depleted. The Company’s current reserve reports forecast that these producing zones in the Habanero field will be depleted in 2014 and 2013 and in the Medusa field in 2022, at which time Callon plans to develop the PUDs. The Company did not convert any offshore PUDs to proved developed in 2010. +During 2009, the Company acquired 711 MBbls and 1.3 Bcf, or 928 MBoe, of PUDs in its ExL acquisition. Callon’s development plan for these PUDs began during 2010, and is expected to convert all PUDs to PDPs by 2014. The remaining 100 MBoe increase in PUDs from 2008 to 2009 is associated with the Company’s deepwater property, Medusa, and is a result of including reserves related to the Deepwater Royalty Relief Act. These PUDs were previously excluded due to prices exceeding the BOEMRE imposed thresholds. As a result of court decisions, the BOEMRE is no longer enforcing its price thresholds. At year end 2008, the Company had no PUDs located onshore. See Note 16 for additional information related to the royalty relief. +66 +Table of Contents +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share, per note, per-hedge and per unit data) +NOTE 16 - Bureau of Ocean Energy Management, Regulation and Enforcement (“BOEMRE”) Royalty Recoupment +During 2009, the Company recorded a receivable attributable to a recoupment of royalty payments previously made to the BOEMRE on our deepwater property, Medusa. Following the decisions resulting from several court cases brought by another oil and gas company, the court ruled that the BOEMRE was not entitled to receive these royalty payments. Accordingly, in November 2009 the Company filed for a recoupment of royalties paid to the BOEMRE in the amount of $44,787 from inception-to-date production at the Company’s Medusa field. At December 31, 2009, Callon accrued the royalty recoupment of $44,787 and estimated interest of $7,681. The Company received the recoupment of principal in January 2010, and received $7,927 of interest during the second quarter of 2010, which included additional accrued interest through the repayment date. In addition, the Company is no longer required to make any future royalty payments to the BOEMRE related to its Medusa production. +Royalty recoupment of $2,967 related to 2009 production was recorded as oil and gas sales during the fourth quarter of 2009. For years prior to 2009, royalty recoupment of $40,886 was included in operating revenues as BOEMRE royalty recoupment. Interest income related to the recoupment was recorded as a component of other income and expense. +NOTE 17 – Commitments and Contingencies +From time to time, the Company, as part of the Consolidation and other capital transactions, enters into registration rights agreements whereby certain parties to the transactions are entitled to require the Company to register common stock of the Company owned by them with the SEC for sale to the public in firm commitment public offerings and generally to include shares owned by them, at no cost, in registration statements filed by the Company. Costs of the offering will not include broker’s discounts and commissions, which will be paid by the respective sellers of the common stock. +The Company is involved in various claims and lawsuits incidental to its business. In the opinion of management, the ultimate liability hereunder, if any, will not have a material adverse effect on the financial position or results of operations of the Company. +The Company’s activities are subject to federal, state and local laws and regulations governing environmental quality and pollution control. Although no assurances can be made, the Company believes that, absent the occurrence of an extraordinary event, compliance with existing federal, state and local laws, rules and regulations governing the release of materials into the environment or otherwise relating to the protection of the environment are not expected to have a material effect upon the capital expenditures, earnings or the competitive position of the Company with respect to its existing assets and operations. The Company cannot predict what effect additional regulation or legislation, enforcement polices hereunder, and claims for damages to property, employees, other persons and the environment resulting from the Company’s operations could have on its activities +NOTE 18 – Summarized Quarterly Financial Information (unaudited) +2010 +First Quarter +Second Quarter +Third Quarter +Fourth Quarter +Total revenues +$ +23,385 +$ +21,569 +$ +20,485 +$ +24,443 +Income from operations +7,040 +5,463 +4,655 +4,021 +Net income (loss) +3,923 +2,130 +1,602 +731 +Net income (loss) per common share - basic +0.14 +0.07 +0.06 +0.03 +Net income (loss) per common share - diluted +0.13 +0.07 +0.05 +0.02 +2009 +First Quarter +Second Quarter +Third Quarter +Fourth Quarter +Total revenues +$ +24,815 +$ +25,025 +$ +21,320 +$ +70,985 +(a) +Income from operations +8,506 +5,731 +5,799 +53,417 +(b) +Net income (loss) +2,404 +925 +(955 +) +53,895 +(b) +Net income (loss) per common share - basic +0.11 +(0.04 +) +(0.04 +) +2.31 +Net income (loss) per common share - diluted +0.11 +(0.04 +) +(0.04 +) +2.27 +(a) Includes Medusa royalty recoupment of $43.9 million, net of override, due from the MMS. See Note 17. +(b) Includes Medusa royalty recoupment of $43.9 million, net of override, and estimated interest due from the MMS. See Note 17. +67 +Table of Contents +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share, per note, per-hedge and per unit data) +NOTE 19 – Subsequent Events +Equity Offering and Announced Senior Notes Redemption +During February, 2011, the Company received $73,720 in net proceeds through the public offering of 10,100 shares of its common stock, which included the issuance of 1,100 shares pursuant to the underwriters’ over-allotment option. The Company intends to use approximately $35,000 of the proceeds to repurchase a portion of its 13% Senior Notes, with the remaining proceeds intended for general corporate purposes including the accelerated development of the Company’s Permian Basin and other onshore assets. Immediately following the completion of the equity offering, the Company provided the public notice required by the terms of the Senior Notes to call $31,000 of face value of the Notes. The Company expects to complete the redemption of these notes by March 19, 2011, which will result in a gain on the early extinguishment of debt of $1,974. The gain represents the difference between the $35,030 paid for $37,004 carrying value of the Notes, which included the $31,000 face value of the notes plus $6,004 of accelerated deferred credit amortization, offset by the $4,030 charge related to the 13% call premium required by the terms of the call option. +Arbitration Results +Prior to abandonment of the Entrada project, the Company’s joint interest owner in the Entrada Project failed to fund two loan requests totaling $40,000 under the Callon Entrada credit agreement. These loan requests were to cover Callon Entrada’s share of the costs incurred to develop the Entrada field up to the suspension of the project. Such amounts were subsequently funded by the Company to Callon Entrada and were included as part of the Company’s full-cost pool impairment adjustment recorded in the fourth quarter of 2008. The joint interest partner also failed to fund its working interest share of a settlement payment to terminate a drilling contract for the Entrada Project. The Company and its joint interest partner in the Entrada project arbitrated the matter during 2010. During February, 2011, the arbitration panel reviewing the Company’s claims against the joint interest owner delivered its final decision in which it ruled that the company was not entitled to recover any damages. The Company determination that the arbitration ruling represented a recognizable subsequent event, and as such, recorded a charge as of December 31, 2010 to write off its $6,597 receivable related to certain joint interest billings not being recovered from a joint interest partner. Under the full cost method of accounting, these costs are capitalized to the Company’s full cost pool. +68 +Table of Contents +ITEM 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure +There have been no disagreements with the independent auditors on any matters of accounting principles or practices, financial statement disclosure, or auditing scope or procedures. +ITEM 9A. Controls and Procedures +Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), we evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of December 31, 2010. Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures are effective as of December 31, 2010. +Management’s Report on Internal Control over Financial Reporting . Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2010 based on the framework in Internal Control – Integrated Framework published by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on that evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2010. +Because of its inherent limitations, internal control over financial reporting can provide only reasonable assurance that the objectives of the control system are met and may not prevent or detect misstatements. In addition, any evaluation of the effectiveness of internal controls over financial reporting in future periods is subject to risk that those internal controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +The Company’s independent registered public accounting firm has issued an attestation report regarding its assessment of the Company’s internal control over financial reporting as of December 31, 2010, which appears on page 73. Additionally, the financial statements for each of the years covered in this Annual Report on Form 10-K have been audited by an independent registered public accounting firm, Ernst & Young LLP whose report is presented page 43 of this Annual Report on Form 10-K. +Changes in Internal Control over Financial Reporting. There were no changes to our internal control over financial reporting during our last fiscal quarter that have materially affected, or are reasonable likely to materially affect, our internal control over financial reporting. +ITEM 9A (T). Controls and Procedures +See Item 9A. +ITEM 9B. Other Information +Submissions of Matters to a Vote of the Security Holders +None. +69 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited Callon Petroleum Company’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Callon Petroleum Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, Callon Petroleum Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Callon Petroleum Company as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for each of the three years in the period ended December 31, 2010 and our report dated ­­­­March 14, 2011, expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 14, 2011 +70 +Table of Contents +PART III. +ITEM 10. Directors, Executive Officers and Corporate Governance +For information concerning Item 10, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 12, 2011 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +The Company has adopted a code of ethics that applies to the Company’s chief executive officer, chief financial officer and chief accounting officer. The full text of such code of ethics has been posted on the Company’s website at www.callon.com, and is available free of charge in print to any shareholder who requests it. Request for copies should be addressed to the Secretary at 200 North Canal Street, Natchez, Mississippi 39120. +ITEM 11. Executive Compensation +For information concerning Item 11, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 12, 2011 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +For information concerning the security ownership of certain beneficial owners and management, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 12, 2011 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 13. Certain Relationships and Related Transactions and Director Independence +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 12, 2011 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 14. Principal Accountant Fees and Services +For information concerning Item 14, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 12, 2011 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +71 +Table of Contents +PART IV. +ITEM 15. Exhibits +Exhibit +Description +1 +The following is an index to the financial statements and financial statement schedules that are filed as part of this Form 10-K on pages 42 through 71. +Report of Independent Registered Public Accounting Firm +Consolidated Balance Sheets as of December 31, 2010 and 2009 +Consolidated Statements of Operations for each of the three years in the period ended December 31, 2010 +Consolidated Statements of Stockholders' Equity (Deficit) for each of the three years in the Period Ended December 31, 2010 +Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2010 +Notes to Consolidated Financial Statements +2 +Schedules other than those listed above are omitted because they are not required, not applicable or the required information is included in the financial statements or notes thereto. +3 +Exhibits +2 +Plan of acquisition, reorganization, arrangement, liquidation or succession* +3 +Articles of Incorporation and Bylaws +3.1 +Certificate of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +3.2 +Bylaws of the Company (incorporated by reference from Exhibit 3.2 of the Company's Registration Statement on Form S-4, filed August 4, 1994, Reg. No. 33-82408) +3.3 +Certificate of Amendment to Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.3 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +3.4 +Certificate of Amendment to the Certificate of Incorporation of the Company +4 +Instruments defining the rights of security holders, including indentures +4.1 +Specimen Common Stock Certificate (incorporated by reference from Exhibit 4.1 of the Company's Registration Statement on Form S-4, filed August 4, 1994, Reg. No. 33-82408) +4.2 +Rights Agreement between Callon Petroleum Company and American Stock Transfer & Trust Company, Rights Agent, dated March 30, 2000 (incorporated by reference from Exhibit 99.1 of the Company’s Registration Statement on Form 8-A, filed April 6, 2000, File No. 001-14039) +4.3 +Indenture for the Company’s 13.00% Senior Notes due 2016, dated November 24, 2009, between Callon Petroleum Company, the subsidiary guarantors described therein, Regions Bank and American Stock Transfer & Trust Company (incorporated by reference to Exhibit T3C to the Company’s Form T3, filed November 19, 2009, File No. 022-28916) +9 +Voting trust agreement +None +10 +Material contracts +10.1 +Callon Petroleum Company 1994 Stock Incentive Plan (incorporated by reference from Exhibit 10.5 of the Company's Registration Statement on Form 8-B, filed October 3, 1994) +10.2 +Callon Petroleum Company 1996 Stock Incentive Plan as amended on May 9, 2000 (incorporated by reference from Appendix I of the Company’s Definitive Proxy Statement on Schedule 14A, filed March 28, 2000, File No. 001-14039) +10.3 +Callon Petroleum Company 2002 Stock Incentive Plan (incorporated by reference to Exhibit 10.13 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, File No. 001-14039) +10.4 +Medusa Spar Agreement dated as of August 8, 2003, among Callon Petroleum Operating Company, Murphy Exploration & Production Company-USA and Oceaneering International, Inc. (incorporated by reference to Exhibit 10.19 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +10.5 +Severance Compensation Agreement dated April 18, 2008 by and between Fred L. Callon and Callon Petroleum Company (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed April 23, 2008, File No. 001-14039) +10.6 +Form of Severance Compensation Agreement dated April 18, 2008 by and between Callon Petroleum Company and its executive officers (incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K, filed April 23, 2008, File No. 001-14039) +10.7 +Amendment No. 1 to Severance Compensation Agreement executed on December 31, 2008 by and between Fred L. Callon and Callon Petroleum Company (incorporated by reference from Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.8 +Form of Amendment No. 1 to Severance Compensation Agreement by and between Callon Petroleum Company and its executive officers (incorporated by reference from Exhibit 10.2 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.9 +Amendment No. 3 to the Callon Petroleum Company 1996 Stock Incentive Plan (incorporated by reference from Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.1 +Amendment No. 1 to the Callon Petroleum Company 2002 Stock Incentive Plan (incorporated by reference from Exhibit 10.2 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.11 +Callon Petroleum Company Amended and Restated 2006 Stock Incentive Plan (incorporated by reference from Exhibit 10.3 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.12 +Callon Petroleum Company 2009 Stock Incentive Plan effective as of April 30, 2009 (incorporated by reference from Exhibit A to the Company’s Definitive Proxy Statement on Schedule 14A, filed March 30, 2009, File No. 001-14039) +10.13 +Amendment to the Callon Petroleum Company 1996 Stock Incentive Plan effective as of August 7, 2009 (incorporated by reference from Exhibit 10.1 of the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2009, File No. 001-14039) +10.14 +Third Amended and Restated Credit Agreement dated January 29, 2010, by and among Callon Petroleum Company, the “Lenders” described therein, Regions Bank, as Administrative Agent, Documentation Agent and Syndication Agent (incorporated by reference from Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed February 3, 2010, File No. 001-14039) +10.15 +Callon Petroleum Company 2010 Phantom Share Plan, adopted May 4, 2010 (incorporated by reference to Exhibit 10.1 of the Company’s current Report on Form 8-K filed on May 7, 2010) +10.16 +Form of Callon Petroleum Company Phantom Share Award Agreement, adopted May 4, 2010 (incorporated by reference to Exhibit 10.2 of the Company’s current Report on Form 8-K filed on May 7 , 2010) +10.17 +Deferred Compensation Plan for Outside Directors; Callon Petroleum Company (effective as of January 1, 2011) +11 +Statement re computation of per share earnings* +12 +Statements re computation of ratios* +13 +Annual Report to security holders, Form 10-Q or quarterly reports* +14 +Code of Ethics +14.1 +Code of Ethics for Chief Executive Officers and Senior Financial Officers (incorporated by reference to Exhibit 14.1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +16 +Letter re change in certifying accountant* +18 +Letter re change in accounting principles* +21 +Subsidiaries of the Company +21.1 +Subsidiaries of the Company (incorporated by reference from Exhibit 21.1 of the Company's Registration Statement on Form 8-B filed October 3, 1994) +22 +Published report regarding matters submitted to vote of security holders* +23 +Consents of experts and counsel +23.1 +Consent of Ernst & Young LLP +23.3 +Consent of Huddleston & Co., Inc. +24 +Power of attorney* +31 +Rule 13a-14(a) Certifications +31.1 +Certification of Chief Executive Officer pursuant to Rule 13(a)-14(a) +31.2 +Certification of Chief Financial Officer pursuant to Rule 13(a)-14(a) +32 +Section 1350 Certifications of Chief Executive and Financial Officers pursuant to Rule 13(a)-14(b) +99 +Additional Exhibits +99.1 +Reserve Report Summary prepared by Huddleston and Co. as of December 31, 2010. +* +Not applicable to this filing +72 +Table of Contents +SIGNATURES +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Date: +March 14, 2011 +/s/ Fred L. Callon +Fred L. Callon (principal executive officer, director) +Date: +March 14, 2011 +/s/ B. F. Weatherly +B. F. Weatherly (principal financial officer, director) +Date: +March 14, 2011 +/s/ Rodger W. Smith +Rodger W. Smith (principal accounting officer) +Date: +March 14, 2011 +/s/ L. Richard Flury +L. Richard Flury (director) +Date: +March 14, 2011 +/s/ John C. Wallace +John C. Wallace (director) +Date: +March 14, 2011 +/s/ Richard O. Wilson +Richard O. Wilson (director) +Date: +March 14, 2011 +/s/ Larry D. McVay +Larry McVay (director) +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +Date: +March 14, 2011 +/s/ B. F. Weatherly +B. F. Weatherly, Executive Vice President and +Chief Financial Officer (Principal Financial Officer) +73 \ No newline at end of file diff --git a/raw/filings/0000928022/2010/0000928022-11-000022/filing_metadata.csv b/raw/filings/0000928022/2010/0000928022-11-000022/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..47c7d93f3d02094c5aeecb34b55a051f235bdd9a --- /dev/null +++ b/raw/filings/0000928022/2010/0000928022-11-000022/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000928022,CPE,Callon Petroleum Co,10-K,2011-03-15,2010-12-31,2011-03-14T23:59:33.000Z,0000928022-11-000022,form10k_2010.htm,CALLON PETROLEUM COMPANY FORM 10-K,3216494,0,0,https://www.sec.gov/Archives/edgar/data/928022/000092802211000022/form10k_2010.htm,https://www.sec.gov/Archives/edgar/data/928022/000092802211000022/,2010,2010,1 diff --git a/raw/filings/0000928022/2010/0000928022-11-000022/item1.txt b/raw/filings/0000928022/2010/0000928022-11-000022/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..55b6c1ff1c79f989a381a00567ffbd59c2213d21 --- /dev/null +++ b/raw/filings/0000928022/2010/0000928022-11-000022/item1.txt @@ -0,0 +1,47 @@ +Item 1 & 2. +Business & Properties +5 +Our Business Strategy +5 +Our Strengths +5 +Recent Developments +6 +Exploration and Development Activities +6 +Acquisitions and Divestitures +6 +Oil and Gas Properties +6 +Onshore Properties +7 +Gulf of Mexico Deepwater Properties +8 +Gulf of Mexico Shelf and Other Properties +8 +Proved Reserves +9 +Proved Undeveloped Reserves +10 +Controls over Reserve Estimates +10 +Production Volumes, Average Sales Prices and Average Production Costs +11 +Present Activities and Productive Wells +12 +Leasehold Acreage +12 +Title to Properties +13 +Major Customers +13 +Corporate Offices +13 +Employees +13 +Regulations +13 +Commitments and Contingencies +16 +Available Information +16 \ No newline at end of file diff --git a/raw/filings/0000928022/2010/0000928022-11-000022/item13.txt b/raw/filings/0000928022/2010/0000928022-11-000022/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..8892d53ac39775591b282b060ab60f24968da729 --- /dev/null +++ b/raw/filings/0000928022/2010/0000928022-11-000022/item13.txt @@ -0,0 +1,2 @@ +ITEM 13. Certain Relationships and Related Transactions and Director Independence +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 12, 2011 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000928022/2010/0000928022-11-000022/item9a.txt b/raw/filings/0000928022/2010/0000928022-11-000022/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..a460ecd3244104d363a2b7589cb9bda30aa3fe92 --- /dev/null +++ b/raw/filings/0000928022/2010/0000928022-11-000022/item9a.txt @@ -0,0 +1,8 @@ +ITEM 9A. Controls and Procedures +Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), we evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of December 31, 2010. Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures are effective as of December 31, 2010. +Management’s Report on Internal Control over Financial Reporting . Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2010 based on the framework in Internal Control – Integrated Framework published by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on that evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2010. +Because of its inherent limitations, internal control over financial reporting can provide only reasonable assurance that the objectives of the control system are met and may not prevent or detect misstatements. In addition, any evaluation of the effectiveness of internal controls over financial reporting in future periods is subject to risk that those internal controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +The Company’s independent registered public accounting firm has issued an attestation report regarding its assessment of the Company’s internal control over financial reporting as of December 31, 2010, which appears on page 73. Additionally, the financial statements for each of the years covered in this Annual Report on Form 10-K have been audited by an independent registered public accounting firm, Ernst & Young LLP whose report is presented page 43 of this Annual Report on Form 10-K. +Changes in Internal Control over Financial Reporting. There were no changes to our internal control over financial reporting during our last fiscal quarter that have materially affected, or are reasonable likely to materially affect, our internal control over financial reporting. +ITEM 9A (T). Controls and Procedures +See Item 9A. \ No newline at end of file diff --git a/raw/filings/0000928022/2010/0000928022-11-000022/rp_note.txt b/raw/filings/0000928022/2010/0000928022-11-000022/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2010/0000928022-11-000022/rpt_disclosure.txt b/raw/filings/0000928022/2010/0000928022-11-000022/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2011/0000928022-12-000026/filing.txt b/raw/filings/0000928022/2011/0000928022-12-000026/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..0d098de061b2c83a8de0d8b2f4b27a9d792952ee --- /dev/null +++ b/raw/filings/0000928022/2011/0000928022-12-000026/filing.txt @@ -0,0 +1,5458 @@ +10-K +1 +cpe-20111231x10k.htm +CALLON PETROLEUM COMPANY 2011 FORM 10-K +CPE-2011.12.31-10K +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +Form 10-K +for the year ended +December 31, 2011 +[X] +Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 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 001-14039 +CALLON PETROLEUM COMPANY +(Exact name of registrant as specified in its charter) +Delaware +( State or other jurisdiction of incorporation or organization) +64-0844345 +(I.R.S. Employer Identification No.) +200 North Canal Street +Natchez, Mississippi +(Address of principal executive offices) +39120 +(Zip Code) +601-442-1601 +(Registrant's telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class: +Name of each exchange on which registered: +Common Stock, $.01 par value +New York Stock Exchange +Securities registered pursuant to section 12 (g) of the Act: None +Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes [ ] +No [ X ] +Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. +Yes [ ] +No [ X ] +Indicate by check mark whether 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] +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 definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one): +Large accelerated filer [ ] +Accelerated filer [ X ] +Non-accelerated filer [ ] +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 ] +The aggregate market value of the voting and non-voting common equity stock held by non-affiliates of the registrant was $260.1 million as of June 30, 2011 . +As of March 14, 2012 , 39,410,094 shares of the Registrant’s common stock, par value $.01 per share, were outstanding. +Documents Incorporated by Reference +Portions of the definitive Proxy Statement of Callon Petroleum Company (to be filed no later than 120 days after December 31, 2011 ) relating to the Annual Meeting of Stockholders to be held on May 10, 2012 , which are incorporated into Part III of this Form 10-K. +Table of Contents +TABLE OF CONTENTS +Part I +Special Note Regarding Forward-Looking Statements +3 +Definitions +4 +Item 1 and 2. +Business and Properties +5 +Our Business Strategy +5 +Our Strengths +5 +Recent Developments +6 +Exploration and Development Activities +6 +Acquisitions and Divestitures +6 +Oil and Gas Properties +6 +Onshore Properties +8 +Gulf of Mexico Deepwater Properties +8 +Gulf of Mexico Shelf and Other Properties +9 +Proved Reserves +9 +Proved Undeveloped Reserves +10 +Controls over Reserve Estimates +11 +Production Volumes, Average Sales Prices and Average Production Costs +11 +Present Activities and Productive Wells +12 +Leasehold Acreage +13 +Title to Properties +14 +Insurance +14 +Major Customers +15 +Corporate Offices +15 +Employees +15 +Regulations +16 +Commitments and Contingencies +20 +Available Information +20 +Item 1A. +Risk Factors +20 +Item 1B. +Unresolved Staff Comments +28 +Item 3. +Legal Proceedings +29 +Item 4. +Mine Safety Disclosures +29 +Part II +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +29 +Performance Graph +30 +Item 6. +Selected Financial Data +30 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +32 +General +32 +Overview and Outlook +32 +Liquidity and Capital Resources +34 +Income Taxes +36 +Callon Entrada +36 +Results of Operations +37 +Off-Balance Sheet Arrangements +43 +Significant Accounting Policies and Critical Accounting Estimates +43 +Subsequent Events +45 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +45 +Commodity Price Risk +45 +Interest Rate Risk +46 +Item 8. +Financial Statements and Supplementary Data +47 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +79 +Item 9A. +Controls and Procedures +79 +Item 9B. +Other Information +80 +Part III +Item 10. +Directors and Executive Officers and Corporate Governance +82 +Item 11. +Executive Compensation +82 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +82 +Item 13. +Certain Relationships and Related Transactions and Director Independence +82 +Item 14. +Principal Accountant Fees and Services +82 +Part IV +Item 15. +Exhibits +83 +Signatures +86 +2 +Special Note Regarding Forward Looking Statements +All statements, other than historical fact or present financial information, may be deemed to be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements that address activities, outcomes and other matters that should or may occur in the future, including, without limitation, statements regarding the financial position, business strategy, production and reserve quantities, present value and growth and other plans and objectives for our future operations, are forward-looking statements. Although we believe the expectations expressed in such forward-looking statements are based on reasonable assumptions, such statements are not guarantees of future performance. We have no obligation and make no undertaking to publicly update or revise any forward-looking statements, except as may be required by law. +Forward-looking statements include the items identified in the preceding paragraph, information concerning possible or assumed future results of operations and other statements in this Form 10-K identified by words such as “anticipate,” “project,” “intend,” “estimate,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “plan,” “forecast,” “target” or similar expressions. +You should not place undue reliance on forward-looking statements. They are subject to known and unknown risks, uncertainties and other factors that may affect our operations, markets, products, services and prices and cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. In addition to any assumptions and other factors referred to specifically in connection with forward-looking statements, risks, uncertainties and factors that could cause our actual results to differ materially from those indicated in any forward-looking statement include, but are not limited to: +• +the timing and extent of changes in market conditions and prices for commodities (including regional basis differentials); +• +our ability to transport our production to the most favorable markets or at all; +• +the timing and extent of our success in discovering, developing, producing and estimating reserves; +• +our ability to respond to low natural gas prices; +• +our ability to fund our planned capital investments; +• +the impact of government regulation, including any increase in severance or similar taxes, legislation relating to hydraulic fracturing, the climate and over-the-counter derivatives; +• +the costs and availability of oilfield personnel services and drilling supplies, raw materials, and equipment and services; +• +our future property acquisition or divestiture activities; +• +the effects of weather; +• +increased competition; +• +the financial impact of accounting regulations and critical accounting policies; +• +the comparative cost of alternative fuels; +• +conditions in capital markets, changes in interest rates and the ability of our lenders to provide us with funds as agreed; +• +credit risk relating to the risk of loss as a result of non-performance by our counterparties; and +• +any other factors listed in the reports we have filed and may file with the Securities and Exchange Commission (“SEC”). +We caution you that the forward-looking statements contained in this Form 10-K are subject to all of the risks and uncertainties, many of which are beyond our control, incident to the exploration for and development, production and sale of oil and natural gas. These risks include, but are not limited to, the risks described in Item 1A of this Annual Report on Form 10-K for the year ended December 31, 2011 and all quarterly reports on Form 10-Q filed subsequently thereto (“Form 10-Qs”). +Should one or more of the risks or uncertainties described above or elsewhere in this Form 10-K occur, or should underlying assumptions prove incorrect, our actual results and plans could differ materially from those expressed in any forward-looking statements. We specifically disclaim all responsibility to publicly update any information contained in a forward-looking statement or any forward-looking statement in its entirety and therefore disclaim any resulting liability for potentially related damages. +All forward-looking statements attributable to us are expressly qualified in their entirety by this cautionary statement. +3 +Table of Contents +DEFINITIONS +All defined terms under Rule 4-10(a) of Regulation S-X shall have their statutorily prescribed meanings when used in this report. As used in this document: +• +3-D : three-dimensional. +• +ARO : Asset Retirement Obligation. +• +Bbl or Bbls : barrel or barrels of oil or natural gas liquids. +• +Bcf : billion cubic feet. +• +Boe : barrel of oil equivalent, determined by using the ratio of one Bbl of oil or NGLs to six Mcf of gas. The ratio of one barrel of oil or NGL to six Mcf of natural gas is commonly used in the industry and represents the approximate energy equivalence of oil or NGLs to natural gas, and does not represent the economic equivalency of oil and NGLs to natural gas. The sales price of a barrel of oil or NGLs is considerably higher than the sales price of six Mcf of natural gas. +• +Boe/d : Boe per day. +• +BLM: Bureau of Land Management. +• +BOEM : Bureau of Ocean Energy Management, Regulation and Enforcement; formerly the Minerals Management Service ("MMS"). +• +Btu : a British thermal unit, a measure of heating value. One Mcf of natural gas generally contains one MMBtu of energy. +• +BSEE: Bureau of Safety and Environmental Enforcement. +• +EPA: Environmental Protection Agency. +• +GHG: greenhouse gases. +• +LIBOR : London Interbank Offered Rate. +• +Mbbls : thousand barrels of oil. +• +Mboe : thousand boe. +• +Mboe/d : Mboe per day. +• +Mcfe : thousand cubic feet of natural gas equivalents. +• +Mcf/d : Mcf per day. +• +MMbbls : million barrels of oil. +• +MMboe : million boe. +• +MMBtu : million Btu. +• +MMcf : million cubic feet of natural gas. +• +MMcf/d : MMcf per day. +• +MMS: Minerals Management Service. +• +NGL or NGLs : natural gas liquids, such as ethane, propane, butanes and natural gasoline that are extracted from natural gas production streams. +• +NYMEX : New York Mercantile Exchange. +• +OCS: outer continental shelf. +• +Oil : includes crude oil and condensate. +• +ONRR: Office of Natural Resources Revenue. +• +PDPs : proved developed producing reserves. +• +PDNPs : proved developed non-producing reserves. +• +PUDs : proved undeveloped reserves. +• +Reserve life: a measurement of the time it will take to produce our proved reserves calculated by dividing our estimate net equivalent reserves at December 31, 2011 by our production during 2011 on an equivalent basis. +• +SEC : United States Securities and Exchange Commission. +• +US GAAP: Generally Accepted Accounting Principles in the United States +With respect to information relating to our working interest in wells or acreage, “net” oil and gas wells or acreage is determined by multiplying gross wells or acreage by our working interest therein. Unless otherwise specified, all references to wells and acres are gross. +4 +Table of Contents +PART I. +Items 1 and 2 - BUSINESS and PROPERTIES +Overview and Business Strategy +Callon Petroleum Company has been engaged in the exploration, development, acquisition and production of oil and natural gas properties since 1950. The Company was incorporated under the laws of the state of Delaware in 1994 and succeeded to the business of a publicly traded limited partnership, a joint venture with a consortium of European investors and an independent energy company partially owned by a member of current management. As used herein, the “Company,” “Callon,” “we,” “us,” and “our” refer to Callon Petroleum Company and its predecessors and subsidiaries unless the context requires otherwise. +In 2009, the Company began to shift its operational focus from exploration, development and production in the Gulf of Mexico to the acquisition and development of onshore properties located in the Permian Basin in Texas and the Haynesville Shale area in Louisiana. As of December 31, 2011 , we had estimated net proved reserves of 10.1 MMbbls and 35.1 Bcf, or 15.9 MMboe. Of these reserves and on an MMboe basis, approximately 61% were located onshore in the Permian Basin and Haynesville Shale plays, compared with approximately 50% located onshore at December 31, 2010 . +Well count information is presented gross unless otherwise indicated. +Our Business Strategy +Our goal is to increase stockholder value by: +• +increasing reserves and production levels by using cash flows from, or monetization of, our Gulf of Mexico properties to acquire and develop lower risk, long-life onshore oil and natural gas properties; +• +increasing our reserve life and predictability of production by focusing on acquisition and development of long-life onshore properties; +• +diversifying risk by substantially increasing the number of productive wells we own; and +• +strengthening our balance sheet by focusing on maintaining liquidity and a reduction of our average debt per Boe of proved reserves. +Our Strengths +We believe that we are well positioned to achieve our business objectives and to execute our strategy because of the following competitive strengths: +• +Our offshore properties generate substantial cash flow, which we can deploy in the acquisition, exploration and development of onshore properties. Since 2009, we have invested nearly $150 million onshore primarily using offshore cash flows. +• +We are replacing Gulf of Mexico Shelf high decline-rate, natural gas production with longer reserve life, liquids-rich production from our onshore drilling programs. +• +We have positioned ourselves for further growth by: +◦ +Acquiring 14,470 additional net Permian Basin exploration acres in early 2012, which represents a 152% increase over our Permian acreage position at year-end 2011. +◦ +Initiating a horizontal oil drilling program on a portion of our Permian acreage scheduled to begin drilling during the second quarter of 2012. +• +We have increased reserve life 79% to 8.6 years at year-end 2011 from 4.8 years at year-end 2008. +• +Our management team is experienced in oil and natural gas acquisitions, exploration, development and production in the areas in which we focus our operations. +5 +Table of Contents +• +On December 31, 2011 , our total liquidity position was approximately $88.8 million , including $43.8 million of available cash and $45.0 million of unused borrowing base available under our senior secured credit facility. The borrowing base has increased by 50% over the base at December 31, 2010 . +Recent Developments +Subsequent to December 31, 2011, we completed two acreage acquisitions in the northern Midland Basin in Borden County. The northern portion of the Midland Basin has had limited drilling activity compared with the southern portion of the Basin (where our other Permian Basin properties are located), which increases the risk associated with drilling activities on the acquired acreage. Together, these acquisitions included a total of approximately 16,020 gross ( 14,470 , net) acres, and significantly increased our acreage position in the Permian Basin by 152% to a total of 24,010 acres compared to 9,540 acres held year-end 2011. For additional information regarding these acquisitions, please refer to the Onshore Properties portion of this Item 1. +Exploration and Development Activities +During 2011 , capital expenditures on an accrual basis for exploration and development costs related to oil and natural gas properties included these expenditures (in millions): +36 wells drilled on the Permian Basin acreage of which 23 wells were producing at year-end +$ +85.3 +Leasehold acquisitions and seismic +2.9 +Costs incurred on offshore properties +1.8 +Plugging and abandonment costs in the Gulf of Mexico +2.6 +Capitalized interest +0.7 +Capitalized general and administrative costs allocated directly to exploration and development projects +11.9 +Total capital expenditures +$ +105.2 +With our continued operational focus onshore, primarily in the Permian Basin, we expect that substantially all of our 2012 capital expenditures will be focused on the acquisition, development and operation of onshore properties in the United States, with 10% of capital expenditures directed towards our offshore properties including an up-dip recompletion of the Habanero #2 well. Our projected 2012 capital expenditures budget is discussed in Management’s Discussion and Analysis and Results of Operations, which is included in Part II, Item 7 of this filing. +Acquisitions and Divestitures +In addition to the previously discussed 16,020 gross ( 14,470 , net) northern Permian Basin acres we acquired in February 2012, during the second quarter of 2011, we acquired for $2.2 million approximately 1,215 gross (480, net), unevaluated acres in the Pecan Acres field, located in Midland County and in proximity to our Carpe Diem field. Pecan Acres provides 26 gross (10, net) drilling locations, and we are currently operating a rig drilling vertical wells at Pecan Acres. We have drilled and stimulated two Pecan Acres wells, which are currently flowing back after stimulation. Also at Pecan Acres, we have drilled a third well and are currently drilling a fourth, with plans to fracture stimulate these wells in March 2012. During 2012, we plan to drill an additional six wells at Pecan Acres. +Also during 2011, we sold for $2.8 million our Mystic Bayou field, located in south Louisiana. In addition to the proceeds, the acquirer assumed approximately $0.9 million of ARO related to the properties. +Oil and Natural Gas Properties +As of December 31, 2011 , our estimated net proved reserves totaled 15.9 MMBoe and included 10.1 MMBbls and 35.1 Bcf, with a pre-tax present value, discounted at 10%, of $309.9 million . Pre-tax present value is a non-US GAAP financial measure, which we reconcile to the US GAAP standardized measure of $270.4 million in note (d) to the table below. Oil constitutes approximately 63% of our total estimated equivalent net proved reserves and approximately 44% of our total estimated equivalent proved developed reserves. +The following table sets forth certain information about our estimated net proved reserves prepared by our independent petroleum reserve engineers by major field and for all other properties combined at December 31, 2011 : +6 +Table of Contents +Pre-tax +Discounted +Estimated Net Proved Reserves +Present +Operator +Oil +(MBbls) +Natural Gas +(MMcf) +Total +(MBoe) +Value +($000) +(a) +(b)(c)(d) +Onshore: +Permian Basin +Callon +5,631 +11,783 +7,595 +$ +48,932 +Haynesville Shale +Callon +— +12,382 +2,064 +3,114 +Total Onshore +5,631 +24,165 +9,659 +$ +52,046 +Gulf of Mexico Deepwater: +Mississippi Canyon 538/582 +“Medusa” +Murphy +3,810 +2,719 +4,263 +$ +213,421 +Garden Banks Block 341 +“Habanero” +Shell +610 +4,574 +1,373 +46,606 +Total Gulf of Mexico Deepwater +4,420 +7,293 +5,636 +$ +260,027 +Gulf of Mexico Shelf and Other: +West Cameron Block 295 +Apache +7 +1,253 +216 +$ +3,563 +East Cameron Block 2 +Apache +10 +639 +116 +2,398 +East Cameron Block 257 +Dynamic Offshore +— +754 +126 +946 +Other (c) +Various +7 +1,014 +175 +(9,090 +) +Total Gulf of Mexico Shelf and Other +24 +3,660 +633 +$ +(2,183 +) +Total Net Proved Reserves +10,075 +35,118 +15,928 +$ +309,890 +(a) +We convert Mcf to Boe using a conversion ratio of six Mcf to one Bbl. This ratio, which is typical in the industry and represents the approximate energy equivalent of an Mcf to a Bbl, does not reflect to market price equivalence of an Mcf of natural gas compared with a Bbl of oil or NGLs. On an market price equivalence basis, a barrel of oil or NBLs has a substantially higher price than six Mcf of natural gas. +(b) +Represents the present value of future net cash flows before deduction of federal income taxes, discounted at 10%, attributable to estimated net proved reserves as of December 31, 2011 , as set forth in the Company’s reserve reports prepared by its independent petroleum reserve engineers, Huddleston & Co., Inc. +(c) +Includes a reduction for estimated plugging and abandonment costs that is reflected as a liability on our balance sheet at December 31, 2011 , in accordance with accounting for asset retirement obligations rules. The negative Pre-Tax Present Value of the “Other” reflects plugging and abandonment obligations exceeding the future net cash flows, with most of such obligations estimated to occur within the next five years. +(d) +The Company uses the financial measure “Pre Tax Discounted Present Value” which is a non-US GAAP financial measure. The Company believes that Pre Tax Discounted Present Value, while not a financial measure in accordance with US GAAP, is an important financial measure used by investors and independent oil and gas producers for evaluating the relative value of oil and natural gas properties and acquisitions because the tax characteristics of comparable companies can differ materially. The total standardized measure calculated in accordance with the guidance issued by the FASB for disclosures about oil and gas producing activities for our proved reserves as of December 31, 2011 was $270.4 million inclusive of the $39.5 million discounted estimated future income taxes relating to such future net revenues. The projected per Mcf natural gas price of $5.60 used in the 2011 reserve estimates has been adjusted to reflect the Btu content, transportation charges and other fees specific to the individual properties. The projected per barrel oil price of $98.98 used in the 2011 reserve estimates has been adjusted to reflect all wellhead deductions and premiums on a property-by-property basis, including transportation costs, location differentials and crude quality. +7 +Table of Contents +Onshore Properties +Onshore proved reserves accounted for approximately 61% of year-end 2011 proved reserves on a Boe basis as compared to 50% of 2010 reserves on a Boe basis, demonstrating our strategy of using our offshore cash flow to explore and develop our onshore properties. +Permian Basin +Our primary target in the southern Midland Basin area of the Permian Basin has been the Wolfberry play, which is located on our properties in Crockett, Ector, Midland, and Upton counties, Texas, and which we believe to be a proven, low-risk oil play that includes the Sprayberry, Dean, and Wolfcamp formations. Certain of our southern Midland Basin properties also include the Atoka and Strawn formations. As of December 31, 2011 , we owned approximately 9,540 net acres in the Permian Basin. Following two recent acquisitions of acreage on which we will target different formations and as discussed below, the Company increased its ownership within the Basin to approximately 24,010 net acres. +As of December 31, 2011 , approximately 48% of the Company's proved reserves were attributable to properties in the Permian Basin. Also as of December 31, 2011 , our Permian Basin properties were producing 1,335 Boe/d from 65 wells, of which 31 were placed onto production (and one well taken offline) during 2011 . This 2011 exit-rate production represents a 143% increase over the 2010 exit rate of 550 Boe/d producing from 35 wells. Average net production from the Company's Permian Basin properties increased 135% to 965 Boe/d in 2011 from 411 Boe/d in 2010. +Subsequent to December 31, 2011 , we significantly expanded our Permian Basin acreage position by acquiring approximately 16,020 gross ( 14,470 , net) exploratory acres in the northern portion of the Midland Basin in Borden County. The northern portion of the Midland Basin has had limited drilling activity compared with the southern portion of the Basin, and therefore has increased risk associated with drilling activities on the acquired acreage. The acquisition costs were funded from existing cash balances. The Company has an average 90% working interest across the contiguous acreage positions and is the operator. +For additional information regarding our Permian Basin properties, including our 2012 capital expenditures program and future development plans for the region, please refer to the Properties discussion within Management's Discussion and Analysis, which is located in Part II, Item 7 of this filing. +Haynesville Shale +Callon holds a 69% working interest in a 624 gross (430, net) acre portion of the Haynesville Shale natural gas unit located in southern Bossier Parish, Louisiana. Initial production from the George R. Mills Well No. 1H, our only well on the property, commenced on September 3, 2010. As of December 31, 2011 , the well has produced 2.1 Bcf, and we have an additional six gross (four, net) drilling locations on the acreage. Approximately 13% of our year-end 2011 proved reserves were attributable to our Haynesville Shale property. The Company's one producing Haynesville Shale natural gas well was shut-in for 35 days during the fourth quarter of 2011 due to well interference from an offsetting well. Production was restored in mid-March 2012 following a successful workover. +For additional information regarding the Company's Haynesville Shale property, please refer to the Properties discussion within Management's Discussion and Analysis, which is located in Part II, Item 7 of this filing. +Gulf of Mexico Deepwater Properties +Medusa, Mississippi Canyon Blocks 538/582 +Our Medusa deepwater 1999 discovery, in which we own a 15% working interest, is located in 2,235 feet of water approximately 50 miles offshore Louisiana. Murphy Exploration & Production Company (“Murphy”), the operator, owns a 60% working interest and ENI Deepwater, LLC, owns the remaining 25% working interest. Since the field entered production in 2003, cumulative gross volumes have approximated 55 MMBoe. +During 2011 , the Medusa field produced 641 MBoe net to Callon from eight wells which accounted for 35% of our total production. Six of the field's wells continue to produce from their initial completions as of December 31, 2011 . We project that 1.7 MMBoe of net PDNPs can be accessed by recompletions in the existing wells. These up-hole recompletions in existing wellbores are expected to occur as existing completions deplete to a level that is uneconomic to justify continued production. We anticipate developing another 1.2 MMBoe of net PUDs by drilling an additional well in late 2013. As of December 31, 2011 , the current projected economic life of the field is expected to run through 2025. +8 +Table of Contents +In December 2003, we transferred our undivided 15% working interest in the spar production facilities to Medusa Spar LLC ("LLC") in exchange for cash proceeds of approximately $25 million and a 10% ownership interest in the LLC. A discussion of this transaction is included in Part II, Item 7 of this filing under Off-Balance Sheet Arrangements. +Habanero, Garden Banks Block 341 +The Habanero field, in which we own an 11.25% working interest, is located in 2,015 feet of water approximately 115 miles offshore Louisiana. Production from the Habanero 52 oil sand commenced in late November 2003. The field is operated by Shell Deepwater Development Inc., which owns a 55% working interest, with the remaining working interest owned by Murphy. Since the field entered production in 2003, cumulative gross volumes have approximated 29 MMBoe. +During 2011 , Habanero produced 197 MBoe net to Callon from two wells accounting for 11% of our total production. Our plans include in the fourth quarter of 2012 the development of PUDs by a sidetrack of the Habanero #2 well. As of December 31, 2011 , the Company expects to reach the economic life of the field in 2019. +For additional information regarding the Company's Deepwater properties, please refer to the Properties discussion within Management's Discussion and Analysis, which is located in Part II, Item 7 of this filing. +Gulf of Mexico Shelf and Other Properties +We own interests in 18 producing wells in 11 oil and natural gas fields in the shelf area of the Gulf of Mexico. These wells produced 551 MBoe net to our interest in 2011 , which accounted for 30% of our total production. For additional information regarding the Company's Shelf and other properties, please refer to the Properties discussion within Management's Discussion and Analysis, which is located in Part II, Item 7 of this filing. +Proved Reserves +In December 2008 the Securities and Exchange Commission (“SEC”) approved amendments to its oil and gas reserves estimation and disclosure requirements. The amendments, among other things: +• +allow the use of reliable technologies to estimate proved reserves if those technologies have been demonstrated to result in reliable conclusions about reserve volumes; +• +require disclosure of oil and gas proved reserves by significant geographic area; +• +permit the optional disclosure of probable and possible reserves; +• +modify the prices used to estimate reserves for SEC disclosure purposes to a 12-month average beginning-of-the-month price instead of a period-end price; and +• +require that if a third party is primarily responsible for preparing or auditing the reserve estimates, the company make disclosures relating to the independence and qualifications of the third party, including filing as an exhibit any report received from the third party. +The new requirements were effective for the Company’s year-end financial statements and Annual Report on Form 10-K for the year ended December 31, 2009, and as such the reserves and related information for 2009, 2010 and 2011 are presented consistent with the requirements of the new rule. The new rule does not require prior-year reserve information to be restated, and as such all information related to periods prior to 2009 is presented consistent with the prior SEC rules for the estimation of proved reserves. +Estimates of volumes of proved reserves, net to our interest, at year end are presented in MBbls for oil and in MMcf for natural gas, including NGLs, at a pressure base of 15.025 pounds per square inch. Total volumes are presented in MBoe. For the MBoe computation, 6,000 cubic feet of gas are the equivalent of one barrel of oil. +The following table sets forth certain information about our estimated net proved reserves. All of our proved reserves are located in the continental United States and in federal and state waters in the Gulf of Mexico. +9 +Table of Contents +Years Ended December 31, +2011 +2010 +2009 +Proved developed: +Oil (MBbls) +5,069 +4,503 +4,346 +Natural Gas (MMcf) +11,605 +12,715 +12,301 +MBoe +7,003 +6,622 +6,396 +Proved undeveloped: +Oil (MBbls) +5,006 +3,645 +2,133 +Natural Gas (MMcf) +23,513 +20,241 +6,802 +MBoe +8,925 +7,019 +3,266 +Total proved: +Oil (MBbls) +10,075 +8,149 +6,479 +Natural Gas (MMcf) +35,118 +32,957 +19,103 +MBoe +15,928 +13,641 +9,663 +Estimated pre-tax future net cash flows (a) +$ +568,798 +$ +379,448 +$ +216,702 +Pre-tax discounted present value (a) (b) +$ +309,890 +$ +205,532 +$ +137,368 +Standardized measure of discounted future net cash flows (a) (b) +$ +270,357 +$ +198,916 +$ +135,921 +(a) +Includes a reduction for estimated plugging and abandonment costs that is reflected as a liability on our balance sheet at December 31, 2011 , in accordance with accounting for asset retirement obligations rules. +(b) +The Company uses the financial measure “Pre-tax discounted present value” which is a non-US GAAP financial measure. The Company believes that Pre-tax discounted present value, while not a financial measure in accordance with US GAAP, is an important financial measure used by investors and independent oil and gas producers for evaluating the relative value of oil and natural gas properties and acquisitions because the tax characteristics of comparable companies can differ materially. The total standardized measure calculated in accordance with the guidance issued by the FASB for disclosures about oil and gas producing activities for our proved reserves as of December 31, 2011 was $270.4 million inclusive of the $39.5 million discounted estimated future income taxes relating to such future net revenues. The natural gas Mcf prices of $5.60 used in the 2011 reserve estimates have been adjusted to reflect the Btu content, transportation charges and other fees specific to the individual properties. The projected oil prices of $98.98 used in the 2011 reserve estimates have been adjusted to reflect all wellhead deductions and premiums on a property-by-property basis, including transportation costs, location differentials and crude quality. +See Note 15 of our Consolidated Financial Statements for the additional information regarding the Company’s reserves including its estimates of proved reserves, PDPs, PUDs and the Company’s estimates of future net cash flows and discounted future net cash flows from proved reserves. +Proved Undeveloped Reserves +Annually, the Company reviews its PUDs to ensure an appropriate plan exists for development. Except as noted below, reserves are recognized as PUDs only if the Company has plans to convert the PUDs into PDPs within five years of the date they are first recorded as PUDs. The basis for our development plans are (i) allocation of capital to projects in our 2012 capital budget and (ii) in subsequent years, on the basis of capital allocation in our business plan, each of which generally is governed by our expectations of internally generated cash flow. Reserve calculations at any end-of-year period are representative of our development plans at that time. Changes in commodity pricing, oilfield service costs and availability, and other economic factors may lead to changes in development plans. +The following table summarizes the Company’s recorded PUDs: +10 +Table of Contents +PUDs (MBoe) at December 31, +2011 +2010 +2009 +Permian Basin +4,861 +2,928 +932 +Haynesville Shale +1,730 +1,757 +— +Total Onshore PUDs +6,591 +4,685 +932 +Medusa +1,186 +1,186 +1,186 +Habanero +1,148 +1,148 +1,148 +Total Deepwater PUDs +2,334 +2,334 +2,334 +Total Shelf and other PUDs +— +— +— +Total PUDs +8,925 +7,019 +3,266 +Our 2,334 MBoe of deepwater PUDs have been classified as PUDs for more than five years, though we expect to develop these PUDs within the next two years. Our decision to classify these reserves as PUDs was primarily based on (1) our ongoing development activities in the area, (2) our historical record of completing development of comparable long-term projects, (3) the amount of time which we have maintained the leases or booked reserves without significant development activities and (4) the extent to which we have followed previously adopted development plans. Our discussions with the field's operator have resulted in the modification of certain development plans for both Medusa and Habanero to drill or sidetrack PUDs within a shorter period of time than originally estimated. The Company currently forecasts that one of the two producing wells in the Habanero field will deplete in 2012, and the field operator has provided notice that the well will be sidetracked to a location with PUD reserves of 1,148 Mboe in the fourth quarter of 2012. Within the Medusa field and to access the PUD reserves of 1,186 MBoe, the Company expects to drill a new well in 2013. During 2011 , the Company did not convert any offshore PUDs to PDPs. +The Company's plans to develop its onshore, Permian Basin PUDs include a multi-year drilling program, which is expected to be completed on existing acreage within five years. Similarly, the Company plans to resume drilling on its Haynesville field, and expects to convert its existing PUDs within the next four years. +The Company's PUDs increased 27% to 8,925 MBoe from 7,019 MBoe at December 31, 2011 and 2010 , respectively. Additions during the year added 2,988 MBoe to the Company's PUDs, offset by 1,082 MBoe primarily comprised of transfers to PDPs as a result of our development program. None of these additions to our PUD reserves were offset by amounts no longer deemed to be economic PUDs at year-end. Revisions to PUDs were not material in 2011 . Of our year-end 2010 PUD reserves, 13% were converted to proved developed producing reserves by year end 2011 , at a total cost of $28.5 million , net. +Controls Over Reserve Estimates +Compliance as it relates to reporting the Company’s reserves is the responsibility of our Senior Vice President of Operations, who has over 30 years of industry experience including 25 years as a manager and is our principal engineer. In addition to his years of experience, our principal engineer holds a degree in petroleum engineering and asset evaluation and management. +Callon’s controls over reserve estimates included retaining Huddleston & Co., Inc., a Texas registered engineering firm, as our independent petroleum and geological firm. The Company provided to Huddleston information about our oil and gas properties, including production profiles, prices and costs, and Huddleston prepared its own estimates of the reserves attributable to the Company’s properties. All of the information regarding reserves in this annual report is derived from Huddleston’s report. Huddleston's reserve report letter is included as an Exhibit to this annual report. The principal engineer at Huddleston responsible for preparing the Company’s reserve estimates has over 30 years of experience in the oil and gas industry and is a Texas Licensed Professional Engineer. Further professional qualifications include a degree in petroleum engineering. +The Board of Directors meets with management, including the Senior Vice President of Operations, to discuss matters and policies including those related to reserves. During our last fiscal year, we have not filed any reports with other federal agencies which contain an estimate of total proved net oil and natural gas reserves. +Production Volumes, Average Sales Prices and Average Production Costs +The following table sets forth certain information regarding the production volumes and average sales prices received for, and average production costs associated with, the Company’s sale of oil and natural gas for the periods indicated. +11 +Table of Contents +Years Ended December 31, +2011 +2010 +2009 +(in thousands, except per unit data) +Production +Natural gas and NGLs (Mcf) +5,081 +4,892 +5,740 +Oil (MBbl) +996 +859 +1,012 +Total (MBoe) +1,843 +1,674 +1,969 +Revenues +Natural gas and NGL sales +$ +26,682 +$ +24,639 +27,417 +Oil sales +100,962 +65,243 +73,842 +Total revenues +$ +127,644 +$ +89,882 +$ +101,259 +Lease Operating Expenses +Production costs +$ +17,929 +$ +16,094 +$ +16,778 +Severance/production taxes +1,826 +816 +528 +Gathering +592 +802 +1,141 +Total lease operating expenses +$ +20,347 +$ +17,712 +$ +18,447 +Realized prices +Natural gas ($/Mcf, including realized gains (losses) on derivatives) (a) +$ +5.25 +$ +5.04 +$ +4.78 +Natural gas ($/Mcf, excluding realized gains (losses) on derivatives) (a) +5.25 +4.91 +4.45 +Oil ($/Bbl, including realized gains (losses) on derivatives) (b) +101.34 +75.97 +73.00 +Oil ($/Bbl, excluding realized gains (losses) on derivatives) (b) +101.72 +75.97 +55.84 +Operating costs per Boe - Total Consolidated +Production costs +$ +9.73 +$ +9.61 +$ +8.52 +Severance/production taxes +0.99 +0.49 +0.27 +Gathering +0.32 +0.48 +0.58 +DD&A +26.42 +19.00 +16.99 +Interest +6.36 +7.95 +9.70 +Total operating costs per Boe +$ +43.82 +$ +37.53 +$ +36.06 +(a) +Natural gas prices exceeded the related NYMEX prices, which are quoted on an MMBtu basis, primarily due to the value of the NGLs in our liquids-rich natural gas stream, primarily from our Permian Basin and deepwater production. +(b) +Oil prices for production from our two deepwater fields reflect a premium over NYMEX pricing based on Mars WTI differential for Medusa production and Argus Bonita WTI differential for Habanero production. +Present Activities and Productive Wells +The following table sets forth the wells drilled and completed during the periods indicated. All such wells were drilled in the continental United States and in federal and state waters in the Gulf of Mexico. At December 31, 2011 , the Company was in the process of drilling two development wells (which are excluded from the table below) and had nine development oil wells (which are included in the table below) awaiting fracture stimulation including seven first-time well stimulations. +12 +Table of Contents +Years ended December 31, +2011 +2010 +2009 +Gross +Net +Gross +Net +Gross +Net +Development: +Oil +36 +32.77 +20 +19.37 +— +— +Natural Gas +— +— +1 +0.69 +— +— +Non-productive +— +— +— +— +— +— +Total +36 +32.77 +21 +20.06 +— +— +Exploration: (a) +Oil +— +— +— +— +— +— +Natural Gas +— +— +— +— +— +— +Non-productive +— +— +— +— +— +— +Total +— +— +— +— +— +— +(a) Our wells have been drilled within the productive boundaries of statistical plays, and are therefore classified as development well. +The following table sets forth productive wells as of December 31, 2011 : +Oil Wells +Natural Gas Wells +Gross +Net +Gross +Net +Working interest +75 +60.70 +12 +5.52 +Royalty interest +3 +0.10 +5 +0.13 +Total +78 +60.80 +17 +5.65 +A well is categorized as an oil well or a natural gas well based upon the ratio of oil to natural gas reserves on a Mcfe basis. However, some of our wells produce both oil and natural gas. +For the periods reflected, the following table sets forth by major field(s) net production volumes and estimated proved reserves: +Year ended December 31, +2011 +2010 +2009 +Production Volumes (MBoe) +% of Total Proved Reserves +Production Volumes (MBoe) +% of Total Proved Reserves +Production Volumes (MBoe) +% of Total Proved Reserves +Offshore - Gulf of Mexico: +Medusa +641 +27 +% +593 +33 +% +751 +51 +% +Habanero +197 +8 +% +233 +10 +% +370 +16 +% +Shelf and other +551 +4 +% +616 +7 +% +829 +17 +% +Total offshore: +1,389 +39 +% +1,442 +50 +% +1,950 +84 +% +Onshore: +Permian Basin +353 +48 +% +150 +33 +% +19 +16 +% +Haynesville natural gas shale +101 +13 +% +82 +17 +% +— +— +% +Total onshore: +454 +61 +% +232 +50 +% +19 +16 +% +Total +1,843 +100 +% +1,674 +100 +% +1,969 +100 +% +Leasehold Acreage +The following table shows our approximate developed and undeveloped (gross and net) leasehold acreage as of December 31, +13 +Table of Contents +2011 . +Developed +Undeveloped +Total +Gross +Net +Gross +Net +Gross +Net +Louisiana +2,519 +965 +901 +699 +3,420 +1,664 +Texas (a) +7,148 +6,318 +4,256 +3,221 +11,404 +9,539 +Federal onshore (b) +— +— +64,963 +64,963 +64,963 +64,963 +Federal waters (c) +50,680 +17,784 +40,944 +11,360 +91,624 +29,144 +Total +60,347 +25,067 +111,064 +80,243 +171,411 +105,310 +(a) +A portion of our Texas acreage requires continued drilling to hold the acreage for which we have included in our development plans, though the cost to renew this acreage, if necessary, is not considered material. Excluded from the above table and as previously noted in the Onshore Properties discussion, Callon acquired in February 2012 approximately 16,020 gross (approximately 14,470 net) acres in the northern portion of the Midland Basin. This acreage is also subject to certain drilling requirements with which the Company's development plans are expected to comply. +(b) +The Company's lease of this acreage, located in Nevada, has approximately seven years remaining, and had a carrying value at December 31, 2011 of approximately $2.3 million included in the Company's unevaluated properties balance. The lease requires no drilling activity to hold the acreage, and we continue to monitor the activity of other operators conducting drilling in the area. +(c) +We have two federal blocks in offshore waters, comprising 11,520 gross (2,304 net) acres that will expire in the fourth quarter of 2012. In additional, we hold other insignificant federal waters acreage that will expire during 2012. Because we have no development plans for the acreage, the acreage had no carrying value at December 31, 2011 . +Title to Properties +The Company believes that the title to its oil and natural gas properties is good and defensible in accordance with standards generally accepted in the oil and gas industry, subject to such exceptions which, in our opinion, are not so material as to detract substantially from the use or value of such properties. The Company’s properties are typically subject, in one degree or another, to one or more of the following: +• +royalties and other burdens and obligations, express or implied, under oil and natural gas leases; +• +overriding royalties and other burdens created by us or our predecessors in title; +• +a variety of contractual obligations (including, in some cases, development obligations) arising under operating agreements, farm-out agreements, production sales contracts and other agreements that may affect the properties or their titles; +• +back-ins and reversionary interests existing under purchase agreements and leasehold assignments; +• +liens that arise in the normal course of operations, such as those for unpaid taxes, statutory liens securing obligations to unpaid suppliers and contractors and contractual liens under operating agreements; +• +pooling, unitization and communitization agreements, declarations and orders; and +• +easements, restrictions, rights-of-way and other matters that commonly affect property. +To the extent that such burdens and obligations affect the Company’s rights to production revenues, these characteristics have been taken into account in calculating Callon’s net revenue interests and in estimating the size and value of its reserves. The Company believes that the burdens and obligations affecting our properties are typical within the industry for properties of the kind owned by Callon. +Insurance +In accordance with industry practice, the Company maintains insurance against some, but not all, of the operating risks to which its business is exposed. While not all inclusive, the Company's insurance policies include coverage for general liability insuring both onshore and offshore operations (including sudden and accidental pollution), physical damage to its offshore oil and natural gas properties, aviation liability, auto liability, worker's compensation, employer's liability, and maritime employers liability. At the depths and in the areas in which the Company operates, and in light of the vertical and horizontal drilling that it undertakes, the Company typically does not encounter high pressures or extreme drilling conditions. The Company carries control of well +14 +Table of Contents +insurance for all offshore wells, though unless contractually bound to do so, the Company does not carry control of well insurance for onshore operations. +Currently, the Company has general liability insurance coverage up to $1 million per occurrence and $2 million per policy in the aggregate, which includes sudden and accidental environmental liability coverage for the effects of pollution on third parties arising from its operations. The Company's insurance policies contain high policy limits, and in most cases, deductibles (generally ranging from $0 to $1.5 million) that must be met prior to recovery. These insurance policies are subject to certain customary exclusions and limitations. In addition, the Company maintains $100 million in excess liability coverage, which is in addition to and triggered if the policy limits for other coverages are reached. +The Company requires all of its third-party contractors to sign master service agreements in which they agree to indemnify the Company for injuries and deaths of the service provider's employees as well as contractors and subcontractors hired by the service provider. Similarly, the Company generally agrees to indemnify each third-party contractor against claims made by employees of the Company and the Company's other contractors. Additionally, each party generally is responsible for damage to its own property. +The third-party contractors that perform hydraulic fracturing operations for the Company sign master service agreements generally containing the indemnification provisions noted above. The Company does not currently have any insurance policies in effect that are intended to provide coverage for losses solely related to hydraulic fracturing operations. However, the Company believes its general liability and excess liability insurance policies would cover foreseeable third party claims related to hydraulic fracturing operations and associated legal expenses, in accordance with, and subject to, the terms of such policies. +The Company re-evaluates the purchase of insurance, coverage limits and deductibles annually. Future insurance coverage for the oil and natural gas industry could increase in cost and may include higher deductibles or retentions. In addition, some forms of insurance may become unavailable in the future or unavailable on terms that are economically acceptable. While based on the Company's risk analysis, it believes that it is properly insured, no assurance can be given that the Company will be able to maintain insurance in the future at rates that it considers reasonable. In such circumstances, the Company may elect to self-insure or maintain only catastrophic coverage for certain risks in the future. +Major Customers +Our production is sold generally on month-to-month contracts at prevailing prices. The following table identifies customers to whom we sold a significant percentage of our total oil and natural gas production, on an equivalent basis, during each of the 12-month periods ended: +December 31, +2011 +2010 +2009 +Shell Trading Company +45 +% +44 +% +45 +% +Plains Marketing, L.P. +17 +% +20 +% +23 +% +Enterprise Crude Oil, LLC +16 +% +— +% +— +% +Louis Dreyfus Energy Services +4 +% +13 +% +15 +% +Other +18 +% +23 +% +17 +% +Total +100 +% +100 +% +100 +% +Because alternative purchasers of oil and natural gas are readily available, the Company believes that the loss of any of these purchasers would not result in a material adverse effect on Callon’s ability to market future oil and natural gas production. We are not currently committed to provide a fixed and determinable quantity of oil or gas in the near future under our contracts. +Corporate Offices +The Company’s headquarters are located in Natchez, Mississippi, in approximately 51,500 square feet of owned space. We also maintain leased business offices in Houston and Midland, Texas, and own or lease field offices in the area of the major fields in which we operate properties or have a significant interest. Replacement of any of our leased offices would not result in material expenditures by us as alternative locations to our leased space are anticipated to be readily available . +Employees +Callon had 88 employees as of December 31, 2011 , which included 10 petroleum engineers and four petroleum geoscientists. None of the Company’s employees are currently represented by a union, and the Company believes that it has good relations with its +15 +Table of Contents +employees. +Regulations +General. The oil and natural gas industry is subject to regulation at the federal, state and local level, and some of the laws, rules and regulations that govern our operations carry substantial penalties for non-compliance. Rules and regulations affecting the oil and natural gas industry are under constant review for amendment or expansion, which could increase the regulatory burden and the potential for financial sanctions for noncompliance. This regulatory burden increases our cost of doing business and, consequently, affects our profitability. +Exploration and Production . Our operations are subject to federal, state and local regulations that include requirements for permits to drill and to conduct other operations and for provision of financial assurances (such as bonds and letters of credit) covering drilling and well operations. Other activities subject to regulation are: +• +the location and spacing of wells, +• +the method of drilling and completing and operating wells, +• +the rate and method of production, +• +the surface use and restoration of properties upon which wells are drilled and other exploration activities, +• +notice to surface owners and other third parties, +• +the plugging and abandoning of wells, +• +the discharge of contaminants into water and the emission of contaminants into air, +• +the disposal of fluids used or other wastes obtained in connection with operations, +• +the marketing, transportation and reporting of production, and +• +the valuation and payment of royalties. +For instance, our OCS leases in federal waters are administered by three Bureaus of the DOI. In response to concerns that the former MMS revenue-generating and resource development functions were at odds with its safety and environmental regulatory functions, the DOI reorganized the MMS into three separate agencies: the BOEM, to be the resource manager for conventional and renewable energy and mineral resources on the OCS; the BSEE, to promote and enforce safety in offshore energy exploration and production operations; and the ONRR, to collect and distribute royalties, rents, fees and other revenues, including the development of regulations with respect to revenue valuation and collection and enforcement activities. In this “Exploration and Production” section, we refer to actions of one or more of the foregoing agencies as actions of “the DOI Bureaus”. +The DOI Bureaus require compliance with detailed regulations and orders. Lessees must obtain DOI Bureau approval for exploration, exploitation and production plans and applications for permits to drill prior to the commencement of such operations. Since the April 20, 2010 blowout and oil spill at the BP Deepwater Horizon Macondo oil well, the DOI Bureaus have issued numerous Notices to Lessees and other guidance documents as well as an Interim Final Rule augmenting the existing regulations with more stringent safety, engineering and environmental requirements. The DOI Bureaus have also recently issued a rule requiring that all operators in the OCS formulate detailed Safety and Environmental Management Systems to improve the safety of their operations on the OCS. Current DOI Bureau regulations restrict the flaring or venting of natural gas, and prohibit the flaring of liquid hydrocarbons and oil without prior authorization. The DOI Bureaus are considering whether to require flaring rather than venting, where practical, to reduce the potential effect of greenhouse gas emissions. +DOI Bureau policies concerning the volume of production that a lessee must have to maintain an offshore lease beyond its primary term also are applicable to Callon. Similarly, the DOI Bureaus have promulgated other regulations and a Notice to Lessees governing the plugging and abandonment of wells located offshore and the installation and decommissioning of production facilities. To cover the various obligations of lessees on the OCS, the DOI Bureaus generally requires that lessees post bonds, letters of credit, or other acceptable assurances that such obligations will be met. The cost of these bonds or other surety can be substantial, and there is no assurance that bonds or other surety can be obtained in all cases. Under some circumstances, the DOI Bureaus may require any of our operations on federal leases to be suspended or terminated. Any such suspension or termination could materially adversely affect our financial conditions and results of operations. +As stated above, the April 20, 2010 blowout and oil spill at the BP Deepwater Horizon oil rig has prompted the federal government to impose heightened regulation of oil and natural gas exploration and production on the OCS. Especially with respect to deepwater operations, the DOI Bureaus have issued rules that are more stringent than the rules issued by the MMS, and have announced their intention to issue additional safety rules and be more scrupulous in implementing existing environmental requirements in the future. Legislation has been introduced in the United States Congress to toughen the regulation of oil and natural gas exploration and production on the OCS. In addition, the National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, whose members were appointed by President Obama, issued a report proposing, among other things, fundamental reform of the +16 +Table of Contents +regulation of oil and natural gas exploration and production on the OCS. The tightening of regulation on the OCS could impose higher costs on, and render it more difficult to timely obtain regulatory approval of our proposed activities on the OCS, especially as to deepwater projects. +Operations conducted on federal or state oil and natural gas leases must comply with numerous regulatory restrictions, including various nondiscrimination statues, royalty and related valuation requirements, and certain of these operations must be conducted pursuant to certain on-site security regulations and other appropriate permits issued by the DOI Bureaus or other appropriate federal or state agencies. +Our sales of oil and natural gas are affected by the availability, terms and cost of pipeline transportation. The price and terms for access to pipeline transportation remain subject to extensive federal and state regulation. If these regulations change, we could face higher transmission costs for our production and, possibly, reduced access to transmission capacity. +Various proposals and proceedings that might affect the petroleum industry are pending before Congress, the Federal Energy Regulatory Commission, or FERC, various state legislatures, and the courts. The industry historically has been heavily regulated and we can offer you no assurance that the less stringent regulatory approach recently pursued by the FERC and Congress will continue nor can we predict what effect such proposals or proceedings may have on our operations. +We do not currently anticipate that compliance with existing laws and regulations governing exploration and production will have a significantly adverse effect upon our capital expenditures, earnings or competitive position. +Environmental Regulation . Various federal, state and local laws and regulations concerning the release of contaminants into the environment, including the discharge of contaminants into water and the emission of contaminants into the air, the generation, storage, treatment, transportation and disposal of wastes, and the protection of public health, welfare, and safety, and the environment, including natural resources, affect our exploration, development and production operations, including operations of our processing facilities. We must take into account the cost of complying with environmental regulations in planning, designing, drilling, constructing, operating and abandoning wells. Regulatory requirements relate to, among other things, the handling and disposal of drilling and production waste products, the control of water and air pollution and the removal, investigation, and remediation of petroleum-product contamination. In addition, our operations may require us to obtain permits for, among other things, +• +air emissions, +• +discharges into surface waters (including wetlands), and +• +the construction and operations of underground injection wells or surface pits to dispose of produced saltwater and other nonhazardous oilfield wastes. +In the event of an unauthorized discharge (e.g., to land or water), emission (e.g., to air) or other activity, we may be liable for, among other things, penalties, costs and damages, and subject to injunctive relief, and we could be required to cleanup or mitigate the environmental impacts of those discharges, emissions or activities. Also, under federal, and certain state, laws, the present and certain past owners and operators of a site, and persons that treated, disposed of or arranged for the disposal of hazardous substances found at a site, may be liable, without regard to fault or the legality of the original conduct, for the release of hazardous substances into the environment and for contamination of natural resources caused by such release. The Environmental Protection Agency, state environmental agencies and, in some cases third parties are authorized to take actions in response to threats to human health or the environment and to seek to recover from responsible classes of persons the costs of such actions. We therefore could be required to remove or remediate previously disposed wastes and remediate contamination, including contamination in surface water, soil or groundwater, caused by disposal of that waste, irrespective of whether disposal or release were authorized. We could be responsible for wastes disposed of or released by us or prior owners or operators at properties owned or leased by us or at locations where wastes have been taken for disposal also irrespective of whether disposal or release were authorized. We could also be required to suspend or cease operations in contaminated areas, or to perform remedial well plugging operations or cleanups to prevent future contamination. +Federal, and certain state, laws also impose duties and liabilities on certain “responsible parties” related specifically to the prevention of oil spills and damages resulting from such spills in or threatening United States waters or adjoining shorelines. A liable “responsible party” includes the owner or operator of a facility, vessel or pipeline that is a source of an oil discharge or that poses the substantial threat of discharge or, in the case of offshore facilities, the lessee or permittee of the area in which a discharging facility is located. These laws assign liability, which generally is joint and several, without regard to fault, to each liable party for oil removal costs and a variety of public and private damages. Although defenses and limitations exist to the liability imposed under these laws, they are limited. In the event of an oil discharge or substantial threat of discharge, we could be liable for costs and damages. +17 +Table of Contents +The Environmental Protection Agency and various state agencies have limited the disposal options for hazardous and nonhazardous wastes thereby increasing the costs of disposal. Furthermore, certain wastes generated by our oil and natural gas operations that are currently exempt from treatment as hazardous wastes may in the future be designated as hazardous wastes and, therefore, be subject to considerably more rigorous and costly operating and disposal requirements. +Federal and state occupational safety and health laws require us to organize information about hazardous materials used, released or produced in our operations. Certain portions of this information must be provided to employees, state and local governmental authorities and local citizens. We are also subject to the requirements and reporting set forth in federal workplace standards. +There are federal and certain state laws that impose restrictions on activities adversely affecting the habitat of certain plant and animal species. In the event of an unauthorized impact or taking of a protected species or its habitat, we could be liable for penalties, costs and damages, and subject to injunctive relief, and we could be required to mitigate those impacts. A critical habitat or suitable habitat designation also could result in further material restrictions to land use and may materially delay or prohibit land access for oil and natural gas development. +Oil and natural gas exploration and production activities are being subjected to additional regulatory scrutiny under the Clean Air Act (“CAA”). On July 28, 2011, the EPA proposed a rule to subject oil and natural gas operations to regulation under the New Source Performance Standards (NSPS) and National Emission Standards for Hazardous Air Pollutants (NESHAP) programs under the Clean Air Act, and to impose new and amended requirements under both programs. Under the proposal, EPA would, among other things, amend standards applicable to natural gas processing plants and would expand the NSPS to include all oil and natural gas operations, imposing requirements on those operations. EPA is also proposing NSPS standards for completions of hydraulically fracturing natural gas wells. The proposed standards include the reduced emission completion techniques. The NESHAPS proposal includes maximum achievable control technology (MACT) standards for certain glycol dehydrators and storage vessels, and revises applicability provisions, alternative test protocols and the availability of the startup, shutdown and maintenance exemption. EPA is under a court order to finalize the rules, with the current deadline of April 3, 2012. Should these rules become final and applicable to our operations, they could result in increased operating and compliance costs, increased regulatory burdens and delays in our operations. +We have made and will continue to make expenditures to comply with environmental regulations and requirements. These are necessary costs of doing business within the oil and natural gas industry. Although we are not fully insured against all environmental risks, we maintain insurance coverage which we believe is customary in the industry. Moreover, it is possible that other developments, such as stricter and more comprehensive environmental laws and regulations, as well as claims for damages to property or persons resulting from company operations, could result in substantial costs and liabilities. We believe we are in compliance with existing environmental regulations, and that, absent the occurrence of an extraordinary event the effect of which cannot be predicted, any noncompliance will not have a material adverse effect on our operations or earnings. +Greenhouse Gas (“GHG”) Regulation. Although federal legislation regarding the control of greenhouse gasses, or GHGs, seems unlikely, the EPA has been moving forward with rulemaking to regulate GHGs as pollutants under the CAA. These GHG regulations could require us to incur increased operating costs and could have an adverse effect on demand for the oil and natural gas we produce. +On June 3, 2010, EPA published its so-called "GHG tailoring rule" that will phase in federal prevention of significant deterioration (PSD) permit requirements for new sources and modifications, and Title V operating permits for all sources, that have the potential to emit specific quantities of GHGs. Those permitting provisions, when they become applicable to our operations, could require controls or other measures to reduce GHG emissions from new or modified sources, and we could incur additional costs to satisfy those requirements. On November 30, 2010, EPA published a rule establishing GHG reporting requirements for sources in the petroleum and natural gas industry, requiring those sources to monitor, maintain records on, and annually report their GHG emissions, with the first annual report due in 2012 for the year 2011. Although this rule does not limit the amount of GHGs that can be emitted, it could require us to incur costs to monitor, keep records of, and report GHG emissions associated with our operations. +In addition to federal regulation, a number of states, individually and regionally, also are considering or have implemented GHG regulatory programs. These potential regional and state initiatives may result in so-called "Cap-and-Trade programs", under which overall GHG emissions are limited and GHG emissions are then allocated and sold, and possibly other regulatory requirements, that could result in our incurring material expenses to comply, such as by being required to purchase or to surrender allowances for GHGs resulting from our operations. The federal, regional and local regulatory initiatives also could adversely affect the marketability of the oil and natural gas we produce. The impact of such future programs cannot be predicted, but we do not expect our operations to be affected any differently than other similarly situated domestic competitors. +18 +Table of Contents +Application of the Safe Drinking Water Act to Hydraulic Fracturing. Congress has considered legislation to amend the federal Safe Drinking Water Act to remove the exemption for hydraulic fracturing operations and require reporting and disclosure of chemicals used by the oil and natural gas industry in the hydraulic fracturing process. Hydraulic fracturing involves the injection of water, sand and chemicals under pressure into rock formations to stimulate oil and natural gas production. Sponsors of these bills have asserted that chemicals used in the fracturing process could adversely affect drinking water supplies. A number of states have or are considering hydraulic fracturing regulation. For example, Texas has adopted regulations requiring the disclosure of hydraulic fracturing chemicals. Potential federal as well as existing and potential state regulation could cause us to incur substantial compliance costs, and the requirement could negatively affect our ability to conduct fracturing activities on our assets. +In addition, the EPA has recently been taking actions to assert federal regulatory authority over hydraulic fracturing using diesel under the Safe Drinking Water Act's Underground Injection Control Program. Further, in March 2010, the EPA announced that it would conduct a wide-ranging study on the effects of hydraulic fracturing on drinking water resources. Interim results of the study are expected in 2012, with final results expected in 2014. In addition, in December 2011, the EPA published an unrelated draft report concluding that hydraulic fracturing caused groundwater pollution in a natural gas field in Wyoming. This study remains subject to review and public comment. The agency also announced that one of its enforcement initiatives for 2011 to 2013 would be to focus on environmental compliance by the energy extraction sector. This study and enforcement initiative could result in additional regulatory scrutiny that could make it difficult to perform hydraulic fracturing and increase our costs of compliance and doing business. Consequently, these studies and initiatives could spur further legislative or regulatory action regarding hydraulic fracturing or similar production operations. +Further, EPA has announced an initiative under the Toxic Substances Control Act (“TSCA”) to develop regulations governing the disclosure and evaluation of hydraulic fracturing chemicals. +All of the acreage and undeveloped reserves within the Permian Basin are subject to hydraulic fracturing procedures as the process is required to economically develop the Wolfberry formation. The hydraulic fracturing process is integral to the Company's overall drilling and completion costs in the Permian Basin and represented approximately 34% or $0.8 million of the total drilling/completion costs per vertical well drilled during 2011. +The hydraulic fracturing activity is limited to the oil and natural gas bearing Clearfork, Sprayberry, Wolfcamp, Cline and Atoka formations, which are found at depths ranging between 6,000 and 12,000 feet from the surface in Midland, Ector and Upton Counties, Texas. The Railroad Commission of Texas has defined potable water sources in this area as usable-quality ground water from the surface to a depth of 250 feet for our acreage in Midland and Ector Counties and to a depth of 425 feet for our acreage in Upton county. +The Company diligently reviews best practices and industry standards, and complies with all regulatory requirements in the protection of these potable water sources. Protective practices include, but are not limited to, setting multiple strings of protection pipe across the potable water sources and cementing these pipes from setting depth to surface, continuously monitoring the hydraulic fracturing process in real time, and disposing of all non-commercially produced fluids in certified disposal wells at depths below the potable water sources. +Based on current drilling techniques, a typical fracturing procedure for a vertical well in the Wolfberry formation uses approximately 1.4 million gallons of fresh water, approximately 1.2 million pounds of sand and other elements including enzymes and Guar, a common food additive. +In compliance with the law enacted in Texas in June 2011 and regulations adopted in December 2011, the Company will disclose hydraulic fracturing data to the Ground Water Protection Council and the Interstate Oil and Gas Compact Commission chemical registry. This disclosure is required for each chemical ingredient that is subject to the requirements of OSHA regulations, as well as the total volume of water used in the hydraulic fracturing treatment. A copy of the completed form will be submitted to the Railroad Commission of Texas with the completion report for the well. Additionally, a list of all other chemical ingredients not required by the registry will also be provided to the Railroad Commission for disclosure on a publicly accessible website. +There have not been any incidents, citations or suits related to the Company's hydraulic fracturing activities involving environmental concerns. +Surface Damage Statues (“SDAs”) . In addition, eleven states and some tribal nations have enacted SDAs. These laws are designed to compensate for damage caused by mineral development. Most SDAs contain entry notification and negotiation requirements to facilitate contact between operators and surface owners/users. Most SDAs also contain bonding requirements and specific expenses for exploration and operating activities. Costs and delays associated with SDAs could impair operational effectiveness and increase development costs. +19 +Table of Contents +Mineral Lease Act of 1920 (“Mineral Act”) . The Mineral Act prohibits direct or indirect ownership of any interest in federal onshore oil and natural gas leases by a foreign citizen of a country that denies “similar or like privileges” to citizens of the United States. Such restrictions on citizens of a non-reciprocal country include ownership or holding or controlling stock in a corporation that holds a federal onshore oil and natural gas lease. If this restriction is violated, the corporation's lease can be canceled in a proceeding instituted by the United States Attorney General. Although the regulations of the Bureau of Land Management ("BLM") (which administers the Mineral Act) provide for agency designations of non-reciprocal countries, there are presently no such designations in effect. The Company owns interests in numerous federal onshore oil and natural gas leases. It is possible that holders of the Company's equity interests may be citizens of foreign countries, which could be determined to be citizens of a non-reciprocal country under the Mineral Act. +Other Regulations . If we conduct operations on federal, state or Indian oil and natural gas leases, these operations must comply with numerous regulatory restrictions, including various nondiscrimination statutes, royalty and related valuation requirements. Certain of these operations must be conducted pursuant to certain on-site security regulations and other appropriate permits issued by the BLM, BOEM, BSEE or other appropriate federal, state, or tribal agencies. +Commitments and Contingencies +The Company’s activities are subject to federal, state and local laws and regulations governing environmental quality and pollution control. Although no assurances can be made, the Company believes that, absent the occurrence of an extraordinary event, compliance with existing federal, state and local laws, rules and regulations governing the release of materials into the environment or otherwise relating to the protection of the environment will not have a material effect upon the capital expenditures, earnings or the competitive position of the Company with respect to its existing assets and operations. The Company cannot predict what effect additional regulation or legislation, enforcement polices included, and claims for damages to property, employees, other persons, and the environment resulting from the Company’s operations could have on its activities. +Available Information +We make available free of charge on our Internet web site (www.callon.com) our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and other filings pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and amendments to such filings, as soon as reasonably practicable after each are electronically filed with, or furnished to, the SEC. You may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE., Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers, like Callon, that file electronically with the SEC. +We also make available within the Investors section of our Internet web site our Code of Business Conduct and Ethics, Corporate Governance Guidelines, and Audit, Compensation and Nominating and Governance Committee Charters, which have been approved by our board of directors. We will make timely disclosure by a Current Report on Form 8-K and on our web site of any change to, or waiver from, the Code of Business Conduct and Ethics for our principal executive and senior financial officers. A copy of our Code of Business Conduct and Ethics is also available, free of charge by writing us at: Chief Financial Officer, Callon Petroleum Company, P.O. Box 1287, Natchez, MS 39121. +Item 1A. Risk Factors +Risk Factors +Depressed oil and natural gas prices may adversely affect our results of operations and financial condition . Our success is highly dependent on prices for oil and natural gas, which are extremely volatile, and the oil and natural gas markets are cyclical. Extended periods of low prices for oil or natural gas will have a material adverse effect on us. The prices of oil and natural gas depend on factors we cannot control such as weather, economic conditions, and levels of production, actions by OPEC and other countries and government actions. Prices of oil and natural gas will affect the following aspects of our business: +• +our revenues, cash flows and earnings; +• +the amount of oil and natural gas that we are economically able to produce; +• +our ability to attract capital to finance our operations and the cost of the capital; +• +the amount we are allowed to borrow under our senior secured credit facility; +• +the profit or loss we incur in exploring for and developing our reserves; and +• +the value of our oil and natural gas properties. +20 +Table of Contents +Natural gas prices have been depressed recently and have the potential to remain depressed for the next several years, which may have an adverse effect on our financial condition and results of operations. Natural gas prices have been depressed for the last several years as a result of over-supply caused by, among other things, increased drilling in unconventional reservoirs, reduced economic activity associated with a recession and weather conditions. We expect natural gas prices to be depressed during the foreseeable future. Approximately 37% of our estimated net proved reserves are natural gas, and 46% of our production in 2011 was natural gas. A sustained reduction in natural gas prices could have an adverse effect on our results of operation and financial condition. +If oil and natural gas prices decrease or remain depressed for extended periods of time, we may be required to take additional writedowns of the carrying value of our oil and natural gas properties. We may be required to writedown the carrying value of our oil and natural gas properties when oil and natural gas prices are low or if we have substantial downward adjustments to our estimated net proved reserves, increases in our estimates of development costs or if we experience deterioration in our exploration results. Under the full-cost method, which we use to account for our oil and natural gas properties, the net capitalized costs of our oil and natural gas properties may not exceed the present value, discounted at 10%, of future net cash flows from estimated net proved reserves, using the preceding 12-months' average oil and natural gas prices based on closing prices on the first day of each month, plus the lower of cost or fair market value of our unproved properties. If net capitalized costs of our oil and natural gas properties exceed this limit, we must charge the amount of the excess to earnings. This type of charge will not affect our cash flows, but will reduce the book value of our stockholders' equity. We review the carrying value of our properties quarterly, based on the pricing noted above. Once incurred, a writedown of oil and natural gas properties is not reversible at a later date, even if prices increase. See Note 15 to our Consolidated Financial Statements. +Our actual recovery of reserves may substantially differ from our proved reserve estimates. This Form 10-K contains estimates of our proved oil and natural gas reserves and the estimated future net cash flows from such reserves. These estimates are based upon various assumptions, including assumptions required by the SEC relating to oil and natural gas prices, drilling and operating expenses, capital expenditures, taxes and availability of funds. The process of estimating oil and natural gas reserves is complex. This process requires significant decisions and assumptions in the evaluation of available geological, geophysical, engineering and economic data for each reservoir and is therefore inherently imprecise. Additionally, our interpretations of the rules governing the estimation of proved reserves could differ from the interpretation of staff members of regulatory authorities resulting in estimates that could be challenged by these authorities. +Actual future production, oil and natural gas prices, revenues, taxes, development expenditures, operating expenses and quantities of recoverable oil and natural gas reserves most likely will vary from the estimates. Any significant variance could materially affect the estimated quantities and present value of reserves shown in this report. Additionally, reserves and future cash flows may be subject to material downward or upward revisions, based on production history, development drilling and exploration activities and prices of oil and natural gas. We incorporate many factors and assumptions into our estimates including: +• +Expected reservoir characteristics based on geological, geophysical and engineering assessments; +• +Future production rates based on historical performance and expected future operation investment activities; +• +Future oil and natural gas prices and quality and locational differences; and +• +Future development and operating costs. +You should not assume that any present value of future net cash flows from our producing reserves contained in this Form 10-K represents the market value of our estimated oil and natural gas reserves. We base the estimated discounted future net cash flows from our proved reserves at December 31, 2011 on average 12-month prices and costs as of the date of the estimate. Actual future prices and costs may be materially higher or lower. Further, actual future net revenues will be affected by factors such as the amount and timing of actual development expenditures, the rate and timing of production, and changes in governmental regulations or taxes. At December 31, 2011 , approximately 29% of the discounted present value of our estimated net proved reserves consisted of PUDs. PUDs represented 56% of total proved reserves by volume, and approximately 26% of our PUDs were attributable to our deepwater properties. Recovery of undeveloped reserves generally requires significant capital expenditures and successful drilling operations. Our reserve estimates include the assumption that we will make significant capital expenditures to develop these undeveloped reserves and the actual costs, development schedule, and results associated with these properties may not be as estimated. In addition, the 10% discount factor that we use to calculate the net present value of future net revenues and cash flows may not necessarily be the most appropriate discount factor based on our cost of capital in effect from time to time and the risks associated with our business and the oil and gas industry in general. +Information about reserves constitutes forward-looking information. See “Forward-Looking Statements” for information regarding forward-looking information. +Unless we are able to replace reserves that we have produced, our cash flows and production will decrease over time. The +21 +Table of Contents +high-rate production characteristics of our Gulf of Mexico properties subject us to high reserve replacement needs. In general, the volume of production from oil and natural gas properties declines as reserves are depleted. The decline rates depend on reservoir characteristics. Gulf of Mexico reservoirs tend to be recovered quickly through production with associated steep declines, while declines in other regions after initial flush production tend to be relatively low. Our Gulf of Mexico, deepwater properties accounted for approximately 45% of our production during 2011 and 35% of our estimated proved reserves at December 31, 2011 . Similarly, our Gulf of Mexico shelf properties accounted for approximately 30% of our production during 2011 and 4% of our estimated proved reserves at December 31, 2011 . Our reserves will decline as they are produced unless we acquire properties with proved reserves or conduct successful development and exploration drilling activities. Our future natural gas and oil production is highly dependent upon our level of success in finding or acquiring additional reserves at a unit cost that is sustainable at prevailing commodity prices. Without successful exploration or acquisition activities, our reserves, production and revenues will decline. +Exploring for, developing, or acquiring reserves is capital intensive and uncertain. We may not be able to economically find, develop, or acquire additional reserves, or may not be able to make the necessary capital investments if our cash flows from operations decline or external sources of capital become limited or unavailable. As part of our exploration and development operations, we have expanded, and expect to further expand, the application of horizontal drilling and multi-stage hydraulic fracture stimulation techniques. The utilization of these techniques requires substantially greater capital expenditures, currently expected to be in excess of three times the cost, as compared to the drilling of a traditional vertical well. The incremental capital expenditures are the result of greater measured depths and additional hydraulic fracture stages in horizontal wellbores. We cannot assure you that our future exploitation, exploration, development, and acquisition activities will result in additional proved reserves or that we will be able to drill productive wells at acceptable costs. We cannot assure you that we will be able to find and develop or acquire additional reserves at an acceptable cost. +The unavailability or high cost of drilling rigs, pressure pumping equipment and crews, other equipment, supplies, water, personnel and oil field services could adversely affect our ability to execute our exploration and development plans on a timely basis and within our budget. Our industry is cyclical and, from time to time, there is a shortage of drilling rigs, equipment, supplies, water or qualified personnel. There is currently a shortage of pressure pumping equipment and crews, primarily within our Permian Basin area of operation. During these periods, the costs and delivery times of rigs, equipment and supplies are substantially greater. In addition, the demand for, and wage rates of, qualified drilling rig crews rise as the number of active rigs in service increases. Increasing levels of exploration and production may increase the demand for oilfield services and equipment, and the costs of these services and equipment may increase, while the quality of these services and equipment may suffer. The unavailability or high cost of drilling rigs, pressure pumping equipment, supplies or qualified personnel can materially and adversely affect our operations and profitability. +A significant part of the value of our production and reserves is concentrated in a small number of offshore properties, and any production problems or inaccuracies in reserve estimates related to those properties would adversely impact our business. During 2011 , approximately 63% of our daily production came from four of our properties in the Gulf of Mexico. Moreover, one property accounted for 35% of our production during this period. In addition, at December 31, 2011 , approximately 35% of our total net proved reserves were located in two fields in the Gulf of Mexico. If mechanical problems, storms or other events curtailed a substantial portion of this production or if the actual reserves associated with any one of these producing properties are less than our estimated reserves, our results of operations and financial condition could be adversely affected. +Our exploration projects increase the risks inherent in our oil and natural gas activities. We may seek to replace reserves through exploration, where the risks are greater than in acquisitions and development drilling. During early 2012, we purchased 14,470 net acres in the northern portion of the Midland basin, an area that has seen only limited development activity. We expect to conduct substantial exploration of this acreage over the next several years. Although we have been successful in exploration in the past, we cannot assure you that we will continue to increase reserves through exploration or at an acceptable cost. Additionally, we are often uncertain as to the future costs and timing of drilling, completing and producing wells. Our exploration drilling operations may be curtailed, delayed or canceled as a result of a variety of factors, including: +• +receipt of additional seismic data or other geophysical data or the reprocessing of existing data; +• +material changes in oil or natural gas prices; +• +the costs and availability of drilling rigs; +• +the success or failure of wells drilled in similar formations or which would use the same production facilities; +• +availability and cost of capital; +• +changes in the estimates of the costs to drill or complete wells; +• +our ability to attract other industry partners to acquire a portion of the working interest to reduce exposure to costs and drilling risks; +• +decisions of our joint working interest owners; and +22 +Table of Contents +• +changes to governmental regulations. +Our exploration and development drilling efforts and the operation of our wells may not be profitable or achieve our targeted returns. Exploration, development, drilling and production activities are subject to many risks, including the risk that commercially productive deposits will not be discovered. We may invest in property, including undeveloped leasehold acreage, which we believe will result in projects that will add value over time. However, we cannot guarantee that any leasehold acreage acquired will be profitably developed, that new wells drilled will be productive or that we will recover all or any portion of our investment in such leasehold acreage or wells. Drilling for oil and natural gas may involve unprofitable efforts, not only from dry wells but also from wells that are productive but do not produce sufficient net reserves to return a profit after deducting operating and other costs. In addition, wells that are profitable may not achieve our targeted rate of return. Our ability to achieve our target results are dependent upon the current and future market prices for oil and natural gas, costs associated with producing oil and natural gas and our ability to add reserves at an acceptable cost. +In addition, we may not be successful in controlling our drilling and production costs to improve our overall return. The cost of drilling, completing and operating a well is often uncertain and cost factors can adversely affect the economics of a project. We cannot predict the cost of drilling, and we may be forced to limit, delay or cancel drilling operations as a result of a variety of factors, including: +• +unexpected drilling conditions; +• +pressure or irregularities in formations; +• +equipment failures or accidents and shortages or delays in the availability of drilling rigs and the delivery of equipment; and +• +compliance with governmental requirements. +We may be unable to integrate successfully the operations of future acquisitions with our operations, and we may not realize all the anticipated benefits of these acquisitions. Our business may include producing property acquisitions that would include undeveloped acreage. We can offer no assurance that we will achieve the desired profitability from any acquisitions we may complete in the future. In addition, failure to assimilate recent and future acquisitions successfully could adversely affect our financial condition and results of operations. +Our acquisitions may involve numerous risks, including: +• +operating a larger combined organization and adding operations; +• +difficulties in the assimilation of the assets and operations of the acquired business, especially if the assets acquired are in a new business segment or geographic area; +• +risk that oil and natural gas reserves acquired may not be of the anticipated magnitude or may not be developed as anticipated; +• +loss of significant key employees from the acquired business: +• +diversion of management's attention from other business concerns; +• +failure to realize expected profitability or growth; +• +failure to realize expected synergies and cost savings; +• +coordinating geographically disparate organizations, systems and facilities; and +• +coordinating or consolidating corporate and administrative functions. +Further, unexpected costs and challenges may arise whenever businesses with different operations or management are combined, and we may experience unanticipated delays in realizing the benefits of an acquisition. If we consummate any future acquisition, our capitalization and results of operation may change significantly, and you may not have the opportunity to evaluate the economic, financial and other relevant information that we will consider in evaluating future acquisitions. +We may fail to fully identify problems with any properties we acquire, and as such, assets we acquire may prove to be worth less than we paid because of uncertainties in evaluating recoverable reserves and potential liabilities. We are actively seeking to acquire additional acreage in Texas or other regions in the future. Successful acquisitions require an assessment of a number of factors, including estimates of recoverable reserves, exploration potential, future oil and natural gas prices, operating and capital costs and potential environmental and other liabilities. Although we conduct a review of properties we acquire which we believe is consistent with industry practices, we can give no assurance that we have identified or will identify all existing or potential problems associated with such properties or that we will be able to mitigate any problems we do identify. Such assessments are inexact and their accuracy is inherently uncertain. In addition, our review may not permit us to become sufficiently familiar with the properties to fully assess their deficiencies and capabilities. We do not inspect every well. Even when we inspect a well, we do not always discover structural, subsurface and environmental problems that may exist or arise. We are generally not entitled to contractual indemnification for preclosing liabilities, including environmental liabilities. Normally, we acquire interests in +23 +Table of Contents +properties on an “as is” basis with limited remedies for breaches of representations and warranties. As a result of these factors, we may not be able to acquire oil and natural gas properties that contain economically recoverable reserves or be able to complete such acquisitions on acceptable terms. +There is competition for available oil and natural gas properties. Our competitors include major oil and gas companies, independent oil and gas companies and financial buyers. Some of our competitors may have greater and more diverse resources than we do. High commodity prices and stiff competition for acquisitions have in the past, and may in the future, significantly increase the cost of available properties. The increased competition and rising prices for available properties could limit or impede our ability to identify acquisition opportunities that are economic for a company our size and that are necessary to grow our reserves or replace reserves produced. +We do not operate all of our properties, and have limited influence over the operations of some of these properties, particularly our two deepwater properties. Our lack of control could result in the following: +• +the operator may initiate exploration or development at a faster or slower pace than we prefer or that we anticipate in preparing our reserve estimates; +• +the operator may propose to drill more wells or build more facilities on a project than we have funds for or that we deem appropriate, which may mean that we are unable to participate in the project or share in the revenues generated by the project even though we paid our share of exploration costs; and +• +if an operator refuses to initiate a project, we may be unable to pursue the project. +Any of these events could materially impact the value of our non-operated properties. +Weather, unexpected subsurface conditions, and other unforeseen operating hazards may adversely impact our ability to conduct business. There are many operating hazards in exploring for and producing oil and natural gas, including: +• +our drilling operations may encounter unexpected formations or pressures, which could cause damage to equipment or personal injury; +• +we may experience equipment failures which curtail or stop production; +• +we could experience blowouts or other damages to the productive formations that may require a well to be re-drilled or other corrective action to be taken; +• +hurricanes, storms and other weather conditions could cause damages to our production facilities or wells. +Because of these or other events, we could experience environmental hazards, including release of oil and natural gas from spills, natural gas-leaks, accidental leakage of toxic or hazardous materials, such as petroleum liquids, drilling fluids or fracturing fluids, including chemical additives, underground migration, and ruptures. +If we experience any of these problems, it could affect well bores, platforms, gathering systems and processing facilities, which could adversely affect our ability to conduct operations. We could also incur substantial losses in excess of our insurance coverage as a result of: +• +injury or loss of life; +• +severe damage to and destruction of property, natural resources and equipment; +• +pollution and other environmental damage; +• +clean-up responsibilities; +• +regulatory investigation and penalties; +• +suspension of our operations; and +• +repairs to resume operations. +Offshore operations are also subject to a variety of additional operating risks peculiar to the marine environment, such as capsizing, collisions and damage or loss from hurricanes or other adverse weather conditions. These conditions can cause substantial damage to facilities and interrupt production. As a result, we could incur substantial liabilities that could reduce or eliminate the funds available for development or leasehold acquisitions, or result in loss of equipment and properties. +We engage third parties to provide hydraulic fracturing or other well stimulation services to us in connection with the wells for which we are the operator. Contamination of groundwater by oil and natural gas drilling, production, and related operations may result in fines, penalties, and remediation costs, among other sanctions and liabilities under federal and state laws. In addition, third party claims may be filed by landowners and other parties claiming damages for alternative water supplies, property damages, +24 +Table of Contents +and bodily injury. In March 2010, the EPA announced that it would conduct a wide-ranging study on the effects of hydraulic fracturing on drinking water resources. Interim results of the study are expected in 2012, with final results expected in 2014. The agency also announced that one of its enforcement initiatives for 2011 to 2013 would be to focus on environmental compliance by the energy extraction sector. This study and enforcement initiative, could result in additional regulatory scrutiny that could make it difficult to perform hydraulic fracturing and increase our costs of compliance and doing business. +We cannot assure you that we will be able to maintain adequate insurance at rates we consider reasonable to cover our possible losses from operating hazards. The occurrence of a significant event not fully insured or indemnified against could materially and adversely affect our financial condition and results of operations. +Factors beyond our control affect our ability to market production and our financial results. The ability to market oil and natural gas from our wells depends upon numerous factors beyond our control. These factors could negatively affect our ability to market all of the oil or natural gas we produce. In addition, we may be unable to obtain favorable prices for the oil and natural gas we produce. These factors include: +• +the extent of domestic production and imports of oil and natural gas; +• +the proximity of the natural gas production to natural gas and NGL pipelines; +• +the availability of pipeline capacity; +• +the demand for oil and natural gas by utilities and other end users; +• +the availability of alternative fuel sources; +• +the effects of inclement weather; +• +state and federal regulation of oil and natural gas marketing; and +• +federal regulation of natural gas sold or transported in interstate commerce. +In particular, in areas with increasing non-conventional shale drilling activity, capacity may be limited and it may be necessary for new interstate and intrastate pipelines and gathering systems to be built. +Part of our strategy involves drilling in new or emerging shale formations using horizontal drilling and completion techniques. The results of our planned drilling program in these formations may be subject to more uncertainties than conventional drilling programs in more established formations and may not meet our expectations for reserves or production. The results of our drilling in new or emerging formations, such as the Haynesville Shale and Permian Basin Wolfcamp formation, are generally more uncertain than drilling results in areas that are developed and have established production. Because new or emerging formations have limited or no production history, we are less able to use past drilling results in those areas to help predict our future drilling results. Further, part of our drilling strategy to maximize recoveries from the Haynesville Shale involves the drilling of horizontal wells using completion techniques that have proven to be successful in other shale formations. We also plan to begin horizontal drilling in our Permian Basin properties in 2012. Our experience with horizontal drilling in the Haynesville Shale, as well as the industry's drilling and production history, while growing, is limited. The ultimate success of these drilling and completion strategies and techniques will be better evaluated over time as more wells are drilled and production profiles are better established. Further, access to adequate gathering systems or pipeline takeaway capacity and the availability of drilling rigs and other services may be more challenging in new or emerging areas. If our drilling results are less than anticipated or we are unable to execute our drilling program because of capital constraints, access to gathering systems and takeaway capacity or otherwise, and/or natural gas and oil prices decline, our investment in these areas may not be as attractive as we anticipate and we could incur material writedowns of unevaluated properties and the value of our undeveloped acreage could decline in the future. +The loss of key personnel could adversely affect our ability to operate. We depend, and will continue to depend in the foreseeable future, on the services of our senior officers and other key employees, as well as other third-party consultants with extensive experience and expertise in evaluating and analyzing drilling prospects and producing oil and natural gas from proved properties and maximizing production from oil and natural gas properties. Our ability to retain our senior officers, other key employees and our third party consultants, none of whom are subject to employment agreements, is important to our future success and growth. The unexpected loss of the services of one or more of these individuals could have a detrimental effect on our business. +We may not be insured against all of the operating risks to which our business in exposed. In accordance with industry practice, we maintain insurance against some, but not all, of the operating risks to which our business is exposed. We cannot assure you that our insurance will be adequate to cover losses or liabilities. We experienced Gulf of Mexico production interruption in 2005, 2006 and 2007 from Hurricanes Katrina and Rita and in 2008 and 2009 from Hurricanes Gustav and Ike for which we had no production interruption insurance. Also, we cannot predict the continued availability of insurance at premium levels that justify its purchase. No assurance can be given that we will be able to maintain insurance in the future at rates we consider reasonable +25 +Table of Contents +and may elect none or minimal insurance coverage. The occurrence of a significant event, not fully insured or indemnified against, could have a material adverse affect on our financial condition and operations. +Competitive industry conditions may negatively affect our ability to conduct operations. We compete with numerous other companies in virtually all facets of our business. Our competitors in development, exploration, acquisitions and production include major integrated oil and gas companies as well as numerous independents, including many that have significantly greater resources. Therefore, competitors may be able to pay more for desirable leases and evaluate, bid for and purchase a greater number of properties or prospects than our financial or personnel resources permit. We also compete for the materials, equipment and services that are necessary for the exploration, development and operation of our properties. Our ability to increase reserves in the future will be dependent on our ability to select and acquire suitable prospects for future exploration and development. Factors that affect our ability to compete in the marketplace include: +• +our access to the capital necessary to drill wells and acquire properties; +• +our ability to acquire and analyze seismic, geological and other information relating to a property; +• +our ability to retain the personnel necessary to properly evaluate seismic and other information relating to a property; +• +our ability to procure materials, equipment and services required to explore, develop and operate our properties, including the ability to procure fracture stimulation services on wells drilled; and +• +our ability to access pipelines, and the location of facilities used to produce and transport oil and natural gas production. +Current or proposed financial legislation and rulemaking could have an adverse effect on our ability to use derivative instruments to reduce the effect of commodity price, interest rate and other risks associated with our business. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), which was signed into law on July 21, 2010, establishes, among other provisions, federal oversight and regulation of the over-the-counter derivatives market and entities that participate in that market. The Commodities Futures Trading Commission (the "CFTC") is required to implement rules relating to these activities by July 16, 2012. On October 18, 2011, the CFTC approved regulations to set position limits for certain futures and option contracts in the major energy markets, which regulations are presently being challenged in federal court by the Securities Industry Financial Markets Association and the International Swaps and Derivatives Association. The Dodd-Frank Act may also require us to comply with margin requirements and with certain clearing and trade execution requirements in our derivative activities, although the application of those provisions to us is uncertain at this time. The financial reform legislation may also require the counterparties to our derivative instruments to spin off some of their derivatives activities to separate entities, which may not be as creditworthy as the current counterparties. The schedule for promulgation of final rules has changed repeatedly, but the current schedule published by the Commodities Futures Trading Commission contemplates finishing final regulations in 2012. +The Dodd-Frank Act and any new regulations could significantly increase the cost of derivative contracts (including through requirements to post collateral, which could adversely affect our available liquidity), materially alter the terms of derivative contracts, reduce the availability of derivatives to protect against risks we encounter, reduce our ability to monetize or restructure our existing derivative contracts, and increase our exposure to less creditworthy counterparties. If we reduce our use of derivatives as a result of the Dodd-Frank Act and regulations, our results of operations may become more volatile and our cash flows may be less predictable, which could adversely affect our ability to plan for and fund capital expenditures. Finally, the Dodd-Frank Act was intended, in part, to reduce the volatility of oil and gas prices, which some legislators attributed to speculative trading in derivatives and commodity instruments related to oil and gas. Our revenues could therefore be adversely affected if a consequence of the Dodd-Frank Act and regulations is to lower commodity prices. Any of these consequences could have a material adverse effect on our consolidated financial position, results of operations and cash flows. +We may not have production to offset hedges; by hedging, we may not benefit from price increases. Part of our business strategy is to reduce our exposure to the volatility of oil and natural gas prices by hedging a portion of our production. In a typical hedge transaction, we will have the right to receive from the other parties to the hedge the excess of the fixed price specified in the hedge over a floating price based on a market index, multiplied by the quantity hedged. If the floating price exceeds the fixed price, we are required to pay the other parties this difference multiplied by the quantity hedged. Additionally, we are required to pay the difference between the floating price and the fixed price when the floating price exceeds the fixed price regardless of whether we have sufficient production to cover the quantities specified in the hedge. Significant reductions in production at times when the floating price exceeds the fixed price could require us to make payments under the hedge agreements even though such payments are not offset by sales of production. Hedging will also prevent us from receiving the full advantage of increases in oil or natural gas prices above the fixed amount specified in the hedge. +We also enter into price “collars” to reduce the risk of changes in oil and natural gas prices. Under a collar, no payments are due by either party so long as the market price is above a floor set in the collar and below a ceiling. If the price falls below the floor, the counter-party to the collar pays the difference to us and if the price is above the ceiling, we pay the counter-party the difference. Another type of hedging contract we have entered into is a put contract. Under a put, if the price falls below the set floor price, +26 +Table of Contents +the counter-party to the contract pays the difference to us. See “Quantitative and Qualitative Disclosures About Market Risks” for a discussion of our hedging practices. +Compliance with environmental and other government regulations could be costly and could negatively impact production. Our operations are subject to numerous laws and regulations governing the operation and maintenance of our facilities and the discharge of materials into the environment or otherwise relating to environmental protection. For a discussion of the material regulations applicable to us, see “Regulations.” These laws and regulations may: +• +require that we acquire permits before commencing drilling; +• +impose operational, emissions control and other conditions on our activities; +• +restrict the substances that can be released into the environment in connection with drilling and production activities; +• +limit or prohibit drilling activities on protected areas such as wetlands, wilderness areas or coral reefs; and +• +require measures to remediate or mitigate pollution and environmental impacts from current and former operations, such as cleaning up spills or dismantling abandoned production facilities. +Under these laws and regulations, we could be liable for costs of investigation, removal and remediation, damages to and loss of use of natural resources, loss of profits or impairment of earning capacity, property damages, costs of and increased public services, as well as administrative, civil and criminal fines and penalties, and injunctive relief. We could also be affected by more stringent laws and regulations adopted in the future, including any related climate change, greenhouse gases and hydraulic fracturing. Under the common law, we could be liable for injuries to people and property. We maintain limited insurance coverage for sudden and accidental environmental damages. We do not believe that insurance coverage for environmental damages that occur over time is available at a reasonable cost. Also, we do not believe that insurance coverage for the full potential liability that could be caused by sudden and accidental environmental damages is available at a reasonable cost. Accordingly, we may be subject to liability or we may be required to cease production from properties in the event of environmental incidents. +Climate change legislation or regulations restricting emissions of “greenhouse gasses” could result in increased operating costs and reduced demand for the oil and natural gas we produce. The EPA has adopted its so-called "GHG tailoring rule" that will phase in federal PSD permit requirements for greenhouse gas emissions from new sources and modification of existing sources, federal Title V operating permit requirements for all sources, based upon their potential to emit specific quantities of GHGs. These permitting provisions to the extent applicable to our operations could require us to implement emission controls or other measures to reduce GHG emissions and we could incur additional costs to satisfy those requirements. +In addition, on October 30, 2009, the EPA published a final rule requiring the reporting of greenhouse gas emissions from specified large greenhouse gas emission sources in the United States beginning in 2011 for emissions occurring in 2010. On November 30, 2010, the EPA published its amendments to the greenhouse gas reporting rule to include onshore and offshore oil and natural gas production facilities and onshore oil and natural gas processing, transmission, storage and distribution facilities, which may include facilities we operate. Reporting of greenhouse gas emissions from such facilities will be required on an annual basis beginning in 2012 for emissions occurring in 2011. We will have to incur costs associated with this reporting obligation. +In addition, the United States Congress has considered legislation to reduce emissions of GHGs and many states have already taken legal measures to reduce or measure GHG emissions often involving the planned development of GHG emission inventories and/or regional cap and trade programs. Most of these cap and trade programs would require major sources of emissions or major producers of fuels to acquire and surrender emission allowances. The number of allowances available for purchase is reduced each year in an effort to achieve the overall GHG emission reduction goal. These allowances would be expected to escalate significantly in cost over time. The adoption and implementation of any legislation or regulatory programs imposing GHG reporting obligations on, or limiting emissions of GHGs from, our equipment and operations could require us to incur costs to reduce emissions of GHGS associated with our operations or could adversely affect demand for the oil and natural gas that we produce. +Significant physical effects of climatic change have the potential to damage our facilities, disrupt our production activities and cause us to incur significant costs in preparing for or responding to those effects. In an interpretative guidance on climate change disclosures, the SEC indicates that climate change could have an effect on the severity of weather (including hurricanes and floods), sea levels, the arability of farmland, and water availability and quality. If such effects were to occur, our exploration and production operations have the potential to be adversely affected. Potential adverse effects could include damages to our facilities from powerful winds or rising waters in low-lying areas, disruption of our production activities either because of climate-related damages to our facilities in our costs of operation potentially arising from such climatic effects, less efficient or non-routine operating practices necessitated by climate effects or increased costs for insurance coverages in the aftermath of such effects. Significant physical effects of climate change could also have an indirect affect on our financing and operations by disrupting the transportation or process-related services provided by midstream companies, service companies or suppliers with whom we have +27 +Table of Contents +a business relationship. We may not be able to recover through insurance some or any of the damages, losses or costs that may result from potential physical effects of climate change. In addition, our hydraulic fracturing operations require large amounts of water. Should drought conditions occur, our ability to obtain water in sufficient quality and quantity could be impacted and in turn, our ability to perform hydraulic fracturing operations could be restricted or made more costly. +Federal legislation and state legislative and regulatory initiatives relating to hydraulic fracturing could result in increased costs and additional operating restrictions or delays. Hydraulic fracturing is used to stimulate production of hydrocarbons, particularly natural gas, from tight formations. The process involves the injection of water, sand and chemicals under pressure into formations to fracture the surrounding rock and stimulate production. The process is typically regulated by state oil and gas commissions but is not subject to regulation at the federal level (except for fracturing activity involving the use of diesel). The EPA has commenced a study of the potential environmental impacts of hydraulic fracturing activities, with results of the study anticipated to be available by late 2012, and final results anticipated in 2014. In addition, in December 2011, the EPA published an unrelated draft report concluding that hydraulic fracturing caused groundwater pollution in a natural gas field in Wyoming; this study remains subject to review and public comment. A committee of the U.S. House of Representatives is also conducting an investigation of hydraulic fracturing practices. Legislation was introduced before Congress to provide for federal regulation of hydraulic fracturing and to require disclosure of the chemicals used in the fracturing process. In addition, some states have adopted, and other states are considering adopting, regulations that could restrict hydraulic fracturing in certain circumstances. For example, New York has imposed a de facto moratorium on the issuance of permits for high-volume, horizontal hydraulic fracturing until state-administered environmental studies are finalized. Further, Pennsylvania has adopted a variety of regulations limiting how and where fracturing can be performed. While we have no operations in either New York or Pennsylvania, any other new laws or regulations that significantly restrict hydraulic fracturing in areas in which we do operate could make it more difficult or costly for us to perform hydraulic fracturing activities and thereby affect the determination of whether a well is commercially viable. Further, EPA has announced an initiative under TSCA to develop regulations governing the disclosure and evaluation of hydraulic fracturing chemicals. In addition, if hydraulic fracturing is regulated at the federal level, our fracturing activities could become subject to additional permit requirements or operational restrictions and also to associated permitting delays and potential increases in costs. Such federal or state legislation could require the disclosure of chemical constituents used in the fracturing process to state or federal regulatory authorities who could then make such information publicly available. In addition, restrictions on hydraulic fracturing could reduce the amount of oil and natural gas that we are ultimately able to produce in commercial quantities. +Certain U.S. federal income tax preferences currently available with respect to oil and natural gas production may be eliminated as a result of future legislation. In recent years, the Obama administration's budget proposals and other proposed legislation have included the elimination of certain key U.S. federal income tax incentives currently available to oil and gas exploration and production. If enacted into law, these proposals would eliminate certain tax preferences applicable to taxpayers engaged in the exploration or production of natural resources. These changes include, but are not limited to (i) the repeal of the percentage depletion allowance for oil and gas properties, (ii) the elimination of current deductions for intangible drilling and development costs, (iii) the elimination of the deduction for U.S. production activities and (iv) the increase in the amortization period from two years to seven years for geophysical costs paid or incurred in connection with the exploration for or development of, oil and gas within the United States. It is unclear whether any such changes will be enacted or how soon any such changes would become effective. The passage of any legislation as a result of these proposals or any other similar changes in U.S. federal income tax laws could negatively affect the Company's financial condition and results of operations. +There are inherent limitations in all control systems, and misstatements due to error or fraud that could seriously harm our business may occur and not be detected. Our management, including our Chief Executive Officer and Chief Financial Officer, do not expect that our internal controls and disclosure controls will prevent all possible error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. In addition, the design of a control system must reflect the fact that there are resource constraints and the benefit of controls must be relative to their costs. Because of the inherent limitations in all control systems, an evaluation of controls can only provide reasonable assurance that all material control issues and instances of fraud, if any, in our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Further, controls can be circumvented by the individual acts of some persons or by collusion of two or more persons. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. A failure of our controls and procedures to detect error or fraud could seriously harm our business and results of operations. +ITEM 1B. Unresolved Staff Comments +None. +28 +Table of Contents +ITEM 3. Legal Proceedings +We are a defendant in various legal proceedings and claims, which arise in the ordinary course of our business. We do not believe the ultimate resolution of any such actions will have a material effect on our financial position or results of operations. +ITEM 4. Mine Safety Disclosures +Not applicable. +PART II. +ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +The Company’s common stock trades on the New York Stock Exchange under the symbol "CPE". The following table sets forth the high and low sale prices per share as reported for the periods indicated. +Stock Price +2011 +High +Low +First quarter +ended +March 31 2011 +$ +9.36 +$ +5.81 +Second quarter +ended +June 30 2011 +8.04 +5.93 +Third quarter +ended +September 30 2011 +7.73 +3.79 +Fourth quarter +ended +December 31 2011 +5.99 +3.02 +2010 +First quarter +ended +March 31 2010 +$ +5.90 +$ +1.40 +Second quarter +ended +June 30 2010 +8.80 +4.46 +Third quarter +ended +September 30 2010 +6.72 +3.54 +Fourth quarter +ended +December 31 2010 +6.39 +4.45 +As of March 1, 2012 the Company had approximately 3,322 common stockholders of record. +The Company has never paid dividends on its common stock, and intends to retain its cash flow from operations for the future operation and development of its business. In addition, the Company’s credit facility and the terms of our outstanding debt prohibit the payment of cash dividends on our common stock. +During the fourth quarter of 2011 , neither the Company nor any affiliated purchasers made repurchases of Callon’s equity securities. +Equity Compensation Plan Information +The following table summarizes information regarding the number of shares of our common stock that are available for issuance under all of our existing equity compensation plans as of December 31, 2011 (securities amounts are presented in thousands). +Outstanding Options +Plan Category +Number of securities to be issued upon exercise of outstanding options +Weighted-average exercise price of outstanding options +Number of securities remaining available for future issuance under equity compensation plans +Equity compensation plans approved by security holders +99 +$ +10.34 +2,349 +Equity compensation plans not approved by security holders +74 +6.44 +— +Total +173 +8.66 +2,349 +For additional information regarding the Company’s benefit plans and share-based compensation expense, see Notes 9 and 10 to the Consolidated Financial Statements. +29 +Table of Contents +Performance Graph +The following graph compares the yearly percentage change for the five years ended December 31, 2011 , in the cumulative total shareholder return on the Company’s common stock against the cumulative total return for the following: +• +the Morningstar Group Index consisting of independent oil and gas drilling and exploration companies; and +• +the New York Stock Exchange Market Index. +Company/Market/Peer Group +12/31/2006 +12/31/2007 +12/31/2008 +12/31/2009 +12/31/2010 +12/31/2011 +Callon Petroleum Company +$ +100.00 +$ +109.45 +$ +17.30 +$ +9.98 +$ +39.39 +$ +33.07 +NYSE Composite Index +$ +100.00 +$ +109.14 +$ +66.42 +$ +85.40 +$ +97.02 +$ +93.46 +Morningstar Group Index +$ +100.00 +$ +140.25 +$ +55.41 +$ +99.97 +$ +104.51 +$ +90.66 +ITEM 6. Selected Financial Data +The following table sets forth, as of the dates and for the periods indicated, selected financial information about us. The financial information for each of the five years in the period ended December 31, 2011 has been derived from our audited Consolidated Financial Statements for such periods. The information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto. The following information is not necessarily indicative of our future results. The information included in this table for the year ended December 31, 2009 include the effects of corrections on the previously reported financial statements, as further discussed in Note 1 to the Consolidated Financial Statements included in Part II, Item 8 of this filing. +30 +Table of Contents +For the year ended December 31, +2011 +2010 +2009 +2008 +2007 +Restated +Statement of Operations Data: +(In thousands, except per share amounts) +Operating revenues: +Oil and natural gas sales +$ +127,644 +$ +89,882 +$ +101,259 +$ +141,312 +$ +170,768 +Medusa BOEM royalty recoupment +— +— +40,886 +— +— +Total operating revenues +$ +127,644 +$ +89,882 +$ +142,145 +$ +141,312 +$ +170,768 +Operating expenses: +Non-impairment related operating expenses +$ +88,022 +$ +68,703 +$ +68,692 +$ +97,497 +$ +114,418 +Impairment of oil and gas properties +— +— +— +485,498 +— +Total operating expenses +$ +88,022 +$ +68,703 +$ +68,692 +$ +582,995 +$ +114,418 +Income (loss) from continuing operations +39,622 +21,179 +73,453 +(441,683 +) +56,350 +Net income (loss) (a) +104,149 +8,386 +46,796 +(438,893 +) +15,194 +Earnings (loss) per share ("EPS"): +Basic +$ +2.75 +$ +0.29 +$ +2.12 +$ +(20.68 +) +$ +0.73 +Diluted +$ +2.70 +$ +0.28 +$ +2.11 +$ +(20.68 +) +$ +0.71 +Weighted average number of shares outstanding for Basic EPS +37,908 +28,817 +22,072 +21,222 +20,776 +Weighted average number of shares outstanding for Diluted EPS +38,582 +29,476 +22,200 +21,222 +21,290 +Statement of Operations Data: +Net cash provided by operating activities +$ +79,167 +$ +100,102 +$ +19,698 +$ +89,054 +$ +109,283 +Net cash used in investing activities +(91,511 +) +(59,738 +) +(43,189 +) +(4,511 +) +(215,791 +) +Net cash provided by (used in) financing activities +38,703 +(26,252 +) +10,000 +(120,667 +) +(157,862 +) +Balance Sheet Data: +Oil and natural gas properties, net +$ +215,912 +$ +168,868 +$ +130,608 +$ +159,252 +$ +681,706 +Total assets +367,460 +218,326 +227,991 +266,090 +792,482 +Long-term debt (b) +125,345 +165,504 +179,174 +272,855 +392,012 +Stockholder' equity (deficit) +198,955 +15,810 +(80,854 +) +(129,804 +) +287,075 +Proved Reserves Data: +Total oil (MMBbls) +10,075 +8,149 +6,479 +6,027 +24,531 +Total natural gas (MMcf) +35,118 +32,957 +19,103 +18,652 +116,454 +Total proved reserves (MBoe) +15,928 +13,641 +9,663 +9,136 +43,940 +Standardized measure +$ +270,357 +$ +198,916 +$ +135,921 +$ +86,305 +$ +1,133,989 +(a) +2011 net income includes $67.0 million of income tax benefit related to the reversal of the Company's deferred tax asset valuation allowance. See Note 12 for additional information. +(b) +2011 and 2010 long-term debt includes a non-cash deferred credit of $18,384 and $27,543 , respectively that will be amortized into earnings as a reduction to interest expense over the life of the 13% Senior Notes due 2016. See Note 6 for additional information. +(c) +Following the decisions resulting from several court cases brought by another oil and gas company, the court ruled that the BOEM was not entitled to receive these royalty payments. The amount above reflects royalty recoupments for production from the fields 2003 inception through December 31, 2008, which were accrued at December 31, 2009 and paid by the BOEM during 2010. See Note 16 for additional information. +We follow the full-cost method of accounting for oil and gas properties. Under this method of accounting, our net capitalized costs to acquire, explore and develop oil and gas properties may not exceed the sum of (1) the estimated future net revenues from proved reserves using a 12-month pricing average discounted at 10% and (2) the lower of cost or market of unevaluated properties, net of tax (the full-cost ceiling amount). If these capitalized costs exceed the full-cost ceiling amount, the excess is charged to expense. For the year ended December 31, 2008, the Company recorded a $485.5 million impairment of oil and gas properties +31 +Table of Contents +as a result of the ceiling test. See Notes 2 and 13 to the Consolidated Financial Statements for a description of the relevant accounting policy and the Company’s oil and gas properties disclosures, respectively. +ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +General +The following management’s discussion and analysis is intended to assist in understanding the principal factors affecting the Company’s results of operations, liquidity, capital resources and contractual cash obligations. This discussion should be read in conjunction with the accompanying audited consolidated financial statements, information about our business practices, significant accounting policies, risk factors, and the transactions that underlie our financial results, which are included in various parts of this filing. +We have been engaged in the exploration, development, acquisition and production of oil and gas properties since 1950. In 2009, we began to shift our operational focus from exploration in the Gulf of Mexico to building an onshore asset portfolio in order to provide a multi-year, low-risk drilling program in both oil and natural gas basins. This onshore transition has been, and is expected to continue to be, primarily funded by reinvesting the cash flows from our Gulf of Mexico properties. +Well count information is presented gross unless otherwise indicated. +Overview and Outlook +During 2011 , Callon had net income and fully diluted earnings per share of $104.1 million and $2.70 , respectively, compared to net income of $8.4 million and fully diluted earnings per share of $0.28 , respectively for 2010 . Net income during 2011 includes an income tax benefit of $67.0 million , primarily related to the full reversal of the valuation allowance we previously recorded against our deferred tax assets (see Note 12 for additional information). The Company’s earnings, and the drivers of these earnings, are discussed in greater detail within the “Results of Operations” section included below. +Also during 2011 , Callon replaced 224% of production volumes for the year and increased proved reserves by approximately 2.3 MMBoe, or 17% , net of current-year production. We further diversified our net proved reserves with nearly 61% on a MMBoe basis now being located onshore as of December 31, 2011 vs. 50% at December 31, 2010 . Further, compared to the prior year, Callon increased Permian Basin oil production by 143% , from a combination of drilling 36 additional vertical wells, of which 23 were placed on production during 2011 , and due to eight wells that were drilled during 2010 and placed onto production during 2011 . +We made significant progress during 2011 towards our goal of strengthening our financial position and improving our liquidity, which better positions Callon for future growth. Significant financial achievements include: +• +Reported an income tax benefit of $67.0 million primarily from the reversal of the valuation allowance previously recorded against our net deferred tax assets. As a result of reporting net income from 2009 to 2011, we achieved income on an aggregate basis for the three-year period ended December 31, 2011. Additionally we expect to generate sufficient taxable income necessary to fully utilize all of the deferred tax assets prior to their expiration. +• +Completed a public offering of 10.1 million shares during February 2011 for which the Company received $73.8 million in net proceeds. While approximately 47% of the proceeds were used to reduce the Company's debt outstanding, the remaining proceeds were available primarily for general corporate purposes and to fund the Company's acquisition and development activities in the Permian Basin. +• +Redeemed $31 million aggregate principal amount of our Senior Notes during March 2011, resulting in a net gain on the early extinguishment of debt of approximately $2.0 million. This redemption reduced the principal of the Company's debt outstanding by approximately 22% to $107 million, reduced 2011 interest expense by approximately $3.2 million and will reduce each prospective full year interest expense by $4.0 million through the Senior Notes' maturity in 2016. +• +Increased the borrowing base under our credit facility with Regions Bank to $45 million, representing a $15 million or 50% increase over the previously approved $30 million borrowing base and simultaneously received a reduction in the credit facility's minimum interest rate from 6% to 3%. +• +Increased cash flows related to higher production from our Permian Basin properties. Our Permian production rate has increased approximately 143% since December 31, 2010 to a 2011 exit rate of approximately 1,335 net Boe/d compared +32 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +to a 2010 exit rate of 550 Boe/d. +• +Executed an agreement with our former joint interest partner to complete the wind-down of the Company's previously abandoned deepwater Entrada Project. Through the agreement, the Company acquired rights to the remaining, unsold assets from the project. Upon recording these assets in the Company's consolidated financial statements, we recognized a gain of $5.0 million and a related income tax benefit of $2.7 million. +Highlights of our onshore and deepwater development program include: +• +Onshore – Permian Basin +Our primary target in the Permian Basin has been the Wolfberry play, which is located on our properties in Crockett, Ector, Midland, and Upton counties, Texas, and which we believe to be a proven, low-risk oil play that includes the Sprayberry, Dean, and Wolfcamp formations. Certain of our Permian Basin properties also include the Atoka and Strawn formations. As of December 31, 2011 , we owned approximately 9,540 net acres in the Permian Basin. Following two recent acquisitions discussed below, the Company increased its ownership to approximately 24,010 net acres. +As of December 31, 2011 , approximately 48% of Callon's proved reserves were attributable to our properties in the Permian Basin. Also as of December 31, 2011 , our Permian Basin properties were producing 1,335 boe/d from 65 wells, of which 31 were placed on production (and one well taken offline) during 2011 and 35 were producing in prior years. This 2011 exit-rate production represents a 143% increase over the 2010 exit rate of 550 Boe/d producing from 35 wells. Average net production from our Permian Basin properties increased 135% to 965 Boe/d in 2011 from 411 Boe/d in 2010. +During 2011 , we invested approximately $85.3 million into our Wolfberry development program, which included drilling 36 vertical wells targeting the Wolfberry trend, of which 23 were producing prior to December 31, 2011 , seven are scheduled to be fracture stimulated in the first and second quarters of 2012 and six wells were in the process of being brought online. Throughout 2011 , Callon fractured stimulated 40 vertical wells including 35 first-time well stimulations. We expect to continue to carry an inventory of wells awaiting fracture stimulation until the service organizations in the region build the additional capacity needed to handle the region's requirements. +With respect to our 2012 capital budget, 79% will be dedicated to further developing our Permian Basin properties, and includes plans to drill up to 28 development wells including seven horizontal and 21 vertical wells. During the second quarter of 2012, we plan to commence a horizontal drilling program expected to ultimately include up to 24 wells on our southern Permian Basin properties. This drilling program was based on our ongoing evaluation of our acreage position in the East Bloxom Field, located in Upton County, TX, and recent industry drilling results in northern Upton County and western Reagan County, TX. To support our horizontal drilling program, we recently contracted a new-generation drilling rig for a term of two years that is expected to be delivered in April 2012 at a cost of approximately $9.1 million per full year. +In February 2012, we significantly expanded our Permian Basin acreage position with the acquisition of approximately 16,020 gross ( 14,470 net) acres in the northern portion of the Midland basin in Borden County. We plan to initiate a 3-D seismic survey in the first half of 2012 and subsequently commence exploratory drilling in the third quarter of 2012. Our drilling plans include three horizontal exploration wells and one vertical exploration well. +• +Onshore – Haynesville Natural Gas Shale +The Company currently holds a 69% working interest in approximately 430 net acres in the Haynesville Shale natural gas unit. Initial production from our first, and currently only, well on the property commenced in September 2010. As of December 31, 2011 , the well has produced 2.1 billion cubic feet of natural gas. Approximately 13% of our year-end 2011 proved reserves were attributable to our Haynesville Shale property. Our multi-year development plan for this property includes drilling and operating a total of seven gross (five, net) horizontal wells. We have no remaining drilling obligations in our Haynesville Shale position, and currently plan to mobilize a rig to the area once natural gas prices warrant continued development of the remaining six planned horizontal wells. +The Company's one producing Haynesville Shale natural gas well was shut-in for 35 days during the fourth quarter of 2011 due to well interference from an offsetting well. Production was restored in mid-March 2012 following a successful workover. +33 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +• +Offshore – Deepwater Properties +Our deepwater properties continue to play a key role in our transition to onshore operations by providing strong cash flows used to fund the development of our onshore properties. Together, our two deepwater properties produced approximately 840 MBoe equal to approximately 45% of the Company's total production in 2011 , and at year-end had 5.6 MMBoe of net proved reserves. Production from our deepwater properties is approximately 84% oil, which in the present market offers favorable pricing in relation to natural gas. Oil prices for production from our two deepwater fields are adjusted based upon Mars WTI differential for Medusa production and Argus Bonito WTI differential for Habanero production. +Six of our Medusa field's eight wells continue to produce from their initial completions and, as of December 31, 2011 , had an estimated 1.7 MMBoe of net PDNPs that will be accessed by recompletions in the existing wells. These up-hole recompletions in existing wellbores are expected to occur as existing completions deplete to a level that is uneconomic to justify continued production. We anticipate developing another 1.2 MMBoe of net PUDs by drilling an additional well in late 2013. Continued development plans include drilling in 2014 an additional well targeting probable reserves. +On March 29, 2011, the operator of our Medusa property successfully recompleted the A6 well from the T4-C zone to the T4-B zone (at a net cost to Callon of $0.2 million), which increased production net to Callon from approximately 80 Boe/day to approximately 850 Boe/day. As of December 31, 2011 , production from the A6 well was approximately 425 Boe/day, net. Callon has confirmed with the operator that the Medusa platform will be shut-in approximately 25 days during the second quarter of 2012 due to planned construction activities on the West Delta 143 oil pipeline, through which Medusa's production is transported. +Callon received confirmation from the operator of the Habanero Field that drilling of the #2 sidetrack well targeting up-dip PUDs will commence during the fourth quarter of 2012. In addition, Callon has been notified that the Habanero Field will be shut-in for scheduled maintenance operations on the Auger platform, which processes Habanero production volumes. As a result, the operator of the Habanero Field expects production to be offline for a total of approximately 60 days during the second and third quarters 2012. +• +Offshore – Shelf & Other Properties +We own interests in 18 producing wells in 11 oil and natural gas fields in the shelf area of the Gulf of Mexico. These wells produced 551 MBoe net to our interest in 2011 , which accounted for 30% of our total production. Production from the East Cameron Block 257 Field, which in the third quarter of 2011 contributed to our total production approximately 260 Boe/d, was suspended in the fourth quarter of 2011 due to a natural gas leak in a upstream section of the Stingray Pipeline which transports production volumes from the field. Production will re-commence once the Stingray Pipeline is brought back online, which is currently anticipated to occur before July 2012. +Liquidity and Capital Resources +Historically, our primary sources of capital have been cash flows from operations, borrowings from financial institutions and the sale of debt and equity securities. Cash and cash equivalents increased by $26.4 million during 2011 to $43.8 million compared to $17.4 million at December 31, 2010 . The increase in our cash balance is primarily attributable to higher oil prices, increased production levels and the receipt of $73.8 million from the sale of 10.1 million shares of common stock. Offsetting these increases were approximately $35 million used to repurchase $31 million principal amount of our outstanding Senior Notes and the use of cash for ongoing operations, including capital expenditures. +In January 2010, we amended our senior secured credit agreement to include Regions Bank as the sole arranger and administrative agent. The senior secured credit agreement matures on September 25, 2012, and provides for a $100 million facility with a current borrowing base of $45 million. The current borrowing base represents a $15 million, or 50%, increase over the previous $30 million borrowing base as of December 31, 2010 . Simultaneous with the May 2011 increase in the borrowing base, Regions Bank also approved a reduction in the minimum interest rate on the facility from 6% to 3%. The rate is calculated as LIBOR, with a minimum of 0.5%, plus a tiered rate ranging from 2.5% to 3.0%, which is based on the amount drawn on the facility. The senior secured credit agreement has a commitment fee of 0.5% per annum on the unused portion of the borrowing base that is payable quarterly. As of December 31, 2011 , the interest rate on the facility was 3%, though no amounts were outstanding under the facility as of that date. We continue to discuss with Regions Bank the syndication of our senior secured credit agreement, and expect any such syndication to include an extension of the maturity beyond September 25, 2012. +34 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +At December 31, 2011 , we had approximately $107 million principal amount of 13% Senior Notes due 2016 outstanding with interest payable quarterly, a $31 million decrease from amounts outstanding at December 31, 2010 following the partial redemption previously discussed. The principal reduction in our Senior Notes reduced 2011 cash interest paid by approximately $3.2 million , and will reduce cash interest paid each full-year thereafter by approximately $4.0 million . +2012 Capital Expenditures +For 2012 , we designed a flexible capital spending program, which we plan to fund from cash on hand and cash flows from operations. We believe these resources along with borrowings under our senior secured credit agreement, if needed, will be adequate to meet our capital, interest payments, and operating requirements for 2012 . However, depending on commodity prices and other economic conditions we experience in 2012 , our capital budget may be adjusted up or down. +While on a consolidated basis, inflation has not had a material impact on us, we have experienced increasing inflationary pressure in our Permian Basin operations, and we believe this trend may affect future development at our Medusa and Habanero fields. With respect to the Permian, increased demand for materials and services, including the costs associated with various down-hole drilling difficulties and other similar development costs, have exceeded our original development cost expectation. For example, drilling rig rates have increased 34% due to increased labor costs to maintain crew continuity, and the costs of fracture stimulation services and associated wireline services have increased approximately 13% during 2011 as compared to 2010. We also continue to monitor drilling rig operator efficiency, and have replaced one operator with another that we believe will improve drilling efficiency. +Our 2012 capital budget includes approximately $139 million , of which 79% is dedicated to our onshore activities. Our budget includes further exploration and development of our Permian Basin properties with plans to drill approximately 28 gross wells including seven horizontal wells and 21 vertical wells. As previously discussed, we expect to drill four of the planned horizontal wells as development wells on our East Bloxom property. The remaining three horizontal wells, which will be exploration wells, are planned for our newly acquired northern Midland Basin acreage. We expect to drill 20 vertical wells on our southern Permian Basin properties and one vertical exploration well on our newly acquired northern Midland Basin acreage. Components of the 2012 capital budget include: +Development of legacy, southern Permian Basin properties +$ +62 +Acquisition and exploration of northern Permian Basin properties +48 +Gulf of Mexico development, primarily Habanero +14 +Capitalized general and administrative costs +13 +Capitalized interest and other +2 +Total projected capital expenditures budget +$ +139 +Our total liquidity at December 31, 2011 was $88.8 million , including $43.8 million of cash available at December 31, 2011 and $45 million of borrowing base availability under our Credit Facility. Our total liquidity on March 1, 2012 and subsequent to the previously discussed northern Permian Basin acreage acquisition, was approximately $70.0 million, including $25.0 million of cash available and the $45 million of borrowing base availability under our Credit Facility. +The following table includes the Company’s contractual obligations and purchase commitments as of December 31, 2011 , at which date the Company had no product delivery commitments: +(amounts in thousands) +Payments due by Period +Total +< 1 Year +1 - 3 Years +3 - 5 Years +>5 Years +13% Senior Notes +$ +106,961 +— +— +$ +106,961 +— +Office space lease commitments +2,960 +107 +700 +684 +1,469 +Medusa Oil Pipeline Throughput Commitment +62 +22 +27 +13 +— +Total +$ +109,983 +$ +129 +$ +727 +$ +107,658 +$ +1,469 +During February 2012, we contracted a drilling rig for a term of two years to support our horizontal drilling program in the Permian Basin. This agreement increases our expected contractual obligations as follows: <1 year of $6.9 million and 1-3 years of $11.4 million . The agreement includes early termination provisions that would reduce the minimum rentals under the agreement, +35 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +assuming the lessor is unable to re-charter the rig and staffing personnel to another lessee, as follows: <1 year of $4.4 million and 1-3 years of $6.8 million . +Summary cash flow information is provided as follows: +Operating Activities. For the year ended December 31, 2011 , net cash provided by operating activities was $79.2 million , compared to $100.1 million for the same period in 2010 . Excluding from 2010 operating cash flows $52.7 million related to the BOEMRE royalty recoupment and related interest, cash flow provided by operating activities increased year-over-year by approximately 67% or $31.8 million primarily as a result of a 29% increase in the average realized sales price on an equivalent basis and a 10% increase in total production on an equivalent basis. +Investing Activities. For the year ended December 31, 2011 , net cash used in investing activities was $91.5 million as compared to $59.7 million for the same period in 2010 . The $31.8 million increase in net cash used in investing activities is primarily attributable to an increase in capital expenditures related to drilling activity on our Permian Basin acreage, which was partially offset by $7.6 million in proceeds received for the sale of certain mineral interests and assets acquired as part of the Entrada project wind-down agreement discussed below and in Note 3 to the financial statements. +Financing Activities . For the year ended December 31, 2011 , net cash provided by financing activities was $38.7 million compared to cash used by financing activities of $26.3 million during the same period of 2010 . The 2011 net cash provided by financing activities included $73.8 million of net proceeds from an equity offering offset by approximately $35.1 million used to redeem a $31.0 million principal portion of our outstanding 13% Senior Notes and to pay the $4.0 million call premium and other redemption expenses. The 2010 expenditures related to the $10.0 million repayment of outstanding borrowings under the Credit Facility and the $16.2 million redemption of the Company's remaining outstanding 9.75% Senior Notes. +Income Taxes +As of December 31, 2010, we continued to carry a full valuation allowance against our net deferred tax assets. We consider both the positive and negative information in determining whether it is more likely than not that our deferred tax assets are recoverable. With the loss we incurred in 2008, primarily as a result of a writedown of our oil and gas properties following the ceiling test, which created a loss on an aggregate basis for the three-year period ended December 31, 2008. Because of this cumulative loss together with our near term projected results of operations, we established a full valuation allowance as of December 31, 2008, and have continued to carry the full valuation allowance each reporting period since December 31, 2008. +We reported profitable operations from 2009 to 2011, and have income on an aggregate basis for the three-year period ended December 31, 2011. Additionally we expect to generate sufficient taxable income necessary to fully utilize all of the deferred tax assets prior to their expiration. Consequently, we reversed the valuation allowance at December 31, 2011, which then had a balance of $67.0 million . For additional information, see Note 12 to the Consolidated Financial Statements. +Callon Entrada +Effective January 1, 2010, Callon Entrada Company ("Callon Entrada"), a variable interest entity, was deconsolidated from our consolidated financial statements because we no longer had the power to direct the activities that most significantly affected Callon Entrada's economic activities being the liquidation of the surplus equipment related to the Entrada project. The deconsolidation of Callon Entrada resulted in the removal of approximately $1.8 million of current assets, $2.0 million of current liabilities, $30.3 million of deferred tax assets, $30.3 million of tax valuation allowance and approximately $84.8 million of non-recourse debt and the related obligation for the cumulative amount of interest. Retained earnings increased by $85.1 million as a cumulative effect of change related to this accounting standard. No gain was recognized in the statement of operations. +During the second quarter of 2011, we entered into a final project wind-down agreement with CIECO Energy LLC (“CIECO”), our former joint interest partner in the Entrada deepwater project. The agreement provides for the extinguishment of all existing agreements and commitments between the parties as it relates to the past development of the Entrada project. The agreement includes a formal extinguishment of the non-recourse credit agreement between Callon Entrada and CIECO and the assignment to Callon Entrada of CIECO's 50% rights to the remaining assets including primarily the unsold, residual equipment and all engineering data related to the Entrada project, and resulted in our becoming Callon Entrada's primary beneficiary and consolidating its results with ours. +For additional information regarding Callon Entrada and related matters, please refer to Note 3 included in Item II, Part 8 of this filing. +36 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Results of Operations +The following table sets forth certain unaudited operating information with respect to the Company's oil and natural gas operations for the periods indicated: +For the year ended December 31, +2011 +2010 +Change +% Change +2009 +Change +% Change +Net production: +Oil (MBbls) +996 +859 +137 +16 +% +1,012 +(153 +) +(15 +)% +Natural Gas (MMcf) +5,081 +4,892 +189 +4 +% +5,740 +(848 +) +(15 +)% +Total production (MBoe) +1,843 +1,674 +169 +10 +% +1,969 +(295 +) +(15 +)% +Average daily production (Boe) +5,049 +4,587 +462 +10 +% +5,395 +(808 +) +(15 +)% +Average realized sales price (see below): +Oil (Bbl) +$ +101.34 +$ +75.97 +$ +25.37 +33 +% +$ +73.00 +$ +2.97 +4 +% +Natural Gas (Mcf) +5.25 +5.04 +0.21 +4 +% +4.78 +0.26 +5 +% +Total (Boe) +69.26 +53.69 +15.57 +29 +% +51.44 +2.25 +4 +% +Oil and natural gas revenues (in thousands): +Oil revenue +$ +100,962 +$ +65,243 +$ +35,719 +55 +% +$ +73,842 +$ +(8,599 +) +(12 +)% +Natural Gas revenue +26,682 +24,639 +2,043 +8 +% +27,417 +(2,778 +) +(10 +)% +Total +$ +127,644 +$ +89,882 +$ +37,762 +42 +% +$ +101,259 +$ +(11,377 +) +(11 +)% +Additional per Boe data: +Sales price +$ +69.26 +$ +53.69 +$ +15.57 +29 +% +$ +51.44 +$ +2.25 +4 +% +Lease operating expense +(11.04 +) +(10.58 +) +(0.46 +) +4 +% +(9.37 +) +(1.21 +) +13 +% +Operating margin +$ +58.22 +$ +43.11 +$ +15.11 +35 +% +$ +42.07 +$ +1.04 +2 +% +Below is a reconciliation of the average NYMEX price to the average realized sales price per barrel of oil and Mcf of natural gas: +Average NYMEX oil price ($/Bbl) +$ +95.14 +$ +79.52 +$ +15.62 +20 +% +$ +61.80 +$ +17.72 +29 +% +Basis differential and quality adjustments (a) +7.58 +(2.39 +) +9.97 +417 +% +(4.64 +) +2.25 +(48 +)% +Transportation +(1.00 +) +(1.16 +) +0.16 +(14 +)% +(1.32 +) +0.16 +(12 +)% +Hedging +(0.38 +) +— +(0.38 +) +100 +% +17.16 +(17.16 +) +(100 +)% +Average realized oil price ($/Bbl) +$ +101.34 +$ +75.97 +$ +25.37 +33 +% +$ +73.00 +$ +2.97 +4 +% +Average NYMEX natural gas price ($/Mcf) +$ +4.03 +$ +4.40 +$ +(0.37 +) +(8 +)% +$ +4.17 +$ +0.23 +6 +% +Basis differential and quality adjustments (b) +1.22 +0.51 +0.71 +139 +% +0.28 +0.23 +82 +% +Hedging +— +0.13 +(0.13 +) +(100 +)% +0.33 +(0.20 +) +(61 +)% +Average realized natural gas price ($/Mcf) +$ +5.25 +$ +5.04 +$ +0.21 +4 +% +$ +4.78 +$ +0.26 +5 +% +(a) +Oil prices for production from our two deepwater fields reflect a premium over NYMEX pricing based on Mars WTI differential for Medusa production and Argus Bonita WTI differential for Habanero production. +(b) +Natural gas prices exceeded the related NYMEX prices, which are quoted on an MMBtu basis, primarily due to the value of the NGLs in our liquids-rich natural gas stream, primarily from our Permian Basin and deepwater production. +Revenues +The following tables are intended to reconcile the change in oil, natural gas and total revenue by reflecting the effect of changes in +37 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +volume, changes in the underlying commodity prices and the impact of our hedge program (in thousands): +Oil +Natural Gas +Total +Revenues for the year ended December 31, 2008 +$ +82,963 +$ +58,349 +$ +141,312 +Volume increase (decrease) +6,165 +(989 +) +5,176 +Price decrease +(32,639 +) +(31,832 +) +(64,471 +) +Impact of hedges increase +17,353 +1,889 +19,242 +Net decrease during the year +(9,121 +) +(30,932 +) +(40,053 +) +Revenues for the year ended December 31, 2009 +$ +73,842 +$ +27,417 +$ +101,259 +Volume decrease +(11,164 +) +(4,050 +) +(15,214 +) +Price increase +2,556 +649 +3,205 +Impact of hedges increase +9 +623 +632 +Net decrease during the year +(8,599 +) +(2,778 +) +(11,377 +) +Revenues for the year ended December 31, 2010 +$ +65,243 +$ +24,639 +$ +89,882 +Volume increase +10,406 +952 +11,358 +Price increase +25,688 +1,091 +26,779 +Impact of hedges decrease +(375 +) +— +(375 +) +Net increase during the year +35,719 +2,043 +37,762 +Revenues for the year ended December 31, 2011 +$ +100,962 +$ +26,682 +$ +127,644 +Total Revenue +Total oil and natural gas revenues of $127.6 million for the year ended December 31, 2011 increased approximately $37.8 million or 42% from $89.9 million during the year ended December 31, 2010 . The year-over-year increase in total revenue was principally driven by higher realized pricing on an equivalent unit basis combined with an increase in overall production. Compared to full year of 2010, and on an equivalent basis, the average price realized by the Company increased 29% , while overall production on an equivalent basis increased by 10% . Production increases were primarily attributable to the Company's development program on its Permian Basin properties, to the addition of the Company's Haynesville Shale natural gas well which began producing late in the third quarter of 2010 and to a well recompletion at our offshore, deepwater Medusa field. Offsetting the increases in production were normal and expected declines in other properties, the third quarter 2011 temporary 17 day and 21 day shut-in of our Medusa and Habanero wells, respectively, due to a tropical storm and other required maintenance work on the facilities, and a 35-day shut-in of our Haynesville well due to interference caused by an offsetting well. +Total oil and natural gas revenues of $89.9 million for the year ended December 31, 2010 were approximately $11.4 million, or 11%, less than $101.3 million for the same period of 2009. The largest contributors to the year-over-year decline included a 15% decline in production on an equivalent basis, partially offset by a 4% increase in average realized prices. Compared to 2009, the decline in production on an equivalent basis during 2010 was primarily driven by normal and expected declines in our other properties and damage to one of our Gulf of Mexico natural gas field production facilities. These declines were partially offset by new production from our Permian Basin and Haynesville Shale properties. +Oil Revenue +For the year ended December 31, 2011 , oil revenues of $101.0 million increased $35.7 million or 55% compared to revenues of $65.2 million for the year ended December 31, 2010 . As noted above, both an increase in commodity prices and production resulted in increased oil revenue. The average price realized increased 33% to $101.34 per barrel compared to $75.97 for the same period of 2010. Similarly, production increased by 16% to 996 MBbls compared to 859 MBbls during the same period in 2010. Oil prices for +38 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +production from our two deepwater fields are adjusted and reflect a premium over NYMEX pricing based on Mars WTI differential for Medusa production and Bonita WTI differential for Habanero production. As discussed above, production increases relate primarily to progress in developing our Permian Basin properties and the successful recompletion at our Medusa field, partially offset by the downtime experienced at our deepwater fields and due to normal and expected declines in our other properties. +Oil revenues of $65.2 million for the year ended December 31, 2010 were approximately $8.6 million, or 12%, less than oil revenues of $73.8 million for the same period of 2009. The largest contributor to the decline was a 15% decrease in production, partially offset by a 4% increase in the average realized oil price. In addition to normal and expected production declines, volumes declined primarily due to our working interest in Habanero #1 decreasing from 25% to 11.25% in June 2009 following the payout of a sidetrack on this well. The payout was associated with a third quarter 2007 sidetrack of the #1 well for which the operator elected to non-consent. These declines were partially offset by production from our newly drilled and completed wells on the Permian Basin properties that we acquired during the fourth quarter of 2009. +Natural Gas Revenue +For the year ended December 31, 2011 , natural gas revenues of $26.7 million represented an increase of 8% or $2.0 million when compared to natural gas revenues of $24.6 million for the year ended December 31, 2010 . Natural gas production increased 4% , primarily driven by production from our Haynesville Shale natural gas well, which was placed on production during September 2010, and due to the production from East Cameron #2 well, which was shut-in during the first quarter of 2010 for repairs to the host facility and did not return to production until December 2010. In addition to production increases , the average realized price increased 4% to $5.25 per Mcf compared to an average realized price of $5.04 per Mcf in 2010 . Our natural gas prices on an MMBtu equivalent basis exceeded the related NYMEX prices primarily due to the value of the NGLs in our natural gas stream, primarily from our Permian Basin and deepwater production. Offsetting the increases in production are normal and expected declines in production from our other natural gas properties and a 35-day shut-in, as of December 31, 2011, of our Haynesville well due to interference caused by an offsetting well. The Haynesville well returned to production in mid-March 2012. +Natural gas revenues of $24.6 million for the year ended December 31, 2010 were approximately $2.8 million, or 10%, less when compared to natural gas revenues of $27.4 million for the same period of 2009. The largest contributor to the decline was a 15% decrease in production, partially offset by a 5% increase in the average realized sales price of natural gas. The largest contributor to the decline in production was the shut-in of the East Cameron #2 well, which was shut-in during January 2010 due to damage resulting from a fire on a third-party facility. Production at the East Cameron #2 well was restored during the latter part of the fourth quarter of 2010 following the completion of the necessary repairs and BOEM inspections. Also contributing to the production decrease was the Habanero #1 well reversionary interest discussed above in the oil revenue analysis, while the remaining decrease in production was due to normal and expected declines from our other properties and production suspensions related to well recompletions and BOEM recompletion work approval at our Mobile Block 864 well. Offsetting these declines are increases from our Permian Basin properties discussed above, and production from our first Haynesville natural gas well, which was placed on production during September 2010. +Operating Expenses +39 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +For the year ended December 31, +Total Change +Boe Change +2011 +Per Boe +2010 +Per Boe +$ +% +$ +% +Lease operating expenses +$ +20,347 +$ +11.04 +$ +17,712 +$ +10.58 +$ +2,635 +15 +% +$ +0.46 +4 +% +Depreciation, depletion and amortization +48,701 +26.42 +31,805 +19.00 +16,896 +53 +% +7.42 +39 +% +General and administrative +16,636 +9.03 +16,507 +9.86 +129 +1 +% +(0.83 +) +(8 +)% +Accretion expense +2,338 +1.27 +2,446 +1.46 +(108 +) +(4 +)% +(0.19 +) +(13 +)% +Acquisition expense +— +— +233 +0.14 +(233 +) +(100 +)% +(0.14 +) +(100 +)% +Total operating expenses +$ +88,022 +$ +68,703 +For the year ended December 31, +Total Change +Boe Change +2010 +Per Boe +2009 +Per Boe +$ +% +$ +% +Lease operating expenses +$ +17,712 +$ +10.58 +$ +18,447 +$ +9.37 +(735 +) +(4 +)% +$ +1.21 +13 +% +Depreciation, depletion and amortization +31,805 +19.00 +33,443 +16.98 +(1,638 +) +(5 +)% +2.02 +12 +% +General and administrative +16,507 +9.86 +13,355 +6.78 +3,152 +24 +% +3.08 +45 +% +Accretion expense +2,446 +1.46 +3,149 +1.60 +(703 +) +(22 +)% +(0.14 +) +(9 +)% +Acquisition expense +233 +0.14 +298 +0.15 +(65 +) +(22 +)% +(0.01 +) +(7 +)% +Total operating expenses +$ +68,703 +$ +68,692 +Lease Operating Expenses +For the year ended December 31, 2011 , lease operating expenses ("LOE") per Boe of $11.04 increased by 4% or $0.46 compared to $10.58 for the year ended December 31, 2010 . The significant growth in the number of wells now producing in our Permian Basin properties and our Haynesville Shale well increased total LOE approximately $3.6 million , or $1.95 on a per Boe basis, compared to the corresponding period of 2010. Additionally, total LOE increased approximately $0.5 million related to Medusa Spar maintenance work, the increased production from the Medusa A6 well following the well recompletion, and increased $0.8 million due to processing fees at our East Cameron #2 well, which resumed production in December 2010 after being shut-in for repairs on the host facility during the first quarter of 2010. Partially offsetting these increases was a mix of lower LOE related primarily to our shelf properties. +For the year ended December 31, 2010, LOE decreased 4% to $17.7 million compared to $18.4 million for the same period in 2009. The primary contributor to the reduction in LOE was normal and expected declines in production in addition to the reduction in our working interest in Habanero #1 well following the payout of a sidetrack on this well. Partially offsetting these decreases, LOE increased related to our acquisition of the Permian Basin properties and a modest increase in insurance rates due to adding additional coverage to our program designed to better protect the Company from damage caused by severe weather. +Depreciation, Depletion and Amortization +Depreciation, depletion and amortization (“DD&A”) for the year ended December 31, 2011 increased 39% per Boe to $26.42 per Boe compared to $19.00 per Boe for the year ended December 31, 2010 . The prior period DD&A rates were effectively reduced by the impact of a $486 million 2008 impairment charge following a ceiling test writedown. This significant oil and natural gas property impairment charge resulted in a lower, prospective DD&A rate for the then existing reserves. Also contributing to the current rate increase are the ongoing onshore development cost increases in the area. +For the year ended December 31, 2010, DD&A decreased approximately $1.7 million or 5% to $31.8 million compared to $33.4 million for the same period of 2009. Production declines account for nearly all of the decrease, while a rate increase partially offset the production volume decreases. +General and Administrative, net of amounts capitalized +For the year ended December 31, 2011 , general and administrative (“G&A”) expenses of $16.6 million , net of amounts capitalized, +40 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +was relatively flat compared to $16.5 million for the year ended 2010 . +For the year ended December 31, 2010, G&A expenses, net of amounts capitalized, increased $3.2 million or 24% to $16.5 million from $13.4 million for the same period of 2009. Our performance-based incentive program runs from April to March, and adjustments to our accruals are recorded during the first quarter upon completion of the program and evaluation by our Compensation Committee. During the first quarter of 2009, we recorded a 75% reduction in incentive-based compensation related to our actual 2008 results. These results, which were negatively affected by the decline in oil and natural gas prices, the abandonment of the Entrada project and worsening broader economic conditions, were lower than the performance goals set for fiscal year 2008. Conversely, the increase experienced during 2010 relates primarily to a 21% increase in incentive-based compensation related to exceeding performance goals set for fiscal year 2009. Also contributing to the increase are (1) a valuation adjustment to mark to fair value a portion of our share-based awards that will vest in the future which are accounted for as a liability, (2) additional employee-related costs, including non-recurring early retirement expenses, (3) costs associated with adding new employees, including relocation and related costs, and (4) higher legal costs and other charges related to an arbitration hearing involving a dispute with our joint interest partner in the Entrada development project. Partially offsetting the increases are $2.2 million of expenses related to staff reductions incurred during the second quarter of 2009 for which no similar charge was recorded during 2010. +Accretion Expense +Accretion expense related to our asset retirement obligation decreased 4% for the year ended December 31, 2011 compared to the same periods of 2010. Accretion expense correlates directionally with the Company's asset retirement obligation (“ARO”). At December 31, 2011 , our ARO of $13.9 million was lower than the $15.9 million ARO at December 31, 2010 . See Note 14 for additional information regarding the Company's ARO. +For the year ended December 31, 2010, accretion expense decreased $0.7 million or 22% to $2.4 million from $3.1 million incurred during the same period of 2009. The Company’s accretion expense decreases as its ARO decreases. As of December 31, 2010, our average ARO liability for 2010 of $15.0 million was significantly lower than our average ARO liability of $27.0 million for the same period in 2009. For additional information regarding the company’s oil and natural gas properties and the related ARO, see Notes 13 and 14 included to the Consolidated Financial Statements. +Other (Income) Expense +For the year ended December 31, +2011 +2010 +$ Change +% Change +2009 +$ Change +% Change +Interest expense +$ +11,717 +$ +13,312 +$ +(1,595 +) +(12 +)% +$ +19,089 +$ +(5,777 +) +(30 +)% +Callon Entrada non-recourse credit facility interest expense (See Note 3) +— +— +— +— +% +7,072 +(7,072 +) +(100 +)% +(Gain) Loss on early extinguishment of debt +(1,942 +) +339 +(2,281 +) +(673 +)% +— +339 +— +% +Gain related to acquired assets, net (See Note 3) +(5,041 +) +— +(5,041 +) +100 +% +— +— +— +% +9.75% Senior Notes restructuring expenses +— +— +— +— +% +1,024 +(1,024 +) +(100 +)% +Interest on BOEM royalty recoupment +— +(91 +) +91 +(100 +)% +(7,681 +) +7,590 +(99 +)% +Other (income) expense +(1,426 +) +(166 +) +(1,260 +) +759 +% +190 +(356 +) +(187 +)% +Total other (income) expenses +$ +3,308 +$ +13,394 +$ +19,694 +Income tax (benefit) expense +$ +(67,036 +) +$ +(174 +) +$ +(66,862 +) +38,426 +% +$ +7,623 +* +$ +(7,797 +) +100 +% +Equity in earnings of Medusa Spar LLC +799 +427 +372 +87 +% +660 +(233 +) +(35 +)% +* 2009 Income tax expense has been restated. See Note 1. +Interest Expense +Interest expense on Callon's debt obligations decreased 12% to $11.7 million for the year ended December 31, 2011 compared to $13.3 million for the same period of 2010 . The decrease relates primarily to the redemption of $31 million principal of 13% Senior Notes during March 2011. This early redemption reduced interest expense by approximately $3.2 million for the current year compared to 2010 . Additionally, 2010 interest expense included approximately $0.5 million related to the remaining outstanding $16.1 million of 9.75% Senior Notes, which were redeemed on April 30, 2010 and were therefore not included in 2011 interest expense. Offsetting these declines in interest expense is a $1.4 million drop in capitalized interest in 2011 compared to 2010 , and relates to a lower balance +41 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +year-over-year in average unevaluated oil and natural gas properties following the transfer to evaluated earlier in 2011 of certain leases, primarily offshore, that the Company elected not to renew. Further offsetting the declines discussed above are slight decreases in the deferred credit amortization recorded in 2011 compared to 2010 . +For the year ended December 31, 2010, interest expense decreased $5.8 million or 30% to $13.3 million compared to $19.1 million for the same period of 2009. The decrease was primarily due to the $3.7 million amortization of our deferred credit related to the Senior Notes, which is recorded as a decrease to interest expense. Also reducing interest expense during 2010 was a decrease in the amount of discount amortization recognized related to our 9.75% Senior Notes, 92% of which were exchanged during 2009. Further, the remaining $16.1 million of outstanding 9.75% Senior Notes that did not participate in the exchange were later redeemed on April 30, 2010 resulting in approximately $1.1 million of interest expense savings during 2010 as compared to 2009. +Callon Entrada Non-Recourse Credit Agreement Interest Expense +As discussed in Note 3 to the Consolidated Financial Statements and as a result of the deconsolidation of Callon Entrada effective January 1, 2010, we incurred no expense related to this non-recourse credit facility during 2011 or 2010. +(Gain) Loss on Early Extinguishment of Debt +During March 2011, using a portion of the proceeds from the Company's February 2011 equity offering, the Company redeemed 13% Senior Notes with a carrying value of $37 million, including $6.0 million of the Notes' deferred credit, in exchange for $35.1 million, comprised of the $31 million principal of the notes, the $4.0 million call premium and miscellaneous redemption expenses, which resulted in a $1.9 million net gain on the early extinguishment of debt. +For the year ended December 31, 2010, the loss on early extinguishment of debt was $0.34 million, though no similar expense was incurred during 2009. The $0.34 million related to the 1% call premium, equal to $0.16 million, paid to redeem the remaining $16.1 million of 9.75% Senior Notes not exchanged during the restructuring of the 9.75% Senior Notes, plus $0.18 million for the accelerated amortization of the 9.75% Senior Notes’ remaining discount and debt issuance costs. For additional information, see Note 6 to the Consolidated Financial Statements. +Gain related to acquired assets, net +For information concerning the net gain on acquired assets including the related income tax benefit, please see Note 3 to the Consolidated Financial Statements. +9.75% Senior Notes Restructuring Expense +During the fourth quarter of 2009, we exchanged our 9.75% Senior Note for the 13% Senior Notes and convertible preferred stock. In connection with this exchange, we incurred $1.0 million of financing cost related to consultant and legal expenses. For additional information, see Note 6 to the Consolidated Financial Statements. +Interest on BOEM Royalty Recoupment +During 2009 we filed for a $44.8 million royalty recoupment for royalty payments previously made on production from Medusa field. During the first quarter of 2010, the Company received both the recoupment of principal and $7.7 million of interest. In addition, the Company is no longer required to make any future royalty payments to the BOEM related to its Medusa production. For additional information, see Note 16 to the Consolidated Financial Statements. +Income Tax Benefit +The income tax benefit of $67.0 million in 2011 resulted primarily from the reversal of the valuation allowance established in 2008 against our net deferred tax assets. As a result of reporting net income from 2009 to 2011, we achieved income on an aggregate basis for the three-year period ended December 31, 2011. Additionally we expect to generate sufficient taxable income necessary to fully utilize all of the deferred tax assets prior to their expiration. As a result, we reversed the $67.0 million valuation allowance at December 31, 2011. +As explained in Note 1, the Company restated its 2009 income tax expense to reflect the tax expense incurred related to income generated by the settlement of its oil and natural gas hedges, which were valued at $21.8 million at December 31, 2008. Additionally, see Note 12 to our Consolidated Financial Statements for additional information related to our income taxes. +42 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Off-Balance Sheet Arrangements +The Company holds a 10% ownership interest in Medusa Spar LLC (“LLC”), which is accounted for under the equity method of accounting for investments. The LLC owns a 75% undivided ownership interest in the deepwater spar production facilities at the Company’s Medusa Field in the Gulf of Mexico. The LLC earns a tariff based upon production volume throughput from the Medusa area. Callon is obligated to process through the spar production facilities its share of production from the Medusa Field and any future discoveries in the area. The balance of Medusa Spar LLC is owned by Oceaneering International, Inc. and Murphy Oil Corporation. +Summary of Significant Accounting Policies and Critical Accounting Estimates +Property and Equipment +The Company utilizes the full-cost method of accounting for its oil and natural gas properties whereby all costs incurred in connection with the acquisition, exploration and development of oil and natural gas reserves, including certain overhead costs, are capitalized into the “full-cost pool.” The amounts capitalized into the full-cost pool are depleted (charged against earnings) using the unit-of-production method. The full-cost method of accounting for our proved oil and natural gas properties requires that the Company makes estimates based on its assumptions of future events that could change. These estimates are described below. +Depreciation, Depletion and Amortization (DD&A) of Oil and Natural Gas Properties +The Company calculates depletion by using the depletable base, equal to the net capitalized costs in our full-cost pool plus estimated future development costs, and the estimated net proved reserve quantities. Capitalized costs added to the full-cost pool include the following: +• +cost of drilling and equipping productive wells, dry hole costs, acquisition costs of properties with proved reserves, delay rentals and other costs related to exploration and development of our oil and natural gas properties; +• +payroll costs including the related fringe benefits paid to employees directly engaged in the acquisition, exploration and/or development of oil and natural gas properties as well as other directly identifiable general and administrative costs associated with such activities. Such capitalized costs do not include any costs related to the production of oil and natural gas or general corporate overhead; +• +costs associated with unevaluated properties, those lacking proved reserves, are excluded from the depletable base. These unevaluated property costs are added to the depletable base at such time as wells are completed on the properties, the properties are sold or the Company determines these costs have been impaired. The Company’s determination that a property has or has not been impaired (which is discussed below) requires assumptions about future events; +• +estimated costs to dismantle, abandon and restore properties that are capitalized to the full-cost pool when the related liabilities are incurred (see also the discussion below regarding Asset Retirement Obligations) ; and +• +estimated future costs to develop proved properties are added to the full-cost pool for purposes of the DD&A computation. The Company uses assumptions based on the latest geologic, engineering, regulatory and cost data available to it to estimate these amounts. However, the estimates made are subjective and may change over time. The Company’s estimates of future development costs are reviewed at least annually and as additional information becomes available. +• +capitalized costs included in the full-cost pool plus estimated future development costs are depleted and charged against earnings using the unit-of-production method. Under this method, the Company estimates the proved reserves quantities at the beginning of each accounting period. For each Mcfe produced during the period, the Company records a depletion charge equal to the amount included in the depletable base (net of accumulated depreciation, depletion and amortization) divided by our estimated net proved reserve quantities. +Because the Company uses estimates and assumptions to calculate proved reserves (as discussed below) and the amounts included in the depletable base, our depletion rates may materially change if actual results differ from these estimates. +Ceiling Test +43 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Under the full cost method of accounting, the Company compares, at the end of each financial reporting period, the present value of estimated future net cash flows from proved reserves (excluding cash flows related to estimated abandonment costs), to the net capitalized costs of proved oil and natural gas properties net of related deferred taxes. The Company refers to this comparison as a “ceiling test.” If the net capitalized costs of proved oil and natural gas properties exceed the estimated discounted (at 10%) future net cash flows from proved reserves, the Company is required to write-down the value of its oil and natural gas properties to the value of the discounted cash flows. Estimated future net cash flows from proved reserves are based on a twelve-month average pricing assumption and include consideration of existing cash flow hedges. Given the volatility of oil and natural gas prices, it is reasonably possible that the Company’s estimates of discounted future net cash flows from proved oil and natural gas reserves could change in the near term. If oil and natural gas prices decline significantly, even if only for a short period of time, it is possible that write-downs of oil and natural gas properties could occur in the future. See Notes 2 and 13 for additional information regarding the Company’s oil and natural gas properties. +Estimating Reserves and Present Value of Estimated Future Net Cash Flows +Estimates of quantities of proved oil and natural gas reserves, including the discounted present value of estimated future net cash flows from such reserves at the end of each quarter, are based on numerous assumptions, which are likely to change over time. These assumptions include: +• +the prices at which the Company can sell its oil and natural gas production in the future. Oil and natural gas prices are volatile, but we are required to assume that they remain constant. In general, higher oil and natural gas prices will increase quantities of proved reserves and the present value of estimated future net cash flows from such reserves, while lower prices will decrease these amounts; and +• +the costs to develop and produce the Company’s reserves and the costs to dismantle its production facilities when reserves are depleted. These costs are likely to change over time. Increases in costs will reduce estimated oil and natural gas quantities and the present value of estimated future net cash flows, while decreases in costs will increase such amounts. +Changes in these prices and/or costs will affect the present value of estimated future net cash flows more than the estimated quantities of oil and natural gas reserves for the Company’s properties that have relatively short productive lives. +In addition, the process of estimating proved oil and natural gas reserves requires that the Company’s independent and internal reserve engineers exercise judgment based on available geological, geophysical and technical information. We have described the risks associated with reserve estimation and the volatility of oil and natural gas prices under “Risk Factors.” +Sales of oil and natural gas properties are accounted for as adjustments to the net full cost pool with no gain or loss recognized unless the adjustment would significantly alter the relationship between capitalized costs and proved reserves. +Unproved Properties +Costs, including capitalized interest, associated with properties that do not have proved reserves are excluded from the depletable base, and are included in the line item “Unevaluated properties excluded from amortization.” Unproved property costs are transferred to the depletable base when wells are completed on the properties or the properties are sold. In addition, the Company is required to determine whether its unproved properties are impaired and, if so, include the costs of such properties in the depletable base. The Company determines whether an unproved property is impaired by periodically reviewing its exploration program on a property-by-property basis. This determination may require the exercise of substantial judgment by management. +Asset Retirement Obligations +We are required to record its estimate of the fair value of liabilities for obligations associated with the retirement of tangible long-life assets and the associated asset retirement costs. Interest is accreted on the present value of the asset retirement obligation and reported as accretion expense within operating expenses in the Consolidated Statements of Operations. See Note 14 for additional information. +Derivatives +To manage oil and natural gas price risk on a portion of its planned future production, we have historically utilized hedges on approximately 50% of our projected production volumes in any given year. The Company does not use these instruments for +44 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +trading purposes. Settlement of derivative contracts are generally based on the difference between the contract price and prices specified in the derivative instrument and a NYMEX price or other cash or futures index price. +The Company’s derivative contracts that existed at December 31, 2011 are accounted for as cash flow hedges, and are recorded at fair market value on its consolidated balance sheet under the caption “Fair Market Value of Derivatives”. The estimated fair value of these contracts is based upon closing exchange prices on NYMEX and in the case of collars and floors, the time value of options. Changes in fair value recorded through other comprehensive income (loss), net of tax, in stockholders’ equity. The cash settlements on these contracts are recorded in the Statement of Operations as an increase or decrease in oil and natural gas sales. The changes in fair value related to ineffective derivative contracts are recognized as derivative expense (income). The cash settlement on these contracts is also recorded within derivative expense (income). +In February 2012, we elected to no longer designate subsequent derivative contracts as accounting hedges under FASB ASC 815-20-25. As such, all future derivative positions, including a collar into which we entered during February 2012, will be carried at their fair value on the balance sheet and are marked-to-market at the end of each period. Any realized and unrealized gains or losses are recorded on the statement of operations. Unrealized gains (losses) related to our derivative contracts not designated as accounting hedges will be reported as a component of the Company's revenues. +For additional information regarding derivatives and their fair values, see Notes 7 and 8 to the Consolidated Financial Statements and Part II, Item 7A Commodity Price Risk. +Income Taxes +The amount of income taxes recorded requires interpretations of complex rules and regulations of federal and state tax jurisdictions. We recognize current tax expense based on estimated taxable income for the current period and the applicable statutory tax rates. We routinely assess potential uncertain tax positions and, if required, estimate and establish accruals for such amounts. We have recognized deferred tax assets and liabilities for temporary differences, operating losses and other tax carryforwards. We routinely assess our deferred tax assets and reduce such assets by a valuation allowance if we deem it is more likely than not that some portion or all of the deferred tax assets will not be realized. Numerous judgments and assumptions are inherent in the determination of future taxable income, including factors such as future operating conditions (particularly as related to prevailing oil and gas prices). +Subsequent Events +Subsequent to December 31, 2011, Callon completed two acreage acquisitions within the northern portion of the Permian Basin's Midland Basin in Borden County. Together, these acquisitions included a total of 16,020 gross exploratory acres ( 14,470 , net), and significantly increased the Company's acreage position in the Permian Basin by 152% to a total of 24,010 net acres compared to 9,540 net acres held at year-end 2011. For additional information regarding subsequent events, see Note 19 to the Consolidated Financial Statements. +Recent Accounting Standards +Various accounting standards and interpretations were issued in 2011 with effective dates subsequent to December 31, 2011. We have evaluated the recently issued accounting pronouncements that are effective in 2012 and believe that none of them will have a material effect on our financial position, results of operations or cash flows when adopted. For a discussion of recently issued accounting standards, see Note 2 to the Consolidated Financial Statements. +ITEM 7A. Quantitative and Qualitative Disclosures about Market Risks +Commodity Price Risk +The Company’s revenues, earnings, cash flow, capital investments and, ultimately, future rate of growth are highly dependent on the prices we receive for our crude oil and natural gas, which have historically been very volatile due to unpredictable events such as economical growth or retraction, weather and climate, changes in supply and government actions. Oil and natural gas price declines and volatility could adversely affect the Company’s revenues, cash flows and profitability. Price volatility is expected to continue. Based on projected annual sales volumes for 2012 , excluding production from 2012 exploratory drilling and the effects of the Company’s hedging program, a 10% decline in the NYMEX price of crude oil and natural gas would reduce our revenues by approximately $5.2 million and $1.7 million , respectively. +45 +Table of Contents +While the Company does not enter into derivative transactions for speculative purposes, in order to limit its exposure to this risk, the Company most often utilizes price "collars" to reduce the risk of changes in oil and natural gas prices. Under these arrangements, no payments are due by either party as long as the market price is above the floor price and below the ceiling price set in the collar. If the price falls below the floor, the counterparty to the collar pays the difference to Callon, and if the price rises above the ceiling, Callon pays the difference to the counterparty. +The Company may also enter into derivative financial instruments including fixed price “swaps.” These swaps reduce our exposure to decreases in commodity prices, while simultaneously limiting the benefit the Company might otherwise have received from any increases in commodity prices. Similarly, the Company’s derivatives policy also allows Callon to, at its discretion, purchase “puts,” which reduce our exposure to decreases in oil and natural gas prices while allowing realization of the full benefit from any increases in oil and natural gas prices. If the price falls below the floor, the counter-party pays the difference to the Callon. +During 2011 , all of the Company’s derivative positions were designated as cash flow hedges for accounting purposes, though the Company has the discretion not to designate its hedges as such. See Note 7 to the Consolidated Financial Statements for a description of our hedged position at December 31, 2011 . +Interest Rate Risk +On December 31, 2011 , all of the Company’s debt, consisting entirely of its 13% Senior Notes, had fixed interest rates. The Company’s revolving credit facility with Regions Bank includes a variable interest rate, and as such fluctuates based on short-term interest rates. Although the Company had no borrowings outstanding at December 31, 2011 under its revolving credit facility, were the Company to fully draw its available $45 million borrowing base at the beginning of the year, a 100 basis point change in the variable interest rate would increase the Company’s annual interest expense by $0.5 million. For additional information, see Note 6 to the Consolidated Financial Statements additional information regarding the Company’s credit facility and other borrowings at December 31, 2011 . +46 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +Report of Independent Registered Public Accounting Firm +48 +Consolidated Balance Sheets as of December 31, 2011 and 20 10 +49 +Consolidated Statements of Operations for Each of the Three Years in the Period Ended December 31, 201 1 +50 +Consolidated Statements of Stockholders' Equity (Deficit) for Each of the Three Years in the Period Ended December 31, 201 1 +51 +Consolidated Statements of Cash Flows for Each of the Three Years in the Period Ended December 31, 201 1 +52 +Notes to Consolidated Financial Statements +53 +47 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited the accompanying consolidated balance sheets of Callon Petroleum Company as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Callon Petroleum Company as of December 31, 2011 and 2010, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. +As discussed in Note 2 to the consolidated financial statements, effective January 1, 2010, the Company changed its accounting for its subsidiary, Callon Entrada Company, as a result of adopting the amended accounting pronouncement related to the consolidation of variable interest entities. In 2009, the Company changed its reserve estimates and related disclosures as a result of adopting new oil and gas reserve estimation and disclosure requirements. +As discussed in Note 1 to the consolidated financial statements, the 2009 and 2010 consolidated financial statements have been restated to correct an error as a result of the Company's inappropriate application of the accounting guidance related to intraperiod tax allocation for its income tax provision for the year ended December 31, 2009. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Callon Petroleum Company’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2012, expressed an adverse opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 15, 2012 +48 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(In thousands, except share data) +December, 31 +2011 +2010 +ASSETS +Restated +Current assets: +Cash and cash equivalents +$ +43,795 +$ +17,436 +Accounts receivable +15,181 +10,728 +Fair market value of derivatives +2,499 +— +Other current assets +1,601 +2,180 +Total current assets +63,076 +30,344 +Oil and natural gas properties, full-cost accounting method: +Evaluated properties +1,421,640 +1,316,677 +Less accumulated depreciation, depletion and amortization +(1,208,331 +) +(1,155,915 +) +Net oil and natural gas properties +213,309 +160,762 +Unevaluated properties excluded from amortization +2,603 +8,106 +Total oil and natural gas properties +215,912 +168,868 +Other property and equipment, net +10,512 +3,370 +Restricted investments +3,790 +4,044 +Investment in Medusa Spar LLC +9,956 +10,424 +Deferred tax asset +63,496 +— +Other assets, net +718 +1,276 +Total assets +$ +367,460 +$ +218,326 +LIABILITIES AND STOCKHOLDERS' EQUITY +Current liabilities: +Accounts payable and accrued liabilities +$ +26,057 +$ +17,702 +Asset retirement obligations +1,260 +2,822 +Fair market value of derivatives +— +937 +Total current liabilities +27,317 +21,461 +13% Senior Notes: +Principal outstanding +106,961 +137,961 +Deferred credit, net of accumulated amortization of $13,123 and $3,964, respectively +18,384 +27,543 +Total 13% Senior Notes (See Note 6) +125,345 +165,504 +Asset retirement obligations +12,678 +13,103 +Other long-term liabilities +3,165 +2,448 +Total liabilities +168,505 +202,516 +Stockholders' equity: +Preferred Stock, $.01 par value, 2,500,000 shares authorized; +— +— +Common Stock, $.01 par value, 60,000,000 shares authorized; 39,398,416 and 28,955,512 shares outstanding at December 31, 2011 and 2010, respectively +394 +290 +Capital in excess of par value +324,474 +248,160 +Other comprehensive (loss) income +1,624 +(937 +) +Retained deficit +(127,537 +) +(231,703 +) +Total stockholders' equity +198,955 +15,810 +Total liabilities and stockholders' equity +$ +367,460 +$ +218,326 +The accompanying notes are an integral part of these financial statements. +49 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF OPERATIONS +(In thousands, except per share amounts) +For the year ended December 31, +2011 +2010 +2009 +Operating revenues: +Restated +Oil sales +$ +100,962 +$ +65,243 +$ +73,842 +Natural gas sales +26,682 +24,639 +27,417 +BOEM royalty recoupment (See Note 16) +— +— +40,886 +Total operating revenues +127,644 +89,882 +142,145 +Operating expenses: +Lease operating expenses +20,347 +17,712 +18,447 +Depreciation, depletion and amortization +48,701 +31,805 +33,443 +General and administrative +16,636 +16,507 +13,355 +Accretion expense +2,338 +2,446 +3,149 +Acquisition expense +— +233 +298 +Total operating expenses +88,022 +68,703 +68,692 +Income from operations +39,622 +21,179 +73,453 +Other (income) expenses: +Interest expense +11,717 +13,312 +19,089 +Callon Entrada non-recourse credit facility interest expense (See Note 3) +— +— +7,072 +(Gain) loss on early extinguishment of debt +(1,942 +) +339 +— +Gain related to acquired assets, net (See Note 3) +(5,041 +) +— +— +9.75% Senior Notes restructuring expenses +— +— +1,024 +Interest on BOEM royalty recoupment +— +(91 +) +(7,681 +) +Other (income) expense, net +(1,426 +) +(166 +) +190 +Total other expenses, net +3,308 +13,394 +19,694 +Income before income taxes +36,314 +7,785 +53,759 +Income tax (benefit) expense +(67,036 +) +(174 +) +7,623 +Income before equity in earnings of Medusa Spar LLC +103,350 +7,959 +46,136 +Equity in earnings of Medusa Spar LLC +799 +427 +660 +Net income available to common shares +$ +104,149 +$ +8,386 +$ +46,796 +Net income per common share: +Basic +$ +2.75 +$ +0.29 +$ +2.12 +Diluted +$ +2.70 +$ +0.28 +$ +2.11 +Shares used in computing net income per common share: +Basic +37,908 +28,817 +22,072 +Diluted +38,582 +29,476 +22,200 +The accompanying notes are an integral part of these financial statements. +50 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) +(In thousands) +Preferred Stock +Common Stock +Capital in Excess of Par +Accumulated Other Comprehensive Income (Loss) +Retained Earnings (Deficit) +Total Stockholders' Equity (Deficit) +Balance at December 31, 2008 +$ +— +$ +216 +$ +227,803 +$ +14,157 +$ +(371,980 +) +$ +(129,804 +) +Comprehensive income: +Net income (Restated) +— +— +— +— +46,796 +Other comprehensive loss (Restated) +— +— +— +(14,012 +) +— +Total comprehensive income +32,784 +Shares issued pursuant to employee benefit plans +— +1 +205 +— +— +206 +Restricted stock +— +1 +4,432 +— +— +4,433 +Common stock issued for Note exchange +— +69 +11,458 +— +— +11,527 +Balance at December 31, 2009 (Restated) +$ +— +$ +287 +$ +243,898 +$ +145 +$ +(325,184 +) +$ +(80,854 +) +Deconsolidation of subsidiary (See Note 3) +— +— +— +— +85,095 +85,095 +Comprehensive income: +Net income +— +— +— +— +8,386 +Other comprehensive loss +— +— +— +(1,082 +) +— +Total comprehensive income +7,304 +Shares issued pursuant to employee benefit plans +— +1 +192 +— +— +193 +Restricted stock +— +2 +4,070 +— +— +4,072 +Balance at December 31, 2010 (Restated) +$ +— +$ +290 +$ +248,160 +$ +(937 +) +$ +(231,703 +) +$ +15,810 +Comprehensive income: +Net income +— +— +— +— +104,149 +Other comprehensive income (See Note 5) +— +— +— +2,561 +— +Total comprehensive income +106,710 +Shares issued pursuant to employee benefit plans +— +— +207 +— +— +207 +Restricted stock +— +3 +2,446 +— +— +2,449 +Common stock issued +— +101 +73,661 +— +— +73,762 +Reconsolidate subsidiary (See Note 3) +— +— +— +— +17 +17 +Balance at December 31, 2011 +$ +— +$ +394 +$ +324,474 +$ +1,624 +$ +(127,537 +) +$ +198,955 +The accompanying notes are an integral part of these financial statements. +51 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In thousands) +For the year ended December 31, +2011 +2010 +2009 +Cash flows from operating activities: +Restated +Net income +$ +104,149 +$ +8,386 +$ +46,796 +Adjustments to reconcile net income to +cash provided by operating activities: +Depreciation, depletion and amortization +49,753 +32,629 +34,274 +Accretion expense +2,338 +2,446 +3,149 +Amortization of non-cash debt related items +461 +397 +2,816 +Amortization of deferred credit +(3,155 +) +(3,670 +) +(294 +) +Equity in earnings of Medusa Spar LLC +(799 +) +(427 +) +(660 +) +Deferred income tax benefit +13,175 +1,503 +18,816 +Valuation allowance +(80,211 +) +(1,503 +) +(11,193 +) +Non-cash interest expense for Callon Entrada non-recourse credit agreement +— +— +3,693 +Non-cash gain on acquired assets +(4,995 +) +— +— +Non-cash (gain) charge for early debt extinguishment +(1,942 +) +339 +— +Non-cash charge related to compensation plans +2,098 +3,107 +2,335 +Payments to settle asset retirement obligations +(2,563 +) +(2,486 +) +(6,657 +) +Changes in current assets and liabilities: +Accounts receivable +(3,734 +) +59,527 +(45,573 +) +Other current assets +180 +(209 +) +(468 +) +Current liabilities +4,695 +907 +(27,260 +) +Change in natural gas balancing receivable +252 +347 +279 +Change in natural gas balancing payable +(115 +) +(300 +) +(312 +) +Change in other long-term liabilities +100 +(115 +) +(12 +) +Change in other assets, net +(520 +) +(776 +) +(31 +) +Cash provided by operating activities +79,167 +100,102 +19,698 +Cash flows from investing activities: +Capital expenditures +(100,243 +) +(59,908 +) +(29,133 +) +Acquisitions +— +(995 +) +(15,756 +) +Proceeds from sale of mineral interests +7,615 +— +— +Investment in restricted assets related to plugging and abandonment +(150 +) +(375 +) +— +Distribution from Medusa Spar LLC +1,267 +1,540 +1,700 +Cash used in investing activities +(91,511 +) +(59,738 +) +(43,189 +) +Cash flows from financing activities: +Increases in senior secured facility +— +— +20,337 +Payments on senior secured facility +— +(10,000 +) +(10,337 +) +Redemption of remaining 9.75% senior notes +— +(16,212 +) +— +Redemption of 13% senior notes +(35,062 +) +— +— +Issuance of common stock +73,765 +Proceeds from exercise of employee stock options +— +(40 +) +— +Cash provided by (used in) financing activities +38,703 +(26,252 +) +10,000 +Net change in cash and cash equivalents +26,359 +14,112 +(13,491 +) +Cash and cash equivalents: +Balance, beginning of period +17,436 +3,635 +17,126 +Less: Cash held by subsidiary deconsolidated at January 1, 2010 +— +(311 +) +— +Balance, end of period +$ +43,795 +$ +17,436 +$ +3,635 +The accompanying notes are an integral part of these financial statements. +52 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +Note +Description +Note +Description +1. +Description of Business and Basis of Presentation +11. +Equity Transactions +2. +Summary of Significant Accounting Policies +12. +Income Taxes +3. +Deconsolidation of Callon Entrada +13. +Oil and Gas Properties +4. +Earnings per Share +14. +Asset Retirement Obligations +5. +Other Comprehensive Income (Loss) +15. +Supplemental Oil and Gas Reserve Data (unaudited) +6. +Borrowings +16. +BOEM Royalty Recoupment +7. +Derivative Instruments and Hedging Activities +17. +Commitments and Contingencies +8. +Fair Value Measurements +18. +Summarized Quarterly Financial Information (unaudited) +9. +Employee Benefit Plans +19. +Subsequent Events +10. +Share-Based Compensation +NOTE 1 – Description of Business, Basis of Presentation and Correction of a Prior Period Error +Callon Petroleum Company has been engaged in the exploration, development, acquisition and production of oil and natural gas properties since 1950. The Company was incorporated under the laws of the state of Delaware in 1994 and succeeded to the business of a publicly traded limited partnership, a joint venture with a consortium of European investors and an independent energy company partially owned by a member of current management. As used herein, the “Company,” “Callon,” “we,” “us,” and “our” refer to Callon Petroleum Company and its predecessors and subsidiaries unless the context requires otherwise. +The Consolidated Financial Statements include the accounts of the Company, and its subsidiary, Callon Petroleum Operating Company (“CPOC”). CPOC also has subsidiaries, namely Callon Offshore Production, Inc. and Mississippi Marketing, Inc. Fiscal years prior to 2010, CPOC also included Callon Entrada Company (“Callon Entrada”), which as discussed in Note 3 was deconsolidated from the Company’s Consolidated Financial Statements effective January 1, 2010. Effective April 29, 2011 and as discussed in Note 3, Callon Entrada was reconsolidated in the Company's financial statements. All intercompany accounts and transactions have been eliminated. Certain prior year amounts have been reclassified to conform to presentation in the current year. To the extent these amounts are material, we have either footnoted them within the Company's disclosures or have noted the items within this footnote. +Unless otherwise indicated, all amounts included within the footnotes to the financial statements are presented in thousands, except for per-share and per-hedge data. +Correction of a Prior Period Error +In conjunction with the preparation of the Company's 2011 financial statements, we determined that prior reporting period financial statements included a misstatement caused by an error in the recording of income tax expense for the year ended December 31, 2009. Management has concluded that the impact of this error is material to previously issued 2009 and 2010 financial statements, and in order to properly report amounts within the Company's stockholders' equity, has restated the prior periods in the current Form 10-K in accordance with SEC guidance. +This restatement results in the reclassification of approximately $7.6 million from other comprehensive income to income tax provision within the Company's 2009 financial statements. The amount of the provision was not the result of any cash taxes that the Company was obligated to pay. Rather the provision relates to the accounting for the required increase in the Company's valuation allowance related to the recoverability of its deferred tax assets, which increased due to the reduction in the associated deferred tax liability from the turnaround of the Company's hedge assets during 2009, which were accounted for through comprehensive income. The Company first established its valuation allowance at December 31, 2008 through its income tax provision related to continuing operations. The restatement does not change the amount of the valuation allowance that was recorded, but instead correctly presents the classification of the income tax provision for the change in the valuation allowance. As a result of the restatement, the Company's 2009 net income was reduced by $7.6 million and its other comprehensive income increased by $7.6 million with no change to the Company's total comprehensive income or total stockholders' equity, total assets or total liabilities for the year then ended. +The information included in this Form 10-K sets forth the effects of these corrections on the previously reported financial statements and accompanying information for the years ended December 31, 2010 and 2009. The net effect of the corrections on the individual financial statement line items for the periods presented are as follows: +53 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +Year ended December 31, 2010 +Year ended December 31, 2009 +As Reported +Adjustment +Restated +As Reported +Adjustment +Restated +Consolidated Balance Sheets: +Other comprehensive loss +$ +(8,560 +) +$ +7,623 +$ +(937 +) +$ +(7,478 +) +$ +7,623 +$ +145 +Retained deficit +(224,080 +) +(7,623 +) +(231,703 +) +(317,561 +) +(7,623 +) +(325,184 +) +Consolidated Statements of Operations: +Income tax (benefit) expense +$ +(174 +) +$ +— +$ +(174 +) +$ +— +$ +7,623 +$ +7,623 +Income before equity in earnings of Medusa Spar LLC +7,959 +— +7,959 +53,759 +(7,623 +) +46,136 +Net income available to common shares +8,386 +— +8,386 +54,419 +(7,623 +) +46,796 +Net income per common share: +Basic +0.29 +— +0.29 +2.47 +(0.35 +) +2.12 +Diluted +0.28 +— +0.28 +2.45 +(0.34 +) +2.11 +Consolidated Statements of Cash Flows +Net income +$ +8,386 +$ +— +$ +8,386 +$ +54,419 +$ +(7,623 +) +$ +46,796 +Valuation allowance +(1,503 +) +— +(1,503 +) +(18,816 +) +7,623 +(11,193 +) +Consolidated Statements of Stockholders' Equity +Comprehensive Income +Net income +$ +8,386 +$ +— +$ +8,386 +$ +54,419 +$ +(7,623 +) +$ +46,796 +Other comprehensive loss +(1,082 +) +— +(1,082 +) +(21,635 +) +7,623 +(14,012 +) +Retained deficit +(224,080 +) +(7,623 +) +(231,703 +) +(317,561 +) +(7,623 +) +(325,184 +) +Other comprehensive income (loss) +(8,560 +) +7,623 +(937 +) +(7,478 +) +7,623 +145 +NOTE 2 – Summary of Significant Accounting Policies +A. +Use of Estimates +The preparation of financial statements in conformity with United States generally accepted accounting principles (“US GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. +B. +Cash and Cash Equivalents +The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. +C. +Accounts Receivable +Accounts receivable consists primarily of accrued oil and natural gas production receivables. The balance in the reserve for doubtful accounts netted within accounts receivable was $36 and $339 at December 31, 2011 and 2010 , respectively. During 2011 , 2010 , and 2009 the Company recorded $(281) , $281 and $0 , respectively of bad debt expense in general and administrative expenses. The negative bad debt expense in 2011 relates to the collection of an amount charged to bad debt during 2010. +D. +Revenue Recognition and Natural Gas Balancing +The Company recognizes revenue under the entitlement method of accounting. Under this method, revenue is deferred for deliveries in excess of the Company’s net revenue interest, while revenue is accrued for the undelivered volumes. Production imbalances +54 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +are generally recorded at the lower of cost or market. The revenue we receive from the sale of natural gas liquids is included in natural gas sales. Natural gas balancing receivables were $144 and $396 as of December 31, 2011 and 2010 , respectively. Natural gas balancing payables were $756 and $870 as of December 31, 2011 and 2010 , respectively. +E. +Major Customers +The Company’s production is generally sold on month-to-month contracts at prevailing prices. The following table identifies customers to whom it sold a significant percentage of its total oil and natural gas production during each of the years ended: +December 31, +2011 +2010 +2009 +Shell Trading Company +45 +% +44 +% +45 +% +Plains Marketing, L.P. +17 +% +20 +% +23 +% +Enterprise Crude Oil, LLC +16 +% +— +% +— +% +Louis Dreyfus Energy Services +4 +% +13 +% +15 +% +Other +18 +% +23 +% +17 +% +Total +100 +% +100 +% +100 +% +Because alternative purchasers of oil and natural gas are readily available, the Company believes that the loss of any of these purchasers would not result in a material adverse effect on its ability to market future oil and natural gas production. +F. +Oil and Natural Gas Properties +The Company uses the full-cost method of accounting for its exploration and development activities. Under this method of accounting, the cost of both successful and unsuccessful exploration and development activities are capitalized as property and equipment. Such amounts include the cost of drilling and equipping productive wells, dry hole costs, lease acquisition costs, delay rentals, interest capitalized on unevaluated leases, other costs related to exploration and development activities, and site restoration, dismantlement and abandonment costs capitalized in accordance with asset retirement obligation accounting guidance. Costs capitalized also include any internal costs that are directly related to exploration and development activities, including salaries and benefits, but do not include any costs related to production, general corporate overhead or similar activities. The Company capitalized $11,857 , $11,829 and $10,107 of these internal costs during 2011 , 2010 and 2009 , respectively. +When applicable, proceeds from the sale or disposition of oil and natural gas properties are accounted for as a reduction to capitalized costs unless a significant portion (greater than 25 percent) of the Company’s reserve quantities are sold, in which case a gain or loss is recognized in income. +Costs of oil and natural gas properties, including future development costs, which have proved reserves and properties which have been determined to be worthless, are depleted using the unit-of-production method based on proved reserves. Excluded from this amortization are costs associated with unevaluated properties, including capitalized interest on such costs. Unevaluated property costs are transferred to evaluated property costs at such time as wells are completed on the properties or management determines that these costs have been impaired. +Under the full cost method of accounting, the Company compares, at the end of each financial reporting period, the present value of estimated future net cash flows from proved reserves (excluding cash flows related to estimated abandonment costs), to the net capitalized costs of proved oil and natural gas properties net of related deferred taxes. The Company refers to this comparison as a “ceiling test.” If the net capitalized costs of proved oil and natural gas properties exceed the estimated discounted (at 10%) future net cash flows from proved reserves, the Company is required to write-down the value of its oil and natural gas properties to the value of the discounted cash flows. Historically, estimated future net cash flows from proved reserves were calculated based on period-end hedge adjusted commodity prices, and the impact of price increases subsequent to the period end could be considered. In December 2008, the Securities and Exchange Commission (“SEC”) issued a final rule, “Modernization of Oil and Gas Reporting,” which adopted revisions to the SEC’s oil and gas reporting requirements. The revisions, which became effective for the Company’s financial statements as of December 31, 2009, replaced the single-day year-end pricing with a twelve-month average pricing assumption. Additionally, consideration of the impact of subsequent price increases after period end is no longer allowed. The changes to prices used in the reserves calculation under the new rule are used in both disclosures and accounting impairment tests. In January 2010, the Financial Accounting Standards Board (“FASB”) issued its final standard on oil and gas reserve estimation and disclosures aligning its requirements with the SEC’s final rule. The new rules were considered a change in accounting principle +55 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +that is inseparable from a change in accounting estimate, which did not require retroactive revision. See Note 13 for additional information regarding the Company’s oil and natural gas properties. +Upon the acquisition or discovery of oil and natural gas properties, the Company estimates by using available geological, engineering and regulatory data the future net costs to dismantle, abandon and restore the property. Such cost estimates are periodically updated for changes in conditions and requirements. In accordance with asset retirement obligation guidance issued by the FASB, such costs are capitalized to the full-cost pool when the related liabilities are incurred. In accordance with SEC's rules, assets recorded in connection with the recognition of an asset retirement obligation are included as part of the costs subject to the full-cost ceiling limitation. The future cash outflows associated with settling the recorded asset retirement obligations are excluded from the computation of the present value of estimated future net revenues used in determining the full-cost ceiling amount. +G. +Amendments to Oil and Natural Gas Reserves Estimation and Disclosure Requirements +In December 2008 the SEC approved amendments to its oil and gas reserves estimation and disclosure requirements. The amendments, among other things: +• +allow the use of reliable technologies to estimate proved reserves if those technologies have been demonstrated to result in reliable conclusions about reserve volumes; +• +require disclosure of oil and gas proved reserves by significant geographic area; +• +permit the optional disclosure of probable and possible reserves; +• +modify the prices used to estimate reserves for SEC disclosure purposes to a 12-month average beginning-of-the-month price instead of a period-end price; and +• +require that if a third party is primarily responsible for preparing or auditing the reserve estimates, the company make disclosures relating to the independence and qualifications of the third party, including filing as an exhibit any report received from the third party. +Additionally, during January 2010, the FASB issued accounting guidance to align the reserve calculation and disclosure requirements of US GAAP with the new SEC oil and gas reserve estimation and disclosure rules. The Company adopted the new requirements effective for its year-end financial statements and our Annual Report on Form 10-K for the year ended December 31, 2009. The adoption had no material impact on the Company’s financial statements. +H. +Other Property and Equipment +The Company depreciates its other property and equipment using the straight-line method over estimated useful lives of three to 20 years. Depreciation expense of $645 , $446 and $423 relating to other property and equipment was included in general and administrative expenses in the Company’s consolidated statements of operations for the years ended December 31, 2011 , 2010 and 2009 , respectively. The accumulated depreciation on other property and equipment was $12,688 and $12,047 as of December 31, 2011 and 2010 , respectively. +I. +Asset Retirement Obligations +The Company is required to record its estimate of the fair value of liabilities for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. Interest is accreted on the present value of the asset retirement obligations and reported as accretion expense within operating expenses in the consolidated statements of operations. See Note 14 for additional information. +J. +Derivatives +Settlements of oil and natural gas derivative contracts are generally based on the difference between the contract price or prices specified in the derivative instrument and a New York Mercantile Exchange (“NYMEX”) price or other cash or futures index price. The current and non-current portion of derivative contracts are carried at fair value in the consolidated balance sheet under the caption “Fair Market Value of Derivatives” and “Other Assets, net / Other long-term liabilities” respectively. The oil and natural gas derivative contracts are settled based upon reported prices on NYMEX. The estimated fair value of these contracts is based upon closing exchange prices on NYMEX and in the case of collars and floors, the time value of options. The Company’s derivative contracts are designated as cash flow hedges, and are recorded at fair market value with the changes in fair value recorded net of tax through other comprehensive income (loss) (“OCI”) in stockholders’ equity. The cash settlements on contracts for future production are recorded as an increase or decrease in oil and natural gas sales. Both changes in fair value and cash settlements of ineffective derivative contracts are recognized as derivative expense (income). See Notes 7 and 8 for additional information. +56 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +K. +Income Taxes +Provisions for income taxes include deferred taxes resulting primarily from temporary differences due to different reporting methods for oil and natural gas properties for financial reporting purposes and income tax purposes. US GAAP requires the recognition of a deferred tax asset for net operating loss carryforwards, statutory depletion carryforward and tax credit carryforwards, net of a valuation allowance. A valuation allowance is provided for that portion of the asset for which it is deemed more likely than not will not be realized. See Note 12 for additional information. +L. +Share-Based Compensation +The Company grants to directors and employees stock options, restricted stock awards ("RS awards"), restricted stock unit awards ("RSU awards") that may be settled in cash or common stock at the option of the Company and RSU awards that may only be settled in cash (“Cash RSU awards”). +Stock Options. For stock options the Company expects to settle in common stock, share-based compensation expense is based on the grant-date fair value and recognized straight-line over the vesting period (generally three years). +RS awards, RSU awards and Cash RSU awards. For RS and RSU awards that the Company expects to settle in common stock, share-based compensation expense is based on the grant-date fair value and recognized straight-line over the vesting period (generally three years). For Cash RSU awards that the Company expects or is required to settle in cash, share-based compensation expense is based on the fair value remeasured at each reporting period, recognized over the vesting period (generally three years) and classified as Accounts payable and accrued liabilities for the portion of the awards that are vested or are expected to vest within the next 12 months, with the remainder classified as Other long-term liabilities . +M. +Statements of Cash Flows +During the three year period ended December 31, 2011 , the Company paid no federal income taxes. During the years ended December 31, 2011 , 2010 and 2009 , the company made cash interest payments of $14,922 , $18,579 and $19,811 , respectively. +N. +Off-Balance Sheet Investment in Medusa Spar LLC +The Company holds a 10% ownership interest in Medusa Spar LLC (“LLC”), which is accounted for under the equity method of accounting for investments. The LLC owns a 75% undivided ownership interest in the deepwater spar production facilities at the Company’s Medusa Field in the Gulf of Mexico. The LLC earns a tariff based upon production volume throughput from the Medusa area. Callon is obligated to process through the spar production facilities its share of production from the Medusa Field and any future discoveries in the area. The balance of Medusa Spar LLC is owned by Oceaneering International, Inc. and Murphy Oil Corporation. +O. +Consolidation of Variable Interest Entities +In June 2009, the FASB issued an accounting standard which became effective for the Company on January 1, 2010, and which amended US GAAP as follows: +• +to require an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a Variable Interest Entity (“VIE”), identifying the primary beneficiary of a VIE; +• +to require ongoing reassessment of whether an enterprise is the primary beneficiary of a VIE, rather than only when specific events occur; +• +to eliminate the quantitative approach previously required for determining the primary beneficiary of a VIE; +• +to amend certain guidance for determining whether an entity is a VIE; +• +to add an additional reconsideration event when changes in facts and circumstances pertinent to a VIE occur; +• +to eliminate the exception for troubled debt restructuring regarding VIE reconsideration; and +• +to require advanced disclosures that will provide users of financial statements with more transparent information about an enterprise’s involvement in a VIE. +The Company adopted the pronouncement for consolidation of variable interest entities on January 1, 2010. Upon adoption, and as discussed in Note 3, the Company reevaluated its interest in its subsidiary, Callon Entrada. Based on the evaluation performed, management concluded that a VIE reconsideration event had taken place resulting in the determination that Callon Entrada is a +57 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +VIE, for which the Company is not the primary beneficiary. Therefore, effective January 1, 2010, Callon Entrada was deconsolidated from the consolidated financial statements of the Company. During the second quarter of 2011 and through the formal execution of a wind-down agreement with its former joint interest partner in the Entrada deepwater project, the Company became the primary beneficiary of Callon Entrada. Consequently, effective April 29, 2011, Callon Entrada was reconsolidated in the Company's financial statements. For additional information, see Note 3. +P. +Earnings per Share ("EPS") +The Company’s basic EPS amounts have been computed based on the weighted-average number of shares of common stock outstanding for the period. Diluted EPS reflects the potential dilution, using the treasury-stock method, which assumes that options were exercised and restricted stock was fully vested. Diluted EPS also includes the impact of unvested share appreciation plans. For awards in which the share price goals have already been achieved, shares are included in diluted EPS using the treasury-stock method. For those awards in which the share price goals have not been achieved, the number of contingently issuable shares included in the diluted EPS is based on the number of shares, if any, using the treasury-stock method, that would be issuable if the market price of the Company’s stock at the end of the reporting period exceeded the share price goals under the terms of the plan. +Q. +Treasury Stock +The Company applies the weighted-average-cost method of accounting for treasury stock transactions and held 29 treasury shares as of December 31, 2011 . +R. +Recent Accounting Pronouncements +From time to time, new accounting pronouncements are issued by FASB that are adopted by the Company as of the specified effective date. If not discussed, management believes that the impact of recently issued standards, which are not yet effective, will not have a material impact on the Company’s financial statements upon adoption. +Presentation of Comprehensive Income +In June 2011, the FASB issued Comprehensive Income (Topic 220) — Presentation of Comprehensive Income (ASU No. 2011-05). The guidance eliminates the option of presenting components of other comprehensive income as part of the statement of stockholders’ equity. The standard will allow the Company the option to present the total of comprehensive income, the components of net income and the components of other comprehensive income in either a single continuous statement of comprehensive income or in two separate but consecutive statements. In December 2011, the FASB issued Comprehensive Income (Topic 220) — Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 (ASU No. 2011-12). The FASB indefinitely deferred the effective date for the guidance related to the presentation of reclassifications of items out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. The standard, except for the portion that was indefinitely deferred, is effective for the Company on January 1, 2012, and must be applied retrospectively. The Company is evaluating the effects of this standard on disclosure, but it will not impact the Company’s results of operations, financial position or cash flows. +Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs +In May 2011, the FASB issued Fair Value Measurement (Topic 820) — Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (ASU No. 2011-04). The standard generally clarifies the application of existing requirements on topics including the concepts of highest and best use and valuation premise and disclosing quantitative information about the unobservable inputs used in the measurement of instruments categorized within Level 3 of the fair value hierarchy. Additionally, the standard includes changes on topics such as measuring fair value of financial instruments that are managed within a portfolio and additional disclosure for fair value measurements categorized within Level 3 of the fair value hierarchy. This standard is effective for the Company on January 1, 2012. The standard will require additional disclosures, but it will not impact the Company’s results of operations, financial position or cash flows. +Balance Sheet Offsetting +In December 2011, the FASB issued Balance Sheet (Topic 210) — Disclosures about Offsetting Assets and Liabilities (ASU No. 2011-11), which updates the Codification to require disclosures regarding netting arrangements in agreements underlying derivatives, certain financial instruments and related collateral amounts, and the extent to which an entity’s financial statement +58 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +presentation policies related to netting arrangements impact amounts recorded to the financial statements. These updates to the disclosure requirements of the Codification do not affect the presentation of amounts in the balance sheet, and are effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those periods. The Company does not expect the implementation of this disclosure guidance to have a material impact on its financial statements. +NOTE 3 - Deconsolidation of Callon Entrada; Global Settlement with Joint Interest Partner +In April 2008, Callon completed the sale of a 50% working interest in the Entrada Field to CIECO Energy (US) Limited (“CIECO”) effective January 1, 2008. At closing, CIECO paid Callon $155,000, and reimbursed the Company $12,600 for 50% of Entrada capital expenditures incurred prior to the closing date. In addition, as part of the purchase and sale agreement, CIECO agreed to loan Callon Entrada, a wholly owned subsidiary of the Company, up to $150,000 plus interest expense incurred up to $12,000, for its share of the development costs for the Entrada project. Based on the terms of the credit agreement with CIECO Energy (Entrada) LLC (“CIECO Entrada”), the debt was to be repaid solely from assets, primarily production, from the Entrada field. All assets of Callon Entrada, including its stock, were pledged to CIECO Entrada under the Callon Entrada credit agreement, and neither Callon nor its subsidiaries (other than Callon Entrada) guaranteed the Callon Entrada credit facility. +Prior to January 1, 2010 and prior to the issuance of revised accounting rules regarding the consolidating of VIEs, the Company was required to consolidate the financial statements and results of operations of Callon Entrada, and as such, Callon Entrada’s non-recourse principal and interest due under the credit facility was reflected in a separate line item in Callon’s 2009 consolidated financial statements. +Based on the Company’s re-evaluation under the revised accounting rules, which are detailed in Note 2, the Company concluded that a VIE reconsideration event had taken place resulting in the determination that Callon Entrada is a VIE, for which the Company was not the primary beneficiary and, as a result, Callon Entrada was deconsolidated from the Company’s consolidated financial statements as of January 1, 2010. Key events considered in this analysis include the following: +Default on non-recourse debt and CIECO’s acceleration rights exercised : As a result of abandoning the Entrada project in November 2008, prior to completion, Callon Entrada’s only source of payment was the proceeds from the sale of equipment purchased but not used for the Entrada project. On April 2, 2009, Callon Entrada received a notice from CIECO Entrada advising Callon Entrada that certain alleged events of default occurred under the credit agreement relating to failure to pay interest when due and the breach of various other covenants related to the decision to abandon the Entrada project. The notice of default received from CIECO Entrada invoked CIECO Entrada’s rights under the Callon Entrada credit agreement to accelerate payment of the principal and interest due, and to invoke its rights to the surplus equipment related to the Entrada project, including the proceeds from the sale of the equipment and the ability to control the decisions related to the sale of the equipment. Based on the advice of legal counsel, Callon believed that it and its other subsidiaries were not otherwise obligated to repay the principal, accrued interest or any other amounts which could become due under the Callon Entrada credit facility. The agreement accrued interest at six-month LIBOR (as in effect on the first day of each interest period) plus 375 basis points and was subject to customary representations, warranties, covenants and events of default. The interest rate increased by 400 basis points on April 2, 2009 when, as discussed above, CIECO Entrada provided notice of default to Callon Entrada,. While at January 1, 2010 Callon Entrada was deconsolidated from these financial statements such that no principal or interest were recorded as outstanding on the Consolidated Balance Sheet at December 31,2010 under this facility, at December 31, 2009, $78,435 of principal and $6,412 of interest were outstanding under this facility. +Abandonment obligations satisfied: Callon guaranteed Callon Entrada’s payment of all amounts to plug and abandon the wells and related facilities and for a breach of law, rule or regulation (including environmental laws) and for any losses of CIECO Entrada attributable to gross negligence of Callon Entrada. The well for which Callon Entrada was responsible was plugged and abandoned in the fourth of quarter of 2008, and the Bureau of Ocean Energy Management, Regulation and Enforcement (“BOEMRE,” formerly the Minerals Management Service) confirmed to Callon during September 2009 that Callon had satisfied all if its abandonment obligations related to this project. +No ability to control future actions of Callon Entrada : As of December 31, 2009, the wind down of the Entrada project was complete, all of the costs related to the Entrada project were paid, and subsequent to the lease expiration June 1, 2009, control of the property reverted to the BOEMRE. The sale of remaining equipment purchased for the Entrada project remained ongoing. The Company believed that the amount of future operating costs of Callon Entrada, for which the Company would be responsible, was insignificant and would be limited to minimal storage fees for the surplus equipment while the equipment was being liquidated. As of December 2010, Callon Entrada had collected $4,235 in sales proceeds from the sale of equipment, net to its interest, which was applied to unpaid interest expense as required under the Callon Entrada credit facility. +59 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +As a result of the events described above, the Company lost its power to direct the only remaining activities that affect Callon Entrada’s future economic performance. Below is a condensed balance sheet of Callon presented to demonstrate the effect of deconsolidation on the financial statements at January 1, 2010: +Callon +Consolidated +at 12/31/09 +Callon +Entrada +Deconsolidated +Callon +Consolidated +at 1/1/2010 +Total current assets +$ +77,684 +$ +(1,767 +) +$ +75,917 +Total oil and Natural gas properties +130,608 +— +130,608 +Other property and equipment +2,508 +— +2,508 +Other assets +17,191 +— +17,191 +Total assets +$ +227,991 +$ +(1,767 +) +$ +226,224 +Other current liabilities +$ +16,889 +$ +(2,015 +) +$ +14,874 +9.75% Senior Notes, due December 2010 +15,820 +— +15,820 +Callon Entrada non-recourse credit facility +84,847 +(84,847 +) +— +Total current liabilities +$ +117,556 +$ +(86,862 +) +$ +30,694 +Total long-term debt +179,174 +— +179,174 +Total other long-term liabilities +12,115 +— +12,115 +Total stockholders’ equity (deficit) +(80,854 +) +85,095 +4,241 +Total liabilities and stockholders’ equity (deficit) +$ +227,991 +$ +(1,767 +) +$ +226,224 +Global Settlement with Joint Interest Partner +During May 2011, the Company entered into a final project wind-down agreement (the “Agreement”) with CIECO. The Agreement, effective as of April 29, 2011, provided for the extinguishment of all existing agreements and commitments between the parties as it related to the past development of the Entrada project. The Agreement included a formal extinguishment of the non-recourse credit agreement between Callon Entrada and CIECO and the assignment to Callon Entrada of CIECO's 50% rights to the remaining assets including primarily the unsold, residual equipment and all engineering data related to the Entrada project. When combined with Callon Entrada's existing 50% ownership of these assets, this Agreement results in Callon Entrada's full ownership of all remaining assets. Also, as a result of this Agreement, which included both the assignment of the rights to the Entrada assets and the proceeds from the ultimate sale of such assets, the Company gained the power to direct the activities related to the sale of the remaining assets, and therefore became the primary beneficiary of Callon Entrada. Therefore, as Callon became its primary beneficiary, Callon Entrada was consolidated in the Company's consolidated financial statements, effective April 29, 2011. +Upon consolidating Callon Entrada, the Company estimated the fair values of the assets acquired to be $11,349 and liabilities assumed of Callon Entrada to be $2,681 as a result of this Agreement. The assets acquired consisted primarily of the Entrada surplus equipment and the liabilities assumed consisted of deferred tax liabilities associated with the basis difference of the equipment. The Company utilized a portion of its deferred tax asset and recognized an income tax benefit equal to $2,681. +During the period from the acquisition date through June 30, 2011, the Company sold certain of the acquired assets for $3,658. Also in connection with this Agreement, Callon Entrada agreed to pay to CIECO approximately $438, which represented the net balance of joint interest billings due to CIECO and which had been previously accrued. The agreement also included joint releases of each party from any further liabilities or obligations to the other party in connection with the Entrada project. +The adjusted fair market value of the net assets acquired of approximately $8,759 were recorded during 2011 as a $5,041 gain and $3,718 as an adjustment to the Company's full cost pool of oil and gas properties. The gain recognition was required as a result of the Company acquiring CIECO's former share of the assets, and the full cost pool adjustment was required to reflect the Company's share of the assets held by the Company prior to the deconsolidation of the Callon Entrada subsidiary in 2010. The gain of $5,041 increased the Company's fully diluted earnings per share by $0.13 for the year ended December 31, 2011. Also as of December 31, 2011 , the remaining unsold assets had carrying values of $6,514 and are included in the Company's balance sheet as a component of Other property and equipment, net. The Company is actively marketing these assets. +NOTE 4 - Earnings per Share +Basic net income per common share was computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted net income per common share was determined on a weighted average basis using +60 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +common shares issued and outstanding adjusted for the effect of stock options and restricted stock considered common stock equivalents computed using the treasury stock method. +A reconciliation of the basic and diluted net income per share computation is as follows (in thousands, except per share amounts): +For the year ended December 31, +2011 +2010 +2009 +Restated +(a) Net income +$ +104,149 +$ +8,386 +$ +46,796 +(b) Weighted average shares outstanding +37,908 +28,817 +22,072 +Dilutive impact of stock options +18 +108 +— +Dilutive impact of restricted stock +656 +551 +128 +(c) Weighted average shares outstanding +for diluted net income per share +38,582 +29,476 +22,200 +Basic net income per share (a/b) +$ +2.75 +$ +0.29 +$ +2.12 +Diluted net income per share (a/c) +$ +2.70 +$ +0.28 +$ +2.11 +The following were excluded from the diluted EPS calculation because their effect would be anti-dilutive: +Stock options +67 +122 +978 +Restricted stock +816 +5 +— +NOTE 5 – Other Comprehensive Income +A summary of the Company’s OCI is detailed below, net of tax: +For the year ended December 31, +2011 +2010 +2009 +Restated +Net income +$ +104,149 +$ +8,386 +$ +46,796 +Other comprehensive income: +Change in fair value of derivatives +2,561 +(1,082 +) +(14,012 +) +Total OCI +$ +106,710 +$ +7,304 +$ +32,784 +NOTE 6 - Borrowings +For the year ended December 31, +2011 +2010 +Principal components: +Credit Facility +$ +— +$ +— +13% Senior Notes due 2016, principal +106,961 +137,961 +Total principal outstanding +$ +106,961 +$ +137,961 +Non-cash components: +13% Senior Notes due 2016 Unamortized deferred credit +18,384 +27,543 +Total carrying value of borrowings +$ +125,345 +$ +165,504 +Senior Secured Revolving Credit Facility (the “Credit Facility”) +61 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +In January 2010, the Company amended its Credit Facility agreement to include Regions Bank as the sole arranger and administrative agent. The third amended and restated Credit Facility, which matures on September 25, 2012, provides for a $100,000 facility. Amounts borrowed under the Credit Facility may not exceed a borrowing base which is reviewed and re-determined on a semi-annual basis using second and fourth quarter financial results and reserve information available at the time of the redetermination. During the second quarter of 2011, the lender completed their borrowing base redetermination, which resulted in a 50% increase in the borrowing base from $30,000 at December 31, 2010 to $45,000 at December 31, 2011 . As of December 31, 2011 , the interest rate on the facility was 3%, defined in the amended agreement as the London Interbank Offered Rate (“LIBOR”), with a minimum of 0.5%, plus a tiered rate ranging from 2.5% to 3.0%, which is based on the amount drawn on the facility. In addition, the Credit Facility carries a commitment fee of 0.5% per annum on the unused portion of the borrowing base, which is payable quarterly. No amounts were outstanding under this facility as of December 31, 2011 . +9.75% Senior Notes (“Old Notes”) (Due December 2010) +During the fourth quarter of 2009, Callon offered to exchange its 13% Senior Notes and convertible preferred stock for any and all of its outstanding Old Notes. Holders of approximately 92% of the Old Notes tendered their Notes in the exchange offer. +On April 30, 2010, the Company redeemed all of the $16,052 remaining Old Notes for $16,343, which included the 1% call premium and $130 of accrued interest through the repurchase date. The Company also recognized $179 of additional interest expense related to the accelerated amortization of the Old Notes’ remaining discount and debt issuance costs, which when added to the $160 call premium resulted in a $339 loss on early extinguishment of this debt. +13% Senior Notes due 2016 (“Senior Notes”) and Deferred Credit +During the fourth quarter of 2009, the Company exchanged $137,961 of Senior Notes for $183,948 of Old Notes. The exchange resulted in a 25% reduction in the principal amount of the Old Notes tendered. In addition, holders of the tendered notes received 3,794 shares of common stock and 311 shares of Convertible Preferred Stock which was valued on November 24, 2009 in the amount of $11,527 and recorded as an increase to stockholders’ equity. On December 31, 2009, each share of the Convertible Preferred Stock was automatically converted by the Company into 10 shares of common stock following shareholder approval and the filing of an amendment to the Company’s charter increasing the number of authorized shares of common stock as necessary to accommodate such conversion. The Senior Notes’ 13% interest coupon is payable on the last day of each quarter. +Upon issuing the Senior Notes during November 2009, the Company reduced the carrying amount of the Old Notes by the fair value of the common and preferred stock issued in the amount of $11,527. The $31,507 difference between the adjusted carrying amount of the Old Notes and the face value of the Senior Notes was recorded as a deferred credit, which is being amortized as a reduction in interest expense over the life of the Senior Notes at an 8.5% effective interest rate. The following table summarizes the Company’s deferred credit balance at December 31, 2011 : +Gross Carrying Amount +Accumulated Amortization +Carrying Value +Amortization Recorded during Current Year as a Reduction of Interest Expense (1) +Estimated Annual Amortization Expense Expected to be Recognized Over Next 12-Months (2) +$ +31,507 +$ +13,123 +$ +18,384 +$ +9,159 +$ +3,350 +(1) +As discussed below, the Company completed in March 2011 the redemption of $31,000 face value of its 13% Senior Notes. As a result of the early redemption of this debt, the Company recognized accelerated amortization of $6,004 for a proportionate share of the deferred credit, thereby increasing amortization recorded during 2011 to the amount reflected in the table. +(2) +Deferred credit amortization expected to be recorded as a reduction in interest expense during 2013, 2014, 2015 and 2016 is $3,647 , $3,971 , $4,323 and $3,093 , respectively. +Following the completion of an equity offering during February 2011, the Company redeemed $31,000 of the Notes. This redemption was completed in March 2011, and resulted in a gain on the early extinguishment of debt of $1,974. The gain represents the difference between the $35,062 paid for $37,004 (including $31,000 principal amount of the notes plus $6,004 of accelerated deferred credit amortization) carrying value of the Notes, offset by the $4,030 charge related to the 13% call premium required by the terms of the call option and $32 of redemption expenses. +Certain of the Company’s subsidiaries guarantee the Company’s obligations under the Senior Notes. The subsidiary guarantors are 100% owned, all of the guarantees are full and unconditional and joint and several, the parent company has no independent +62 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +assets or operations and any subsidiaries of the parent company other than the subsidiary guarantors are minor. +Restrictive Covenants +The Indenture governing our Senior Notes and the Company’s Credit Facility contains various covenants including restrictions on additional indebtedness and payment of cash dividends. In addition, Callon’s Credit Facility contains covenants for maintenance of certain financial ratios. The Company was in compliance with these covenants at December 31, 2011 . +NOTE 7 – Derivative Instruments and Hedging Activities +Objectives and Strategies for Using Derivative Instruments +The Company is exposed to fluctuations in crude oil and natural gas prices on the majority of its production. Consequently, the Company believes it is prudent to manage the variability in cash flows on a portion of its crude oil and natural gas production. The Company utilizes primarily collars and swap derivative financial instruments to manage fluctuations in cash flows resulting from changes in commodity prices. The Company does not use these instruments for trading purposes. +Counterparty Risk +The use of derivative transactions exposes the Company to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments. To reduce the Company’s risk in this area, counterparties to the Company’s commodity derivative instruments predominantly include a large, well-known financial institution and a large, well-known oil and gas company. The Company monitors counterparty creditworthiness on an ongoing basis; however, it cannot predict sudden changes in counterparties’ creditworthiness. In addition, even if such changes are not sudden, the Company may be limited in its ability to mitigate an increase in counterparty credit risk. Should one of these counterparties not perform, the Company may not realize the benefit of some of its derivative instruments under lower commodity prices. +The Company executes commodity derivative transactions under master agreements that have netting provisions that provide for offsetting payables against receivables. In general, if a party to a derivative transaction incurs an event of default, as defined in the applicable agreement, the other party will have the right to demand the posting of collateral, demand a transfer or terminate the arrangement. +Settlements and Financial Statement Presentation +Settlements of oil and natural gas derivative contracts are generally based on the difference between the contract price or prices specified in the derivative instrument and a NYMEX price or other cash or futures index price. The estimated fair value of these contracts is based upon closing exchange prices on NYMEX and in the case of collars and floors, the time value of options. For additional information, including the balance sheet presentation of derivative instrument asset and liability balances, see Note 8 for additional information. +The Company’s derivative contract recorded on the Consolidated Balance Sheets as of December 31, 2011 are designated as cash flow hedges, and are recorded at fair market value with the changes in fair value recorded net of tax through OCI in stockholders’ equity. The future cash settlements on effective derivative contracts are recorded as an increase or decrease in oil and natural gas sales. Both changes in fair value and cash settlements of ineffective derivative contracts are recognized as derivative expense (income). +Listed in the table below are the outstanding oil and natural gas derivative contracts, consisting entirely of collars, as of December 31, 2011 : +Product +Volumes per Month +Quantity Type +Average Floor Price per Hedge +Average Ceiling Price per Hedge +Period +Oil +25 +Bbls +$ +90.00 +$ +122.00 +Jan12 - Dec12 +Oil +25 +Bbls +$ +95.00 +$ +125.00 +Jan12 - Dec12 +The tables below present the effect of the Company’s derivative financial instruments on the consolidated statements of operations as an increase (decrease) to oil and natural gas sales: +63 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +For the year ended December 31, +2011 +2010 +2009 +Amount of Gain (Loss) Reclassified from OCI into Income (1) +$ +(375 +) +$ +632 +$ +19,242 +Amount of Gain Recognized in Income (2) +— +— +— +(1) +Effective portion +(2) +Ineffective Portion and amount Excluded from Effectiveness Testing +Subsequent Event: +During February 2012, the Company entered into a derivative contract with the following terms: +Product +Volumes per Month +Quantity Type +Average Floor Price per Hedge +Average Ceiling Price per Hedge +Period +Oil +40 +Bbls +$ +90.00 +$ +116.00 +Jan13 - Dec13 +Also in February 2012, the Company elected not to designate this derivative contract, nor does it expect to designate future derivative contracts, as an accounting hedge under FASB ASC 815-20-25. Consequently, any derivative contract not designated as an accounting hedge will be carried at its fair value on the balance sheet and are marked-to-market at the end of each period. Both realized and unrealized gains or losses on these derivatives will be recorded on the statement of operations as a component of the Company's revenues. +NOTE 8 – Fair Value Measurements +Fair value is defined within the accounting rules as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The rules established a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. As presented in the tables below, this hierarchy consists of three broad levels: +Level 1 +Valuations consist of unadjusted quoted prices in active markets for identical assets and liabilities and has the highest priority; +Level 2 +Valuations rely on quoted prices in markets that are not active or observable inputs over the full term of the asset or liability; +Level 3 +Valuations are based on prices or third party or internal valuation models that require inputs that are significant to the fair value measurement and are less observable and thus have the lowest priority. +Fair Value of Financial Instruments +Cash, Cash Equivalents, and Short-Term Investments. The carrying amounts for these instruments approximate fair value due to the short-term nature or maturity of the instruments. +Debt. The Company’s debt is recorded at the carrying amount on its Consolidated Balance Sheet. The fair value of Callon’s fixed-rate debt is based upon estimates provided by an independent investment banking firm. The carrying amount of floating-rate debt approximates fair value because the interest rates are variable and reflective of market rates. +The following table summarizes the respective carrying and fair values at: +For the year ended December 31, +2011 +2010 +Carrying Value +Fair Value +Carrying Value +Fair Value +Credit Facility +$ +— +$ +— +$ +— +$ +— +13% Senior Notes due 2016 (a) +125,345 +110,571 +165,504 +140,030 +Total +$ +125,345 +$ +110,571 +$ +165,504 +$ +140,030 +(a) +2011 and 2010 Fair value is calculated only in relation to the $106,961 and $137,961 face value outstanding of the 13% Senior Notes, respectively. The remaining $18,384 and $27,543 , respectively represents the Company's deferred credits +64 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +and have been excluded from the fair value calculation. See Note 6 for additional information. +Assets and Liabilities Measured at Fair Value on a Recurring Basis +Certain assets and liabilities are reported at fair value on a recurring basis (unless otherwise noted below) in Callon’s Consolidated Balance Sheet. The following methods and assumptions were used to estimate the fair values: +Commodity Derivative Instruments. Callon’s derivative policy allows for commodity derivative instruments to consist of collars and natural gas and crude oil basis swaps, though at December 31, 2011 the Company’s portfolio included only collars. The fair value of these derivatives is derived using a valuation model that utilizes market-corroborated inputs that are observable over the term of the derivative contract, and the values are corroborated by quotes obtained from counterparties to the agreements. The Company’s fair value calculations also incorporate an estimate of the counterparties’ default risk for derivative assets and an estimate of the Company’s default risk for derivative liabilities. The Company believes that the majority of the inputs used to calculate the commodity derivative instruments fall within Level 2 of the fair-value hierarchy based on the wide availability of quoted market prices for similar commodity derivative contracts. See Note 7 for additional information regarding the Company’s derivative instruments. +The following tables present the Company’s assets and liabilities measured at fair value on a recurring basis for each hierarchy level: +December 31, 2011 +Balance Sheet Presentation +Level 1 +Level 2 +Level 3 +Total +Assets +Derivative financial instruments - current Portion +Fair market value of derivatives +$ +— +$ +2,499 +$ +— +$ +2,499 +Derivative financial instruments - non-current +Other assets, net +— +— +— +— +Liabilities +Derivative financial instruments - current Portion +Fair market value of derivatives +$ +— +$ +— +$ +— +$ +— +Derivative financial instruments - non-current +Other long-term liabilities +— +— +— +— +Total +$ +— +$ +2,499 +$ +— +$ +2,499 +The derivative fair values above are based on analysis of each contract. Derivative assets and liabilities with the same counterparty are presented here on a gross basis, even where the legal right of offset exists. See Note 7 for a discussion of net amounts recorded in the Consolidated Balance Sheet at December 31, 2011 . +Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis +Certain assets and liabilities are reported at fair value on a nonrecurring basis in Callon’s Consolidated Balance Sheet. The following methods and assumptions were used to estimate the fair values: +Asset Retirement Obligations Incurred in Current Period. Callon estimates the fair value of AROs based on discounted cash flow projections using numerous estimates, assumptions and judgments regarding such factors as (1) the existence of a legal obligation for an ARO, (2) amounts and timing of settlements, (3) the credit-adjusted risk-free rate to be used and (4) inflation rates. AROs incurred for the year ended December 31, 2011 and resulting in fair value measurement, including upward revisions to ARO liabilities of $454 , were Level 3 fair value measurements. See Note 14 for a summary of changes in the Company’s ARO liability. +Other Property and Equipment. See Note 3 for additional information regarding the Entrada project assets acquired through a wind-down agreement with Callon’s former joint interest partner on the project. During the second quarter of 2011, Callon acquired 100% of the rights to all remaining assets related to the Entrada project, which primarily consisted of surplus equipment not used during the Entrada project. As Callon is required to measure the assets acquired at fair value, Callon estimated each asset’s fair value based on several factors including (1) historical prices received for assets sold, (2) the similarity of unsold assets to those previously sold and the sales prices for those similar assets, (3) the number of market participants expected to have an interest in the assets, (4) the degree to which the asset has been customized and would require modification by a purchaser for use, and (5) the nature of the asset being held for sale (i.e. whether the asset is highly specialized, built-for-purpose, etc.). Values assigned to equipment sold prior to the June 30 reporting date and for which the exit price, as defined by US GAAP, became readily determinable, represent Level 2 fair value measurements and represents $3,954 of the total $11,349 acquired through the agreement. The remaining $7,395 of Entrada assets represent Level 3 fair value measurements based on the limited ability of market pricing information for either identical or similar items. Certain assets were assigned $0 values in instances where the fair value was indeterminable due +65 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +to the built-for-purpose or highly specialized nature of the assets. Also as a result of this Agreement, the Company assumed liabilities, which consisted of a deferred tax liability associated with the basis difference of the equipment, which was valued at $2,681. During the third quarter of 2011, the Company determined that certain unsold surplus Entrada equipment with carrying values of $690 had become impaired due to the limited market for these assets and based on discussions with potential buyers. Consequently, the Company reduced these assets' carrying value to $348, which represents a Level 3 fair value measurement. See Note 3 for additional information regarding this equipment. +NOTE 9 – Employee Benefit Plans +The Company utilizes various forms of incentive compensation designed to align the interest of the executives and employees with those of its stockholders. The narrative that follows provides a brief description of each plan, summarizes the overall status of each plan and discusses current year awards under each plan: +Savings and Protection Plan +The Savings and Protection Plan (“401-K Plan”) provides employees with the option to defer receipt of a portion of their compensation, and the Company may, at its discretion, match a portion of the employee's deferral with cash. The Company may also elect, at its discretion, to contribute a non-matching amount in cash and Company Common Stock to employees. The amounts held under the 401-K Plan are invested in various funds maintained by a third party in accordance with the directions of each employee. An employee is fully vested, including Company discretionary contributions, immediately upon participation in the 401-K Plan. The total amounts contributed by the Company, including the value of the common stock contributed, were $811 , $690 and $640 in the years 2011 , 2010 and 2009 , respectively. +2011 Omnibus Incentive Plan (the “2011 Plan”) +The 2011 Plan, which became effective May 12, 2011 following shareholder approval, authorized and reserved for issuance 2,300 shares of common stock, which may be issued upon exercise of vested stock options and/or the vesting of any other share-based equity award that is granted under this plan. The 2011 Plan is currently the Company's only active plan, and included a provision whereby all remaining, un-issued and authorized shares from the Company's previous share-based incentive plans (detailed below) are now issuable under the 2011 Plan. Another provision provided that shares which would otherwise become available for issue under the previous plans as a result of vesting and/or forfeiture of any equity awards existing as of May 12, 2012, would also increase the authorized shares available to the 2011 Plan. +Equity awards issued under this plan may be subject to various vesting, accelerated vesting, and forfeiture provisions upon the occurrence of certain events. Any vested but unexercised options contractually expire 10 years from the date of grant. Equity awards under the 2011 Plan generally vest over time but may also be subject to attaining a specified performance metrics and may be immediate or cliff vest at a specified date. The Company will recognize expense on the grant date for all immediately vesting awards, while it will recognize expense ratably over the requisite service (i.e. vesting) period for both cliff and ratably vesting awards. For performance-based awards, the Company recognizes expense based on its analysis of the performance criteria, and records or reverses expense as necessary based on its analysis. For market-based awards, the Company recognizes expense based on its analysis of the market criteria, and records expense as necessary based on its analysis. Awards with a market-based provision do not allow for the reversal of previously recognized expense, even if the market metric is not achieved and no shares ultimately vest or are awarded. +The provisions discussed above related to the transfer of issuable shares in to the 2011 Plan resulted in the transfer of approximately 841 additional shares authorized for issuance under this Plan, increasing the total shares reserved for issuance to 3,141 . During 2011 , 735 shares were awarded to various officers and employees of the Company and 57 restricted stock units were issued to members of our Board of Directors. These awards will vest based on the passage of time. Consequently and as of December 31, 2011 , the 2011 Plan had 2,349 shares remaining and eligible for future issuance. +The following plans were replaced by the 2011 Plan, though as discussed above, previously issued and unvested awards remain outstanding under the following plans: +1996 Stock Incentive Plan (the “1996 Plan”) +The 1996 Plan, first adopted by the Board of Directors on August 23, 1996 and approved by the shareholders during 1997 and as amended, authorized and reserved for issuance 2,200 shares of common stock for issuance upon exercise of vested stock options and vesting of other share-based equity awards. Unvested options under this plan are subject to various +66 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +accelerated vesting and forfeiture provisions subject to the occurrence of certain events, and unexercised, vested options expire 10 years from the date of grant. Equity awards under the plan generally vest over time or subject to attaining a specified metric, but vesting of awards may be immediate or cliff vest at a specified date. The Company recognizes expense on the grant date for all immediately vesting awards, while it recognizes expense ratably over the requisite service (i.e. vesting) period for both cliff and ratably vesting awards. For performance-based awards, the Company recognizes expense based on its analysis of the performance criteria, and records or reverses expense as necessary based on its analysis. +As discussed above and during 2011, all shares remaining and eligible for future issuance from the 1996 Plan as of the effective date of the 2011 Plan were transferred into the 2011 plan. Consequently, no awards were made from the 1996 plan during the current year. Other activity within the 1996 Plan during 2011 included the expiration of 25 vested, unexercised stock options. As of December 31, 2011, the 1996 Plan had no shares remaining and eligible for future issuance. +2002 Stock Incentive Plan (the “2002 Plan”) +The 2002 Plan, adopted by the Board of Directors on February 14, 2002, authorized and reserved for issuance 350 shares of common stock for issuance upon exercise of vested stock options and vesting of other share-based equity awards. The 2002 Plan is considered a “broadly-based plan” and did not require shareholder approval. Unvested options under this plan are subject to various accelerated vesting and forfeiture provisions subject to the occurrence of certain events, and unexercised, vested options expire 10 years from the date of grant. Equity awards under the plan generally vest over time or subject to attaining a specified metric, but vesting of awards may be immediate or cliff vest at a specified date. The Company recognizes expense on the grant date for all immediately vesting awards, while it recognizes expense ratably over the requisite service (i.e. vesting) period for both cliff and ratably vesting awards. For performance-based awards, the Company recognizes expense based on its analysis of the performance criteria, and records or reverses expense as necessary based on its analysis. +As discussed above and during 2011, all shares remaining and eligible for future issuance from the 2002 Plan as of the effective date of the 2011 Plan were transfered into the 2011 plan. Consequently, no awards were made from the 2002 plan during the current year. Other activity within the 2002 Plan during 2011 included the forfeiture of 13 restricted stock units due to an employee departure from the Company. As of December 31, 2011, the 2002 Plan had no shares remaining and available for future issuance. +2006 Stock Incentive Plan (the “2006 Plan”) +The 2006 Plan, adopted by the Board of Directors on March 9, 2006 and approved by the shareholders at the May 4, 2006 annual meeting, authorized and reserved for issuance 500 shares of common stock for issuance upon exercise of vested stock options and vesting of other share-based equity awards. Unvested options under this plan are subject to various accelerated vesting and forfeiture provisions subject to the occurrence of certain events, and unexercised, vested options expire 10 years from the date of grant. Equity awards under the plan generally vest over time or subject to attaining a specified metric, but vesting of awards may be immediate or cliff vest at a specified date. The Company recognizes expense on the grant date for all immediately vesting awards, while it recognizes expense ratably over the requisite service (i.e. vesting) period for both cliff and ratably vesting awards. For performance-based awards, the Company recognizes expense based on its analysis of the performance criteria, and records or reverses expense as necessary based on its analysis. +As discussed above and during 2011, all shares remaining and eligible for future issuance from the 2006 Plan as of the effective date of the 2011 Plan were transferred into the 2011 plan. Consequently, no awards were made from the 2006 plan during the current year. Other activity during 2011 included the forfeiture of 5 restricted stock units due to an employee departure from the Company and the vesting 48 restricted stock units awarded in prior years. As of December 31, 2011, the 2006 Plan had no shares remaining and available for future issuance. +2009 Stock Incentive Plan (the “2009 Plan”) +The 2009 Plan, adopted by the Board of Directors on March 5, 2009 and approved by shareholders on April 30, 2009, authorizes and reserves for issuance 1,250 shares of common stock for issuance upon exercise of vested stock options and vesting of other share-based equity awards. Unvested options under this plan are subject to various accelerated vesting and forfeiture provisions subject to the occurrence of certain events, and unexercised, vested options expire 10 +67 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +years from the date of grant. Equity awards under the plan generally vest over time or subject to attaining a specified metric, but vesting of awards may be immediate or cliff vest at a specified date. The Company recognizes expense on the grant date for all immediately vesting awards, while it recognizes expense ratably over the requisite service (i.e. vesting) period for both cliff and ratably vesting awards. For performance-based awards, the Company recognizes expense based on its analysis of the performance criteria, and records or reverses expense as necessary based on its analysis. +As discussed above and during 2011, all shares remaining and eligible for future issuance from the 2009 Plan as of the effective date of the 2011 Plan were transferred into the 2011 plan. However, prior to that effective date, 45 restricted stock units were awarded to an employee, which vest one-third on each successive anniversary date of the award. Other activity during 2011 included the forfeiture of 10 restricted stock units due to employee departures from the Company and the vesting of 5 restricted stock units awarded in prior years. As of December 31, 2011, the 2009 Plan had no shares remaining and available for future issuance. +Stock Incentive Award for Inducement of Employment +On June 1, 2009, as an inducement of employment, the Company awarded to its then Executive Vice President and Chief Operating Officer (“COO”) 200 restricted stock units of which one-half were to vest on June 1, 2012 based on achieving certain metrics and one-half was to vest on June 1, 2013 subject to the COO being employed by the Company on that date. The vesting of the portion of the award subject to achieving a specified metric was contingent upon the Company's relative ranking amongst a Company-selected peer group of other public oil and gas companies, and was subject to a 0% - 150% adjustment. The Company also awarded the COO 500 stock options with vesting determined by the Company's stock price achieving certain levels. These stock options were approved to cliff vest in one-third increments upon the stock price reaching specified levels. Following the COO's September 2010 departure from the Company, the COO forfeited all of his restricted and performance-based shares and 333 of the unvested performance-based stock options. Prior to his departure in 2010, the Company did achieve the first of three performance metrics specified in the performance-based stock options agreement resulting in the vesting of these 167 options, for which the Company recorded approximately $180 of compensation expense. +On April 1, 2010, as an inducement of employment, the Company awarded 50 restricted stock units to Gary A. Newberry, its new Senior Vice President of Operations. The restricted stock units cliff vested on January 1, 2011, and were fully expensed as of December 31, 2010. +Other Incentive Awards +During 2011, the Company awarded 308 restricted stock units that cliff vest in December, 2013, which will ultimately be settled in cash. The number of units that will ultimately vest will be based on a calculation that compares the Company's total shareholder return to the same calculated return of a group of peer companies as selected by the Company, and the number of units that vest can range between 0% and 150% of the remaining restricted stock units. Because this award is payable in cash, the entire award is accounting for as a liability, and is recorded on the Company's consolidated balance sheet for the ratable portion of its fair value. Changes in fair value of the award are recorded as adjustments to compensation expense. +Also during 2011, the Company awarded 56 restricted stock units that cliff vest in May 2014 to officers and employees of the Company. In addition, 19 restricted stock units were awarded to a member of our Board of Directors which will vest upon this Director's termination of service to the Company. Upon vesting, these units will be paid in cash based on the closing stock price of the Company's common stock on the vesting date. These awards are accounted for as a liability, and are recorded on the Company's consolidated balance sheet for the ratable portion of its fair value. Changes in fair value of the award are recorded as adjustments to compensation expense. +During 2010, the Company awarded 400 restricted stock units that cliff vest in December, 2012, which will ultimately be settled in cash. During the year of issuance, 50 of these performance-based restricted stock units were forfeited following an employee departure from the Company. During 2011, an additional 10 restricted stock units were forfeited following an employee departure from the Company. The number of units that will ultimately vest will be based on a calculation that compares the Company's total shareholder return the same calculated return of a group of peer companies as selected by the Company, and the number of units that vest can range between 0% and 150% of the remaining 340 restricted stock units. Because this award is payable in cash, the entire award is accounting for as a liability, and is recorded on the Company's consolidated balance sheet for the ratable portion of its fair value. Changes in fair value of the award are recorded as adjustments to compensation expense. +Also during 2010, the Company awarded 94.5 restricted stock units that cliff vest in May 2012. Subsequent to the issuance, 15 +68 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +of these restricted stock units were forfeited following an employee departure from the Company. Upon vesting, these units will be paid in cash based on the closing stock price of the Company's common stock on the vesting date. This award is accounted for as a liability award, and is recorded on the Company's consolidated balance sheet for the ratable portion of its fair value. Changes in fair value of the award are recorded as adjustments to compensation expense. +During 2009, the Company awarded 121.5 restricted stock units that cliff vest in August 2012 and allow for automatic early vesting upon a qualifying retirement. Vesting units under this award will be settled in cash based on the closing price of the Company's common stock on the date of vesting. This award is accounted for as a liability award, and is recorded on the Company's consolidated balance sheet at its fair value. Changes in fair value of the award are recorded as adjustments to compensation expense. +Tabular disclosures related to the share-based awards are presented below in Note 10. +NOTE 10 - Share-Based Compensation +As discussed in Note 9, “Employee Benefit Plans,” the Company has various stock plans (“Plans”) under which employees of the Company and its subsidiaries and non-employee members of the Board of Directors of the Company have been or may be granted certain share-based compensation. Shares available for future stock option or restricted stock grants to employees and directors under existing plans were 2,349 at December 31, 2011 . The Company recorded non-cash share-based compensation expense of $4,393 , $5,701 and $4,821 during the years ended December 31, 2011 , 2010 and 2009 , respectively. The portion of this non-cash share-based compensation expense that was included in general and administrative expense totaled $2,502 , $3,107 and $2,335 for the same years respectively, and the portion capitalized to oil and gas properties was $1,891 , $2,594 and $2,486 , respectively. Non-cash share-based compensation included: +For the year ended December 31, +Non-cash compensation expense for: +2011 +2010 +2009 +Options +$ +24 +$ +206 +$ +144 +RSUs +2,832 +3,898 +4,302 +Share-based units +1,335 +1,396 +182 +401(k) contributions in shares +202 +201 +193 +Total non-cash compensation expense +$ +4,393 +$ +5,701 +$ +4,821 +The following table presents unrecognized compensation expense expected to be recognized in future periods: +As of December 31, +Unrecognized compensation costs related to: +2011 +2010 +2009 +Unvested options +$ +— +$ +57 +$ +649 +Unvested RSUs +5,748 +3,353 +3,201 +Unvested share-based units +2,498 +2,676 +— +Future share-based compensation expense expected to be recognized for: +2012 +2013 +2014 +Thereafter +Total +Options +$ +— +$ +— +$ +— +$ +— +$ +— +RSUs +2,913 +2,129 +706 +— +5,748 +Stock appreciation rights +1,752 +711 +35 +— +2,498 +Liability-based restricted stock unit awards accounted are recorded on the Company’s consolidated balance sheet at December 31, 2011 , 2010 and 2009 as a component of accounts payable and accrued liabilities for $604 , $0 and $0, respectively, and as a component of other long-term liabilities for $2,309 , $1,578 and $182 , respectively. This liability is marked to fair value each reporting period with changes in the fair value recognized in compensation expense. +Stock Options +The Company uses the Black-Scholes option pricing model to estimate the fair value of stock option awards with the following +69 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +weighted-average assumptions for the indicated periods. There were no stock options issued during either 2011 or 2010. +For the year ended December 31, +2011 +2010 +2009 +Dividend yield +n/a +n/a +— +Expected volatility +n/a +n/a +1.36 +Risk-free interest rate +n/a +n/a +0.039 +Expected life of option (in years) +n/a +n/a +9 +Weighted-average grant-date fair value +n/a +n/a +1.23 +Forfeiture rate +n/a +n/a +— +The assumptions above are based on multiple factors, including historical exercise patterns of employees with respect to exercise and post-vesting employment termination behaviors, expected future exercising patterns and the historical volatility of the Company’s stock price. The following table represents stock option activity: +For the year-ended December 31, +2011 +2010 +2009 +Shares +Wtd Avg Ex Price per Option +Shares +Wtd Avg Ex Price per Option +Shares +Wtd Avg Ex Price per Option +Outstanding, beginning of year +198 +$ +9.57 +978 +$ +6.37 +513 +$ +10.27 +Granted (at market) +— +— +— +— +500.00 +2.76 +Exercised +— +— +(168 +) +2.77 +— +— +Forfeited +(15 +) +18.69 +(334 +) +2.78 +(15 +) +14.44 +Expired +(10 +) +11.61 +(278 +) +10.61 +(20.00 +) +9.99 +Outstanding, end of year +173 +$ +8.66 +198 +$ +9.57 +978 +$ +6.37 +Exercisable, end of year +173 +$ +8.66 +184 +$ +8.99 +465 +$ +9.93 +Weighted-average remaining contract life per unit: +Outstanding options at end of period in years +2.0 +3.1 +5.8 +Outstanding exercisable at end of period in years +2.0 +2.9 +1.8 +As of December 31, +2011 +2010 +2009 +Aggregate intrinsic value of options outstanding & exercisable +$ +— +$ +— +— +Aggregate intrinsic value of options exercised during the year +— +175 +— +Fair value of shares vesting during the year +— +207 +58 +There were no stock option exercises in the year ended December 31, 2009 , and no cash proceeds from the exercise of stock options for the years ended December 31, 2011 or 2010 due to the fact that all options were exercised through net-share settlements. +Restricted Stock Units +The following table represents unvested restricted stock activity for the year ended December 31, 2011 : +70 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +Weighted average +Number of Shares +Grant-Date Fair Value per Share +Period over which expense is expected to be recognized +Outstanding at the beginning of the period +1,421 +$ +5.35 +Granted +837 +6.81 +Vested +(312 +) +10.67 +Forfeited +(28 +) +2.81 +Outstanding at the end of the period +1,918 +$ +5.16 +2.0 years +NOTE 11 – Equity Transactions +During February, 2011, the Company received $73,720 in net proceeds from the public offering of 10,100 shares of its common stock, which included the issuance of 1,100 shares pursuant to the underwriters' over-allotment option. The Company used $35,062 of the proceeds to repurchase $31,000 principal amount of its Senior Notes, with the remaining proceeds intended for general corporate purposes including the planned development of the Company's Permian Basin and other onshore assets. The Company completed the redemption in March 2011, which resulted in a gain on the early extinguishment of debt of $1,974. The gain represents the difference between the $35,062 paid for the $37,004 (including the $31,000 principal amount of the notes plus $6,004 of accelerated deferred credit amortization) carrying value of the Notes, offset by the $4,030 charge related to the 13% call premium required by the terms of the call option and $32 of redemption expenses. +NOTE 12 – Income Taxes +The following table presents Callon’s net tax benefits relating to its reported net losses and other temporary differences from operations: +For the year ended December 31 +2011 +2010 +Deferred tax asset: +Restated +Federal net operating loss carryforward +$ +86,551 +$ +79,680 +Statutory depletion carryforward +7,032 +6,140 +Alternative minimum tax credit carryforward +208 +208 +Asset retirement obligations +3,552 +4,018 +Other +6,935 +11,796 +Deferred tax asset before valuation allowance +104,278 +101,842 +Less: Valuation allowance +— +(80,211 +) +Total deferred tax asset +104,278 +21,631 +Deferred tax liability: +Oil and gas properties +40,782 +21,631 +Other +— +— +Total deferred tax liability +40,782 +21,631 +Net deferred tax asset +$ +63,496 +$ +— +As of December 31, 2010, the Company continued to carry a full valuation allowance against its net deferred tax assets. The Company considered both the positive and negative evidence in determining whether it is more likely than not that its deferred tax assets are recoverable. The Company incurred a loss in 2008, primarily as a result of a writedown of its oil and gas properties following the ceiling test, which created a loss on an aggregate basis for the three-year period ended December 31, 2008. Primarily as a result of recent cumulative losses, the Company established a full valuation allowance as of December 31, 2008, and has continued to carry the full valuation allowance each reporting period since December 31, 2008. +The Company reported profitable operations from 2009 to 2011, and has income on an aggregate basis for the three-year period ended December 31, 2011. After considering all available positive and negative evidence, the Company expects that it is more +71 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +likely than not that it will fully utilize its deferred tax assets recorded at December 31, 2011. Among other factors, the Company believes its recent cumulative income, together with its future operating results using current proved reserves, provide sufficient positive evidence to reach this conclusion. Consequently, the Company reversed the related valuation allowance at December 31, 2011. +If not utilized, the Company’s federal operating loss ("NOL") carryforwards will expire as follows: +Expiring +Total +2012 +2013 +2014 +2015 +2016 +2017 - 2031 +Federal NOL carryforwards +247,929 +— +— +— +— +— +247,929 +The Company has limited state taxable income, and is not subject to state income taxes. Accordingly, the Company has established a full valuation allowance on the tax benefit of approximately $7,880 associated with the state net operating loss carryforwards of approximately $172,643 which expire in years through 2031, as the Company does not anticipate generating taxable state income in the states in which these carryforwards apply. These amounts are not included in the deferred tax summary table above. +The Company had no significant unrecognized tax benefits at December 31, 2011. Accordingly, the Company does not have any interest or penalties related to uncertain tax positions. However, if interest or penalties were to be incurred related to uncertain tax positions, such amounts would be recognized in income tax expense. Tax periods for years 2000 through 2011 remain open to examination by the federal and state taxing jurisdictions to which the Company is subject. +In addition, the NOL carryback provision of the Internal Revenue Code was amended on November 6, 2009, as part of The Worker, Homeownership and Business Assistance Act of 2009 (the “WHB Act”). The WHB Act allows businesses with NOLs for 2008 and 2009 to carry back losses for up to five years and suspends the 90% limitation on the use of any alternative minimum tax NOL deduction attributable to carrybacks of the applicable NOL. There would be no limit on the NOL carrybacks for the first four preceding years of the carryback period, but for the fifth preceding year, the NOL carryback would be limited to fifty percent of a company’s taxable income in that year. In applying the new five-year NOL carryback rule, the Company was able to file during 2010 for a refund claim to recover approximately $174. +Below is a reconciliation of the reported amount of income tax expense attributable to continuing operations for the year to the amount of income tax expense that would result from applying domestic federal statutory tax rates to pretax income from continuing operations. +For the years ended December 31, +Component of Income Tax Rate Reconciliation +2011 +2010 +2009 +Restated +Income tax expense computed at the statutory federal income tax rate +35 +% +35 +% +35 +% +Change in valuation allowance +(216 +)% +(18 +)% +(20 +)% +Percentage depletion carryforward +(3 +)% +(15 +)% +0 % +Other +3 +% +— +% +(1 +)% +Effective income tax rate +(181 +)% +2 +% +14 +% +For the years ended December 31, +Components of Income Tax Expense +2011 +2010 +2009 +Restated +Current income tax benefit +$ +— +$ +(174 +) +$ +— +Deferred income tax expense +13,175 +1,503 +18,816 +Valuation allowance +(80,211 +) +(1,503 +) +(11,193 +) +Total income tax (benefit) expense +$ +(67,036 +) +$ +(174 +) +$ +7,623 +* See Note 1 for additional information related to the restated 2009 amounts. +NOTE 13 – Oil and Natural Gas Properties +The following table discloses certain financial data relating to the Company's oil and natural gas activities, all of which are located in the United States. +72 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +For the year ended December 31, +2011 +2010 +2009 +Capitalized costs incurred: +Evaluated Properties- +Beginning of period balance +$ +1,316,677 +$ +1,593,884 +$ +1,581,698 +Deconsolidation of Subsidiary January 1, 2010 +— +(364,589 +) +— +Capitalized G&A +11,205 +10,676 +7,993 +Property acquisition costs +— +— +15,755 +Exploration costs +5,473 +14,739 +— +Development costs +88,285 +61,967 +(11,562 +) +End of period balance +$ +1,421,640 +$ +1,316,677 +$ +1,593,884 +Unevaluated Properties (excluded from amortization): +Beginning of period balance +$ +8,106 +$ +25,442 +$ +32,829 +Additions +3,794 +3,561 +6,140 +Capitalized interest +573 +2,000 +3,213 +Transfers to evaluated +(9,870 +) +(22,897 +) +(16,740 +) +End of period balance +$ +2,603 +$ +8,106 +$ +25,442 +Accumulated depreciation, depletion and amortization: +Beginning of period balance +$ +1,155,915 +$ +1,488,718 +$ +1,455,275 +Provision charged to expense +52,416 +31,786 +33,443 +Deconsolidation of Subsidiary January 1, 2010 +— +(364,589 +) +— +Sale of mineral interests +— +— +— +End of period balance +$ +1,208,331 +$ +1,155,915 +$ +1,488,718 +Unevaluated property costs, primarily including lease acquisition costs incurred at federal and state lease sales, unevaluated drilling costs, seismic, capitalized interest and certain overhead costs related to exploration and development being excluded from the amortizable evaluated property base, consisted of $841 incurred in 2011 and $1,762 in 2010. These costs are directly related to the acquisition and evaluation of unproved properties and major development projects. The excluded costs and related reserves are included in the amortization base as the properties are evaluated and proved reserves are established or impairment is determined. The Company expects that the majority of these costs will be evaluated over the next three to five years. The Company’s unevaluated property balance, which primarily relates to the Company’s Federal onshore property prospect lease, decreased by $5,503 to $2,603 at December 31, 2011 compared to December 31, 2010 . The decrease primarily related to the write-off of leases, primarily in the Gulf of Mexico shelf region, that the Company elected not to renew. +Depletion per unit-of-production (Boe) amounted to $26.42 , $19.00 and $16.98 for the years ended December 31, 2011 , 2010 , and 2009 , respectively. Lease operating expense, or production costs, per unit-of-production (Boe) amounted to $11.04 , $10.58 , and $9.37 for the years ended December 31, 2011 , 2010 , and 2009 , respectively. +Under the full-cost accounting rules of the SEC, the Company reviews the carrying value of its proved oil and natural gas properties each quarter. Under these rules, capitalized costs of oil and natural gas properties, net of accumulated depreciation, depletion and amortization and deferred income taxes, may not exceed the present value of estimated future net cash flows from proved oil and natural gas reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of related tax effects (the full-cost ceiling amount). These rules generally require pricing based on the preceding 12-months’ average oil and natural gas prices based on closing prices on the first day of each month and require a write-down if the “ceiling” is exceeded. Given the volatility of oil and natural gas prices, it is reasonably possible that the Company’s estimate of discounted future net cash flows from proved oil and natural gas reserves could change in the near term. If oil and natural gas prices decline significantly, even if only for a short period of time, it is possible that write-downs of oil and natural gas properties could occur in the future. For the years ended December 31, 2011 , 2010 , and 2009 , the Company recorded no impairment charges related to its oil and natural gas properties as a result of this calculation. +NOTE 14 – Asset Retirement Obligations +73 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +The following table summarizes the activity for the Company’s asset retirement obligations: +For the year ended December 31, +2011 +2010 +Asset retirement obligations at beginning of the period +$ +15,925 +$ +14,650 +Accretion expense +2,338 +2,446 +Liabilities incurred +36 +608 +Liabilities settled +(3,797 +) +(3,035 +) +Revisions to estimate +(564 +) +1,256 +Asset retirement obligations at end of period +13,938 +15,925 +Less: current asset retirement obligations +(1,260 +) +(2,822 +) +Long-term asset retirement obligations at the end of the period +$ +12,678 +$ +13,103 +Certain of the Company's operating agreements require that assets be restricted for future abandonment obligations. Amounts recorded on the Consolidated Balance Sheets at December 31, 2011 as long-term restricted investments were $3,790 . These assets, which primarily include short-term U.S. Government securities, are held in abandonment trusts dedicated to pay future abandonment costs for several of the Company’s oil and natural gas properties. +NOTE 15 – Supplemental Oil and Natural Gas Reserve Data (unaudited) +The Company's proved oil and natural gas reserves at December 31, 2011 , 2010 and 2009 have been estimated by Huddleston & Co., Inc., the Company’s independent petroleum engineers. The reserves were prepared in accordance with guidelines established by the SEC. Accordingly, the following reserve estimates are based upon existing economic and operating conditions. +There are numerous uncertainties inherent in establishing quantities of proved reserves. The following reserve data represents estimates only and should not be construed as being exact. In addition, the standardized measure of discounted future net cash flows should not be construed as the current market value of the Company's oil and natural gas properties or the cost that would be incurred to obtain equivalent reserves. +Estimated Reserves +Changes in the estimated net quantities of crude oil and natural gas reserves, all of which are located onshore within the continental United States and offshore within the Gulf of Mexico, are as follows: +74 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +Reserve Quantities +For the year ended December 31, +2011 +2010 +2009 +Proved developed and undeveloped reserves: +Crude Oil (MBbls): +Beginning of period +8,149 +6,479 +6,027 +Revisions to previous estimates +(110 +) +423 +(356 +) +Change in ownership +— +— +563 +Purchase of reserves in place +— +— +1,257 +Sale of reserves in place +(30 +) +— +— +Extensions and discoveries +3,062 +2,106 +— +Production +(996 +) +(859 +) +(1,012 +) +End of period +10,075 +8,149 +6,479 +Natural Gas (MMcf): +Beginning of period +32,957 +19,103 +18,651 +Revisions to previous estimates +486 +354 +3,632 +Change in ownership +— +— +420 +Purchase of reserves in place +— +— +2,140 +Sale of reserves in place +(308 +) +— +— +Extensions and discoveries +7,064 +18,392 +— +Production +(5,081 +) +(4,892 +) +(5,740 +) +End of period +35,118 +32,957 +19,103 +Proved developed reserves: +Crude Oil (MBbls): +Beginning of period +4,503 +4,346 +4,663 +End of period +5,069 +4,503 +4,346 +Natural Gas (MMcf): +Beginning of period +12,715 +12,301 +13,463 +End of period +11,605 +12,715 +12,301 +Proved undeveloped reserves: +Crude Oil (MBbls): +Beginning of period +3,645 +2,133 +1,364 +End of period +5,006 +3,645 +2,133 +Natural Gas (MMcf): +Beginning of period +20,241 +6,802 +5,188 +End of period +23,513 +20,241 +6,802 +Standardized Measure +The following tables present the standardized measure of future net cash flows related to estimated proved oil and natural gas reserves together with changes therein, including a reduction for estimated plugging and abandonment costs that are also reflected as a liability on the balance sheet at December 31, 2011 . You should not assume that the future net cash flows or the discounted future net cash flows, referred to in the tables below, represent the fair value of our estimated oil and natural gas reserves. Prior to December 31, 2009, the Company was required to determine estimated future net cash flows using period-end market prices for oil and natural gas without considering hedge contracts in place at the end of the period. Effective December 31, 2009, the SEC issued a final rule which changed prices used in reserves calculations. Prices are no longer based on a single-day, period-end price. Rather, they are based on either the preceding 12-months’ average price based on closing prices on the first day of each month, or prices defined by existing contractual arrangements. The following table summarizes the average 12-month oil and natural gas prices net of differentials for the respective periods: +75 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +2011 +2010 +2009 +Average 12-month price, net of differentials, per Mcf of natural gas +$ +5.60 +$ +5.10 +$ +4.75 +Average 12-month price, net of differentials, per barrel of oil +98.98 +78.07 +57.40 +Future production and development costs are based on current costs with no escalations. Estimated future cash flows net of future income taxes have been discounted to their present values based on a 10% annual discount rate. +Natural gas production from our deepwater and Permian Basin properties has a high BTU content of separator natural gas. The natural gas Mcf prices of $5.60 and $5.10 used in the 2011 and 2010 reserve estimates include adjustments to reflect the Btu content, transportation charges and other fees specific to the individual properties. The projected oil prices of $98.98 and $78.07 used in the 2011 and 2010 reserve estimates have been adjusted to reflect all wellhead deductions and premiums on a property-by-property basis, including transportation costs, location differentials and crude quality. +Standardized Measure +For the year ended December 31, +2011 +2010 +2009 +Future cash inflows +$ +1,194,079 +$ +804,111 +$ +462,607 +Future costs - +Production +(356,653 +) +(277,793 +) +(195,735 +) +Development and net abandonment +(268,628 +) +(146,870 +) +(50,170 +) +Future net inflows before income taxes +568,798 +379,448 +216,702 +Future income taxes +(78,813 +) +(24,719 +) +(2,809 +) +Future net cash flows +489,985 +354,729 +213,893 +10% discount factor +(219,628 +) +(155,813 +) +(77,972 +) +Standardized measure of discounted future net cash flows +$ +270,357 +$ +198,916 +$ +135,921 +Changes in Standardized Measure +For the year ended December 31, +2011 +2010 +2009 +Standardized measure at the beginning of the period +$ +198,916 +$ +135,921 +$ +86,305 +Sales and transfers, net of production costs +(107,297 +) +(72,171 +) +(82,674 +) +Net change in sales and transfer prices, net of production costs +125,518 +126,571 +94,435 +Net change due to purchases and sales of in place reserves +1,275 +621 +45,009 +Extensions, discoveries, and improved recovery, net of future production and development costs incurred +22,598 +23,739 +-- +Changes in future development cost +(83,110 +) +(68,960 +) +6,194 +Revisions of quantity estimates +(949 +) +23,295 +39,242 +Accretion of discount +68,384 +10,597 +5,797 +Net change in income taxes +(32,918 +) +(5,170 +) +(2,368 +) +Changes in production rates, timing and other +77,940 +24,473 +(56,019 +) +Aggregate change +71,441 +62,995 +49,616 +Standardized measure at the end of period +$ +270,357 +$ +198,916 +$ +135,921 +The Company ended 2011 with estimated net proved reserves of 15,928 MBoe, representing a 17% increase over 2010 year-end estimated net proved reserves of 13,641 MBoe. The increase is primarily due to the Company’s development of a portion of its Permian Basin, on which it drilled a total of 36 oil wells during 2011 . +The Company annually reviews its proved undeveloped reserves (“PUDs”) to ensure an appropriate plan for development exists. Generally, reserves for the Company’s onshore properties are booked as PUDs only if the Company has plans to convert the PUDs +76 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +into proved developed reserves within five years of the date they are first booked as PUDs. Callon had 8,925 MBoe of PUDs at December 31, 2011 , representing a 27% increase over the 7,019 MBoe of PUDs at December 31, 2010 . Of its 2011 PUDs, 1,186 MBoe and 1,148 MBoe were attributable to the Company’s offshore properties in the Medusa and Habanero fields in the Gulf of Mexico, respectively. Callon plan to develop its Medusa PUDs by drilling a new well in 2013, and to develop its Habanero PUDs by side tracking an existing well during the fourth quarter of 2012. The Company did not convert any offshore, deepwater PUDs to proved developed in 2011 . +During 2009, the Company acquired 711 MBbls and 1.3 Bcf, or 928 MBoe, of PUDs in its ExL acquisition. Callon’s development plan for these PUDs began during 2010, and is expected to convert all PUDs to PDPs by 2014. Also during 2009, Callon's deepwater Medusa field PUDs increased 100 MBoe as a result of including reserves related to the Deepwater Royalty Relief Act. These PUDs were previously excluded due to prices exceeding the BOEM imposed thresholds. As a result of court decisions, the BOEM is no longer enforcing its price thresholds. +NOTE 16 - Bureau of Ocean Energy Management, Regulation and Enforcement (“BOEM”) Royalty Recoupment +During 2009, the Company recorded a receivable attributable to a recoupment of royalty payments previously made to the BOEMRE on our deepwater property, Medusa. Following the decisions resulting from several court cases brought by another oil and gas company, the court ruled that the BOEMRE was not entitled to receive these royalty payments. Accordingly, in November 2009 the Company filed for a recoupment of royalties paid to the BOEMRE in the amount of $44,787 from inception-to-date production at the Company’s Medusa field. At December 31, 2009, Callon accrued the royalty recoupment of $44,787 and estimated interest of $7,681. The Company received the recoupment of principal in January 2010, and received $7,927 of interest during the second quarter of 2010, which included additional accrued interest through the repayment date. In addition, the Company is no longer required to make any future royalty payments to the BOEMRE related to its Medusa production. +Royalty recoupment of $2,967 related to 2009 production was recorded as oil and gas sales during the fourth quarter of 2009. For years prior to 2009, royalty recoupment of $40,886 was included in operating revenues as BOEMRE royalty recoupment. Interest income related to the recoupment was recorded as a component of other income and expense. +NOTE 17 – Commitments and Contingencies +From time to time, the Company, as part of the Consolidation and other capital transactions, enters into registration rights agreements whereby certain parties to the transactions are entitled to require the Company to register common stock of the Company owned by them with the SEC for sale to the public in firm commitment public offerings and generally to include shares owned by them, at no cost, in registration statements filed by the Company. Costs of the offering will not include broker’s discounts and commissions, which will be paid by the respective sellers of the common stock. +The Company is involved in various claims and lawsuits incidental to its business. In the opinion of management, the ultimate liability hereunder, if any, will not have a material adverse effect on the financial position or results of operations of the Company. +The Company’s activities are subject to federal, state and local laws and regulations governing environmental quality and pollution control. Although no assurances can be made, the Company believes that, absent the occurrence of an extraordinary event, compliance with existing federal, state and local laws, rules and regulations governing the release of materials into the environment or otherwise relating to the protection of the environment are not expected to have a material effect upon the capital expenditures, earnings or the competitive position of the Company with respect to its existing assets and operations. The Company cannot predict what effect additional regulation or legislation, enforcement polices hereunder, and claims for damages to property, employees, other persons and the environment resulting from the Company’s operations could have on its activities +NOTE 18 – Summarized Quarterly Financial Information (unaudited) +77 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except per-share and per-hedge data) +Table of Contents +2011 +First Quarter +Second Quarter +Third Quarter +Fourth Quarter +Total revenues +$ +25,449 +$ +36,834 +$ +33,550 +$ +31,811 +Income from operations +5,789 +14,201 +10,524 +9,108 +Net income (loss) +4,164 +19,877 +8,406 +71,702 +Net income (loss) per common share - basic +0.12 +0.51 +0.21 +1.82 +Net income (loss) per common share - diluted +0.12 +0.50 +0.21 +1.79 +2010 +First Quarter +Second Quarter +Third Quarter +Fourth Quarter +Total revenues +$ +23,385 +$ +21,569 +$ +20,485 +$ +24,443 +Income from operations +7,040 +5,463 +4,655 +4,021 +Net income (loss) +3,923 +2,130 +1,602 +731 +Net income (loss) per common share - basic +0.14 +0.07 +0.06 +0.03 +Net income (loss) per common share - diluted +0.13 +0.07 +0.05 +0.02 +NOTE 19 – Subsequent Events +Subsequent to December 31, 2011 , Callon significantly expanded its Permian Basin acreage position by 152% to approximately +24,010 net acres from the approximately 9,540 net acres at year-end 2011 . During February of 2012, the Company acquired approximately 16,020 gross (approximately 14,470 net) acres in the northern portion of the Midland basin. The purchase price was funded from existing cash balances. The northern portion of the Midland basin has had limited drilling activity compared with the southern portion of the basin (where our current production is located), making drilling activities in this area much more high risk. The Company has an average 90% working interest across the contiguous acreage positions and is the operator, and it expects to initiate a 3-D seismic survey in the first half of 2012 and subsequently commence exploratory drilling on the acreage in the third quarter of 2012. +In February 2012, the Company announced plans to commence a horizontal drilling program at its East Bloxom Field targeting the Wolfcamp B shale during the second quarter of 2012. This drilling program was based on the Company's ongoing evaluation of its acreage position in the East Bloxom Field, located in Upton county, Texas, and recent industry drilling results in northern Upton County and western Reagan County, Texas. To support its horizontal drilling program, Callon recently contracted a new-generation drilling rig for a term of two years that is expected to be delivered in April 2012 at a cost of approximately $9.1 million per full year. +78 +Table of Contents +ITEM 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure +There have been no disagreements with the independent auditors on any matters of accounting principles or practices, financial statement disclosure, or auditing scope or procedures. +ITEM 9A. Controls and Procedures +Disclosure Controls and Procedures. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. During the second quarter of 2011, the Company implemented a new financial system that encompasses financial reporting, the general ledger, land management, and other similar and related processes. The new financial system was implemented to enhance the Company's business and financial reporting processes. The Company's principal executive and principal financial officers have concluded that the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) are in effective as of December 31, 2011 as a result of the matter discussed below. +Management’s Report on Internal Control over Financial Reporting . Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control structure is designed to provide reasonable assurance to our management and Board of Directors regarding the reliability of financial reporting and the preparation and fair presentation of our financial statements prepared for external purposes in accordance with U.S. generally accepted accounting principles. +As a result of the matter that caused the restatement described in Note 1 to the consolidated financial statements, management has determined that there is a material weakness in the operating effectiveness of the Company's internal control over the accounting for intraperiod tax allocation. Therefore, our Chief Executive Officer and Chief Financial Officer have subsequently concluded that the Company's internal controls over financial reporting were not effective as of December 31, 2011. +A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. As a result of the inappropriate application of the accounting guidance related to intraperiod tax allocation for our income tax provision for the year ended December 31, 2009, the Company has restated its financial statements for the year ended December 31, 2009. The resulting restatement is more fully described in Note 1 to the consolidated financial statements included in this Form 10-K. +As a consequence of the determination that there was a need to restate the financial statements, management has concluded that the deficiency in the internal control over the accounting for intraperiod tax allocation constitutes a material weakness in internal control over financial reporting. +As a result of this report of management on internal control over financial reporting, Ernst & Young LLP, the Company's independent registered public accounting firm, which also audited the Company's consolidated financial statements included in this Form 10-K, has issued an attestation report on the Company's internal control over financial reporting, which is provided below. +Because of its inherent limitations, internal control over financial reporting can provide only reasonable assurance that the objectives of the control system are met and may not prevent or detect misstatements. In addition, any evaluation of the effectiveness of internal controls over financial reporting in future periods is subject to risk that those internal controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2011 based on the framework in Internal Control – Integrated Framework published by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. +Changes in Internal Control over Financial Reporting. There were no changes to our internal control over financial reporting during our last fiscal quarter that have materially affected, or are reasonable likely to materially affect, our internal control over financial reporting. However, as a result of the matter that led to the restatement and the related assessment of internal control over financial reporting, the Company is implementing remediation steps to address the material weakness discussed above and to improve its internal controls over financial reporting. Specifically, the Company will routinely evaluate the necessity for third party specialists' advice or assistance and utilize such advice or assistance as deemed appropriate when dealing with +79 +Table of Contents +material and complex tax accounting matters in the preparation of its financial statements. +ITEM 9A (T). Controls and Procedures +See Item 9A. +ITEM 9B. Other Information +Submissions of Matters to a Vote of the Security Holders +None. +80 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited Callon Petroleum Company's internal control over financial reporting as of December 31, 2011 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Callon Petroleum Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. The following material weakness has been identified and included in management's assessment: deficiencies in the operating effectiveness of the Company's internal control over the accounting for intraperiod tax allocation. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Callon Petroleum Company as of December 31, 2011 and 2010 and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows each of the three years in the period ended December 31, 2011. This material weakness was considered in determining the nature, timing and extent of audit tests applied in our audit of the 2011 consolidated financial statements and this report does not affect our report dated March 15, 2012, which expressed an unqualified opinion on those financial statements. +In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Callon Petroleum Company has not maintained effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 15, 2012 +81 +Table of Contents +PART III. +ITEM 10. Directors, Executive Officers and Corporate Governance +For information concerning Item 10, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 10, 2012 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +The Company has adopted a code of ethics that applies to the Company’s chief executive officer, chief financial officer and chief accounting officer. The full text of such code of ethics has been posted on the Company’s website at www.callon.com, and is available free of charge in print to any shareholder who requests it. Request for copies should be addressed to the Secretary at 200 North Canal Street, Natchez, Mississippi 39120. +ITEM 11. Executive Compensation +For information concerning Item 11, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 10, 2012 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +For information concerning the security ownership of certain beneficial owners and management, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 10, 2012 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 13. Certain Relationships and Related Transactions and Director Independence +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 10, 2012 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 14. Principal Accountant Fees and Services +For information concerning Item 14, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 10, 2012 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +82 +Table of Contents +PART IV. +ITEM 15. Exhibits +Exhibit +Description +1 +The following is an index to the financial statements and financial statement schedules that are filed as part of this Form 10-K on pages 47 through 78 . +Report of Independent Registered Public Accounting Firm +Consolidated Balance Sheets as of December 31, 2011 and 2010 +Consolidated Statements of Operations for each of the three years in the period ended December 31, 2011 +Consolidated Statements of Stockholders' Equity (Deficit) for each of the three years in the Period Ended December 31, 2011 +Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2011 +Notes to Consolidated Financial Statements +2 +Schedules other than those listed above are omitted because they are not required, not applicable or the required information is included in the financial statements or notes thereto. +3 +Exhibits +2 +Plan of acquisition, reorganization, arrangement, liquidation or succession* +3 +Articles of Incorporation and Bylaws +3.1 +Certificate of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +3.2 +Bylaws of the Company (incorporated by reference from Exhibit 3.2 of the Company's Registration Statement on Form S-4, filed August 4, 1994, Reg. No. 33-82408) +3.3 +Certificate of Amendment to Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.3 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +3.4 +Certificate of Amendment to the Certificate of Incorporation of the Company +(incorporated by reference to Exhibit 3.4 of the Company's Annual Report on Form 10-K for the year ended December 31, 2010, File No. 001-14039) +4 +Instruments defining the rights of security holders, including indentures +4.1 +Specimen Common Stock Certificate (incorporated by reference from Exhibit 4.1 of the Company's Registration Statement on Form S-4, filed August 4, 1994, Reg. No. 33-82408) +4.2 +Rights Agreement between Callon Petroleum Company and American Stock Transfer & Trust Company, Rights Agent, dated March 30, 2000 (incorporated by reference from Exhibit 99.1 of the Company’s Registration Statement on Form 8-A, filed April 6, 2000, File No. 001-14039) +4.3 +Indenture for the Company’s 13.00% Senior Notes due 2016, dated November 24, 2009, between Callon Petroleum Company, the subsidiary guarantors described therein, Regions Bank and American Stock Transfer & Trust Company (incorporated by reference to Exhibit T3C to the Company’s Form T3, filed November 19, 2009, File No. 022-28916) +9 +Voting trust agreement +None +10 +Material contracts +10.1 +Callon Petroleum Company 1994 Stock Incentive Plan (incorporated by reference from Exhibit 10.5 of the Company's Registration Statement on Form 8-B, filed October 3, 1994) +10.2 +Callon Petroleum Company 1996 Stock Incentive Plan as amended on May 9, 2000 (incorporated by reference from Appendix I of the Company’s Definitive Proxy Statement on Schedule 14A, filed March 28, 2000, File No. 001-14039) +10.3 +Callon Petroleum Company 2002 Stock Incentive Plan (incorporated by reference to Exhibit 10.13 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, File No. 001-14039) +83 +Table of Contents +10.4 +Medusa Spar Agreement dated as of August 8, 2003, among Callon Petroleum Operating Company, Murphy Exploration & Production Company-USA and Oceaneering International, Inc. (incorporated by reference to Exhibit 10.19 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +10.5 +Amendment No. 3 to the Callon Petroleum Company 1996 Stock Incentive Plan (incorporated by reference from Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.6 +Amendment No. 1 to the Callon Petroleum Company 2002 Stock Incentive Plan (incorporated by reference from Exhibit 10.2 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.7 +Callon Petroleum Company Amended and Restated 2006 Stock Incentive Plan (incorporated by reference from Exhibit 10.3 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.8 +Callon Petroleum Company 2009 Stock Incentive Plan effective as of April 30, 2009 (incorporated by reference from Exhibit A to the Company’s Definitive Proxy Statement on Schedule 14A, filed March 30, 2009, File No. 001-14039) +10.9 +Amendment to the Callon Petroleum Company 1996 Stock Incentive Plan effective as of August 7, 2009 (incorporated by reference from Exhibit 10.1 of the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2009, File No. 001-14039) +10.10 +Third Amended and Restated Credit Agreement dated January 29, 2010, by and among Callon Petroleum Company, the “Lenders” described therein, Regions Bank, as Administrative Agent, Documentation Agent and Syndication Agent (incorporated by reference from Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed February 3, 2010, File No. 001-14039) +10.11 +Callon Petroleum Company 2010 Phantom Share Plan, adopted May 4, 2010 (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on May 7, 2010) +10.12 +Form of Callon Petroleum Company Phantom Share Award Agreement, adopted May 4, 2010 (incorporated by reference to Exhibit 10.2 of the Company’s current Report on Form 8-K filed on May 7 , 2010) +10.13 +Deferred Compensation Plan for Outside Directors; Callon Petroleum Company (effective as of January 1, 2011) (incorporated by reference to Exhibit 10.17 of the Company's Annual Report on Form 10-K for the year ended December 31, 2010, File No. 001-14039) +10.14 +Underwriting Agreement dated as of February 10, 2011 between Callon Petroleum Company and Johnson Rice & Company L.L.C., as representative of the several underwriters named therein (incorporated by reference to Exhibit 1.1 of the Company's Current Report on Form 8-K filed February11, 2011) +10.15 +Amended and Restated Severance Compensation Agreement, dated as of March 15, 2011 and effective as of January 1, 2011, by and between Fred L. Callon and Callon Petroleum Company (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K filed on March 18, 2011) +10.16 +Form of Amended and Restated Severance Compensation Agreement, dated as of March 15, 2011 and effective as of January 1, 2011, by and between Callon Petroleum Company and its executive officers (incorporated by reference to Exhibit 10.2 of the Company's Current Report on Form 8-K filed on March 18, 2011) +10.17 +Second Amendment to the Third Amended and Restated Credit Agreement dated May 9, 2011 among Callon Petroleum Company and Regions Bank (incorporated by reference to Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q for the period ended March 31, 2011) +10.18 +Severance Compensation Agreement, dated as of September 21, 2011, by and between Gary A. Newberry and Callon Petroleum Company (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K filed on September 21, 2011) +10.19 +Severance Compensation Agreement, dated as of September 21, 2011, by and between Vince Borrello and Callon Petroleum Company +11 +Statement re computation of per share earnings* +12 +Statements re computation of ratios* +13 +Annual Report to security holders, Form 10-Q or quarterly reports* +14 +Code of Ethics +14.1 +Code of Ethics for Chief Executive Officers and Senior Financial Officers (incorporated by reference to Exhibit 14.1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +16 +Letter re change in certifying accountant* +84 +Table of Contents +18 +Letter re change in accounting principles* +21 +Subsidiaries of the Company +21.1 +Subsidiaries of the Company (incorporated by reference from Exhibit 21.1 of the Company's Registration Statement on Form 8-B filed October 3, 1994) +22 +Published report regarding matters submitted to vote of security holders* +23 +Consents of experts and counsel +23.1 +Consent of Ernst & Young LLP +23.2 +Consent of Huddleston & Co., Inc. +24 +Power of attorney* +31 +Rule 13a-14(a) Certifications +31.1 +Certification of Chief Executive Officer pursuant to Rule 13(a)-14(a) +31.2 +Certification of Chief Financial Officer pursuant to Rule 13(a)-14(a) +32 +Section 1350 Certifications of Chief Executive and Financial Officers pursuant to +Rule 13(a)-14(b) +99 +Additional Exhibits +99.1 +Reserve Report Summary prepared by Huddleston and Co. as of December 31, 2011. +101 +Interactive Data Files ** +* +Not applicable to this filing +** +Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability. +85 +Table of Contents +SIGNATURES +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Date: +March 15, 2012 +/s/ Fred L. Callon +Fred L. Callon (principal executive officer, director) +Date: +March 15, 2012 +/s/ B. F. Weatherly +B. F. Weatherly (principal financial officer, director) +Date: +March 15, 2012 +/s/ Rodger W. Smith +Rodger W. Smith (principal accounting officer) +Date: +March 15, 2012 +/s/ L. Richard Flury +L. Richard Flury (director) +Date: +March 15, 2012 +/s/ John C. Wallace +John C. Wallace (director) +Date: +March 15, 2012 +/s/ Anthony J. Nocchiero +Anthony J. Nocchiero (director) +Date: +March 15, 2012 +/s/ Larry D. McVay +Larry McVay (director) +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +Date: +March 15, 2012 +/s/ B. F. Weatherly +B. F. Weatherly, Executive Vice President and +Chief Financial Officer (Principal Financial Officer) +86 \ No newline at end of file diff --git a/raw/filings/0000928022/2011/0000928022-12-000026/filing_metadata.csv b/raw/filings/0000928022/2011/0000928022-12-000026/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..de04fb203a8288f22182962321565e9d3b78bfa0 --- /dev/null +++ b/raw/filings/0000928022/2011/0000928022-12-000026/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000928022,CPE,Callon Petroleum Co,10-K,2012-03-15,2011-12-31,2012-03-15T20:27:35.000Z,0000928022-12-000026,cpe-20111231x10k.htm,CALLON PETROLEUM COMPANY 2011 FORM 10-K,8400776,1,0,https://www.sec.gov/Archives/edgar/data/928022/000092802212000026/cpe-20111231x10k.htm,https://www.sec.gov/Archives/edgar/data/928022/000092802212000026/,2011,2011,1 diff --git a/raw/filings/0000928022/2011/0000928022-12-000026/item1.txt b/raw/filings/0000928022/2011/0000928022-12-000026/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..c77ed0787c4fc774be5226e0e352c59ccaedf7ab --- /dev/null +++ b/raw/filings/0000928022/2011/0000928022-12-000026/item1.txt @@ -0,0 +1,49 @@ +Item 1 and 2. +Business and Properties +5 +Our Business Strategy +5 +Our Strengths +5 +Recent Developments +6 +Exploration and Development Activities +6 +Acquisitions and Divestitures +6 +Oil and Gas Properties +6 +Onshore Properties +8 +Gulf of Mexico Deepwater Properties +8 +Gulf of Mexico Shelf and Other Properties +9 +Proved Reserves +9 +Proved Undeveloped Reserves +10 +Controls over Reserve Estimates +11 +Production Volumes, Average Sales Prices and Average Production Costs +11 +Present Activities and Productive Wells +12 +Leasehold Acreage +13 +Title to Properties +14 +Insurance +14 +Major Customers +15 +Corporate Offices +15 +Employees +15 +Regulations +16 +Commitments and Contingencies +20 +Available Information +20 \ No newline at end of file diff --git a/raw/filings/0000928022/2011/0000928022-12-000026/item13.txt b/raw/filings/0000928022/2011/0000928022-12-000026/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..7224d46046ca312d1f63b7bbae86bea1b67c089f --- /dev/null +++ b/raw/filings/0000928022/2011/0000928022-12-000026/item13.txt @@ -0,0 +1,2 @@ +ITEM 13. Certain Relationships and Related Transactions and Director Independence +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 10, 2012 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000928022/2011/0000928022-12-000026/item9a.txt b/raw/filings/0000928022/2011/0000928022-12-000026/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..09a0b4eb124ff0f943dc9da551c78588829c1f04 --- /dev/null +++ b/raw/filings/0000928022/2011/0000928022-12-000026/item9a.txt @@ -0,0 +1,15 @@ +ITEM 9A. Controls and Procedures +Disclosure Controls and Procedures. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. During the second quarter of 2011, the Company implemented a new financial system that encompasses financial reporting, the general ledger, land management, and other similar and related processes. The new financial system was implemented to enhance the Company's business and financial reporting processes. The Company's principal executive and principal financial officers have concluded that the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) are in effective as of December 31, 2011 as a result of the matter discussed below. +Management’s Report on Internal Control over Financial Reporting . Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control structure is designed to provide reasonable assurance to our management and Board of Directors regarding the reliability of financial reporting and the preparation and fair presentation of our financial statements prepared for external purposes in accordance with U.S. generally accepted accounting principles. +As a result of the matter that caused the restatement described in Note 1 to the consolidated financial statements, management has determined that there is a material weakness in the operating effectiveness of the Company's internal control over the accounting for intraperiod tax allocation. Therefore, our Chief Executive Officer and Chief Financial Officer have subsequently concluded that the Company's internal controls over financial reporting were not effective as of December 31, 2011. +A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. As a result of the inappropriate application of the accounting guidance related to intraperiod tax allocation for our income tax provision for the year ended December 31, 2009, the Company has restated its financial statements for the year ended December 31, 2009. The resulting restatement is more fully described in Note 1 to the consolidated financial statements included in this Form 10-K. +As a consequence of the determination that there was a need to restate the financial statements, management has concluded that the deficiency in the internal control over the accounting for intraperiod tax allocation constitutes a material weakness in internal control over financial reporting. +As a result of this report of management on internal control over financial reporting, Ernst & Young LLP, the Company's independent registered public accounting firm, which also audited the Company's consolidated financial statements included in this Form 10-K, has issued an attestation report on the Company's internal control over financial reporting, which is provided below. +Because of its inherent limitations, internal control over financial reporting can provide only reasonable assurance that the objectives of the control system are met and may not prevent or detect misstatements. In addition, any evaluation of the effectiveness of internal controls over financial reporting in future periods is subject to risk that those internal controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2011 based on the framework in Internal Control – Integrated Framework published by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. +Changes in Internal Control over Financial Reporting. There were no changes to our internal control over financial reporting during our last fiscal quarter that have materially affected, or are reasonable likely to materially affect, our internal control over financial reporting. However, as a result of the matter that led to the restatement and the related assessment of internal control over financial reporting, the Company is implementing remediation steps to address the material weakness discussed above and to improve its internal controls over financial reporting. Specifically, the Company will routinely evaluate the necessity for third party specialists' advice or assistance and utilize such advice or assistance as deemed appropriate when dealing with +79 +Table of Contents +material and complex tax accounting matters in the preparation of its financial statements. +ITEM 9A (T). Controls and Procedures +See Item 9A. \ No newline at end of file diff --git a/raw/filings/0000928022/2011/0000928022-12-000026/rp_note.txt b/raw/filings/0000928022/2011/0000928022-12-000026/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2011/0000928022-12-000026/rpt_disclosure.txt b/raw/filings/0000928022/2011/0000928022-12-000026/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2013/0000928022-14-000049/filing.txt b/raw/filings/0000928022/2013/0000928022-14-000049/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..8d649ed232b71c88f47df936613e779fd4da3bbf --- /dev/null +++ b/raw/filings/0000928022/2013/0000928022-14-000049/filing.txt @@ -0,0 +1,5763 @@ +10-K +1 +cpe-20131231x10k.htm +10-K +CPE-2013.12.31-10K +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +ý ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2013 +OR +¨ TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF SECURITIES EXCHANGE ACT OF 1934 +Commission File Number 001-14039 +Callon Petroleum Company +(Exact Name of Registrant as Specified in Its Charter) +Delaware +(State or Other Jurisdiction of +Incorporation or Organization) +64-0844345 +(IRS Employer +Identification No.) +200 North Canal Street +Natchez, Mississippi +(Address of Principal Executive Offices) +39120 +(Zip Code) +(Registrant’s Telephone Number, Including Area Code): 601-442-1601 +Securities registered pursuant to Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Stock, $.01 par value +New York Stock Exchange +10.0% Series A Cumulative Preferred Stock +New York Stock Exchange +Securities registered pursuant to section 12 (g) of the Act: None +Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No ý +Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No ý +Indicate by check mark whether 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 ý 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 ý No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ +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 definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one): +Large accelerated filer ¨ Accelerated filer ý +Non-accelerated filer ¨ 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 ý +Aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2013 was approximately $129.6 million . +As of March 10, 2014 , 40,465,227 shares of the Registrant’s common stock, par value $.01 per share, were outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the definitive Proxy Statement of Callon Petroleum Company (to be filed no later than 120 days after December 31, 2013 ) relating to the Annual Meeting of Stockholders to be held on May 15, 2014 , which are incorporated into Part III of this Form 10-K. +TABLE OF CONTENTS +Page(s) +Special Note Regarding Forward-Looking Statements +3 +Definitions +4 +Part I +Items 1 and 2. +Business and Properties +5 +Acquisitions and Divestitures +7 +Oil and Natural Gas Properties +8 +Reserves and Production +10 +Production Wells and Leasehold Acreage +13 +Other +16 +Regulations +17 +Available Information +24 +Item 1A. +Risk Factors +25 +Item 1B. +Unresolved Staff Comments +34 +Item 3. +Legal Proceedings +34 +Item 4. +Mine Safety Disclosures +34 +Part II +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +35 +Performance Graph +36 +Item 6. +Selected Financial Data +37 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +38 +Overview and Outlook +38 +Liquidity and Capital Resources +40 +Results of Operations +42 +Significant Accounting Policies and Critical Accounting Estimates +49 +Subsequent Events +51 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +52 +Item 8. +Report of Independent Registered Public Accounting Firm +54 +Financial Statements and Supplementary Data +53 +Consolidated Balance Sheets +55 +Consolidated Statements of Operations +56 +Consolidated Statements of Comprehensive Income +57 +Consolidated Statements of Stockholders’ Equity +58 +Consolidated Statements of Cash Flows +59 +Notes to the Consolidated Financial Statements +60 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +83 +Item 9A. +Controls and Procedures +84 +Item 9B. +Other Information +84 +Report of Independent Registered Public Accounting Firm +85 +Part III +Item 10. +Directors and Executive Officers and Corporate Governance +86 +Item 11. +Executive Compensation +86 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +86 +Item 13. +Certain Relationships and Related Transactions and Director Independence +86 +Item 14. +Principal Accountant Fees and Services +86 +Part IV +Item 15. +Exhibits +87 +Signatures +90 +2 +Special Note Regarding Forward Looking Statements +All statements, other than historical fact or present financial information, may be deemed to be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements that address activities, outcomes and other matters that should or may occur in the future, including, without limitation, statements regarding the financial position, business strategy, production and reserve quantities, present value and growth and other plans and objectives for our future operations, are forward-looking statements. Although we believe the expectations expressed in such forward-looking statements are based on reasonable assumptions, such statements are not guarantees of future performance. We have no obligation and make no undertaking to publicly update or revise any forward-looking statements, except as may be required by law. +Forward-looking statements include the items identified in the preceding paragraph, information concerning possible or assumed future results of operations and other statements in this Form 10-Q identified by words such as “anticipate,” “project,” “intend,” “estimate,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “plan,” “forecast,” “target” or similar expressions. +You should not place undue reliance on forward-looking statements. They are subject to known and unknown risks, uncertainties and other factors that may affect our operations, markets, products, services and prices and cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. In addition to any assumptions and other factors referred to specifically in connection with forward-looking statements, risks, uncertainties and factors that could cause our actual results to differ materially from those indicated in any forward-looking statement include, but are not limited to: +• +the timing and extent of changes in market conditions and prices for commodities (including regional basis differentials), +• +our ability to transport our production to the most favorable markets or at all, +• +the timing and extent of our success in discovering, developing, producing and estimating reserves, +• +our ability to fund our planned capital investments, +• +the impact of government regulation, including any increase in severance or similar taxes, legislation relating to hydraulic fracturing, the climate and over-the-counter derivatives, +• +the costs and availability of oilfield personnel services and drilling supplies, raw materials, and equipment and services, +• +our future property acquisition or divestiture activities, +• +the effects of weather, +• +increased competition, +• +the financial impact of accounting regulations and critical accounting policies, +• +the comparative cost of alternative fuels, +• +conditions in capital markets, changes in interest rates and the ability of our lenders to provide us with funds as agreed, +• +credit risk relating to the risk of loss as a result of non-performance by our counterparties, and +• +any other factors listed in the reports we have filed and may file with the Securities and Exchange Commission. +We caution you that the forward-looking statements contained in this Form 10-K are subject to all of the risks and uncertainties, many of which are beyond our control, incident to the exploration for and development, production and sale of oil and natural gas. These risks include, but are not limited to, the risks described in Item 1A of this Annual Report on Form 10-K for the year ended December 31, 2013 and all quarterly reports on Form 10-Q filed subsequently thereto. +Should one or more of the risks or uncertainties described above or elsewhere in this Form 10-K occur, or should underlying assumptions prove incorrect, our actual results and plans could differ materially from those expressed in any forward-looking statements. We specifically disclaim all responsibility to publicly update any information contained in a forward-looking statement or any forward-looking statement in its entirety and therefore disclaim any resulting liability for potentially related damages. +All forward-looking statements attributable to us are expressly qualified in their entirety by this cautionary statement. +3 +DEFINITIONS +All defined terms under Rule 4-10(a) of Regulation S-X shall have their statutorily prescribed meanings when used in this report. As used in this document: +• +3-D : three-dimensional. +• +ARO : Asset Retirement Obligation. +• +Bbl or Bbls : barrel or barrels of oil or natural gas liquids. +• +Bcf : billion cubic feet. +• +BOE : barrel of oil equivalent, determined by using the ratio of one Bbl of oil or NGLs to six Mcf of gas. The ratio of one barrel of oil or NGL to six Mcf of natural gas is commonly used in the industry and represents the approximate energy equivalence of oil or NGLs to natural gas, and does not represent the economic equivalency of oil and NGLs to natural gas. The sales price of a barrel of oil or NGLs is considerably higher than the sales price of six Mcf of natural gas. +• +BOE/d : BOE per day. +• +BLM: Bureau of Land Management. +• +BOEM : Bureau of Ocean Energy Management, Regulation and Enforcement; formerly the Minerals Management Service. +• +Btu : a British thermal unit, which is a measure of the amount of energy required to raise the temperature of one pound of water one degree Fahrenheit. +• +BSEE: Bureau of Safety and Environmental Enforcement. +• +DOI: Department of Interior. +• +EPA: Environmental Protection Agency. +• +GHG: greenhouse gases. +• +LIBOR : London Interbank Offered Rate. +• +LOE: lease operating expense. +• +MBbls : thousand barrels of oil. +• +MBOE : thousand boe. +• +MBOE/d : Mboe per day. +• +Mcf : thousand cubic feet of natural gas. +• +Mcfe : thousand cubic feet of natural gas equivalents. +• +Mcf/d : Mcf per day. +• +MMBbls : million barrels of oil. +• +MMBOE : million BOE. +• +MMBtu : million Btu. +• +MMcf : million cubic feet of natural gas. +• +MMcf/d : MMcf per day. +• +MMS: Minerals Management Service. +• +NGL or NGLs : natural gas liquids, such as ethane, propane, butanes and natural gasoline that are extracted from natural gas production streams. +• +NYMEX : New York Mercantile Exchange. +• +oil : includes crude oil and condensate. +• +PDPs : proved developed producing reserves. +• +PDNPs : proved developed non-producing reserves. +• +PUDs : proved undeveloped reserves. +• +RSU : restricted stock units. +• +SEC : United States Securities and Exchange Commission. +• +GAAP: Generally Accepted Accounting Principles in the United States +With respect to information relating to our working interest in wells or acreage, “net” oil and gas wells or acreage is determined by multiplying gross wells or acreage by our working interest therein. Unless otherwise specified, all references to wells and acres are gross. +4 +PART I. +Items 1 and 2 - Business and Properties +Overview +Callon Petroleum Company has been engaged in the exploration, development, acquisition and production of oil and natural gas properties since 1950. The Company was incorporated under the laws of the state of Delaware in 1994 and succeeded to the business of a publicly traded limited partnership, a joint venture with a consortium of European investors and an independent energy company partially owned by a member of current management. As used herein, the “Company,” “Callon,” “we,” “us,” and “our” refer to Callon Petroleum Company and its predecessors and subsidiaries unless the context requires otherwise. +In 2013, the Company completed its onshore strategic repositioning that began in 2009, shifting its operations from the offshore waters in the Gulf of Mexico to the onshore, Permian Basin in Texas. In the fourth quarter of 2013, the Company sold its interest in its only remaining deepwater property, the Medusa field, in addition to the sale of the Medusa spar facility and substantially all remaining offshore shelf properties. Previously, Callon sold its interest in its deepwater Habanero field in the fourth quarter of 2012. Collectively, these transactions completed the Company’s transition to an onshore operator with an asset base concentrated exclusively in the Midland Basin, a sub-basin contained in the broader Permian Basin. +Callon exited 2013 with average Permian production in the month of December of 3,611 BOE/d (approximately 84% oil), a 129% increase over our exit rate in 2012. We believe that the Company’s transition to a horizontal development program, which was expanded from two fields to four fields in late 2013, has improved Callon’s overall capital efficiency and has contributed to a net increase of 59% in the Company’s Permian proven reserve base. +The Company operates 100% of its Permian acreage, which provides additional flexibility to modify development plans to address potential changes in the operating and commodity price environments. As of December 31, 2013 , we had estimated net proved reserves of 11.9 MMBbls and 17.8 Bcf, or 14.9 MMBOE, all of which were located in the Permian Basin, compared with approximately 67% located in the Permian Basin at December 31, 2012 . Additionally, 80% of our proved reserves were crude oil and 50% were proved developed at year-end 2013 , on a BOE basis. +Our Business Strategy +Our goal is to enhance stockholder value through the execution of the following strategy: +Drive production and reserve growth through horizontal development of our resource base. Our initial drilling efforts in the Permian Basin targeted the development of multiple zones with vertical wells as part of the “Wolfberry” play. As part of this drilling program, we amassed a database related to the subsurface geology and rock characteristics over the last several years. This information, combined with our review of industry activity and best practices, provided the foundation for Callon to initiate the horizontal development of our resource base in 2012. Importantly, we believe horizontal development of our resource base will provide the opportunity to improve returns relative to vertical drilling by accessing a larger base of reserves in target zone with a lateral wellbore. During the fourth quarter of 2013, approximately 44% of our total Permian production was sourced from horizontal wells. We expect the contribution of horizontal production volumes from our existing properties to increase with the recent expansion of our horizontal development efforts to four fields as part of our current two-rig drilling program. +Expand our drilling portfolio through evaluation of existing acreage. Our horizontal development drilling efforts to date have been primarily focused on the Upper and Lower Wolfcamp B shales, establishing production from both zones in the Southern Midland Basin. We have been focused on these development zones to reduce drilling risk as we continue to grow our asset base in the Permian Basin. We believe additional opportunities exist to selectively target various other prospective zones including the Jo-Mill, Lower Spraberry, Wolfcamp A, Wolfcamp C and Cline formations, and plan to selectively drill potential identified locations to complement our core development efforts in the Wolfcamp B. Moreover, we will monitor the efficiency of our horizontal wells related to reservoir drainage over time and pursue downspacing initiatives within target zones if overall returns can be enhanced. We recently transitioned to closer spacing of our horizontal laterals in the Southern Midland Basin in both the Upper and Lower Wolfcamp B shales. +Outside of our core development areas in the Southern and Central Midland Basin, we maintain an exploration position in the Northern Midland Basin. Our current activity in the Northern Midland Basin is limited to vertical drilling in order to assess resource potential and economic returns. If our exploration concept is proven to economically produce hydrocarbons on a repeatable basis from vertical wells, we will then determine whether the testing of horizontal development concepts is warranted. +5 +Pursue selective acquisitions in the Permian Basin. We have demonstrated our ability to acquire and trade acreage in the Midland Basin. Specifically, we added our Taylor Draw field in 2012 and Garrison Draw Field in 2013 for a total of $23 million, including acquired production and proved reserves. These two fields are now part of our core horizontal development plan. We have built on these acquisitions with recent acquisitions of acreage near our existing East Bloxom (see Recent Developments below), as well as completing an acreage trade at Garrison Draw which added contiguous acreage for effective long lateral horizontal development. We will continue to pursue leasehold acquisitions in the Permian Basin, and primarily in the Midland Basin, that have horizontal resource potential that can be further augmented by bolt-on acreage acquisitions and acreage trades over time. +Capitalize on opportunities to further reduce cost of capital. Following the disposition of our offshore properties, we have the opportunity to recapitalize the Company with a lower cost of capital commensurate with an improved credit risk profile as a purely onshore operator. As part of an ongoing effort to reduce our cost of capital, we have redeemed nearly $90 million of our 13% Senior Notes due 2016 (the “Senior Notes”) since 2011 and recently called for the redemption of the remaining $49 million of principal to occur in April 2014, replacing these Senior Notes with lower cost financing. Additionally, we believe the demonstrated growth in our proved developed reserve base provides the foundation for a meaningful expansion of our borrowing base capacity under our revolving credit agreement. We recently increased the notional amount and reduced the interest expense related to our revolving credit agreement, evidencing another step in reducing our overall cost of capital (see Recent Developments below). +Our Strengths +Established resource base and acreage position in the Permian Basin . Our production is exclusively from the Permian Basin in West Texas, an area that has supported production since the 1940s. The basin has well-established infrastructure from historical operations, and we believe the basin also benefits from a relatively stable regulatory environment that has been established over time. We have assembled a position of approximately 13,600 net acres in the Southern and Central Midland Basin that are prospective for multiple oil-bearing intervals that have been produced by us and other industry participants. As of December 31, 2013, our estimated net proved reserves were comprised of approximately 80% oil and 20% natural gas, which includes NGLs in the production stream. This oil exposure provides us the opportunity to benefit from currently more favorable prices as compared to natural gas. +Multi-year drilling inventory . Our current acreage position in the Permian Basin provides visible growth potential from a horizontal drilling inventory of almost 20 years based on our current two-rig horizontal drilling program. As of December 31, 2013, based upon the results of horizontal wells drilled by us and other offsetting operators, and our analysis of core data and historical vertical well performance, we have identified an inventory of approximately 540 potential horizontal well locations in multiple horizons across our Southern and Central Midland Basin acreage. Of these potential locations, approximately 225 are identified in the Upper Wolfcamp B, Lower Wolfcamp B and Wolfcamp A zones which have been drilled on our acreage and are currently producing. +Experienced team operating in the Permian Basin. We have assembled a management team experienced in acquisitions, exploration, development and production in the Midland Basin. Reflective of this experience, we have realized improvements in our drilling and capital efficiency since launching our horizontal drilling program in 2012. For example, our average drill time for a typical 7,800 foot lateral Wolfcamp shale well decreased from approximately 30 days at the start of our drilling program in 2012 to under 20 days as of February 2014. We continue to evaluate our completion techniques, and downspacing initiatives that we believe have the potential to improve resource recovery and contribute to enhanced returns on capital. In addition, we regularly evaluate our operating results against those of other operators in the area in an effort to benchmark our performance against the best performing operators and evaluate and adopt best practices. +High degree of operational control . We operate all of our Permian Basin acreage, providing us the opportunity to modify our operational plans to respond to changes in operational and commodity price environments. This operating control also allows us to modify drilling and completion techniques, and change drilling schedules as needed to manage the assimilation of newly acquired acreage that may have drilling commitments. +Operating culture focused on safety and the environment . We have established a Health, Safety and Environmental department dedicated to our operations in the Permian Basin. This group is responsible for monitoring the activity and safety compliance of both our employees as well as third party service providers and consultants. This department also coordinates closely with our operational team to ensure effective communication with appropriate regulatory bodies as well as landowners. We believe that our proactive efforts in this area have made a positive impact on our operations and culture. As an example, we were recently awarded the Midland Bruno Hanson/Midland College Award for Environmental Excellence which is given to companies that demonstrate strong environmental stewardship in the Permian Basin. +6 +Financial flexibility to fund growth initiatives . We bolstered our capital structure in 2013 with the issuance of Series A Cumulative Preferred Stock and the sale of our offshore assets. We have continued to build upon these transactions with the recent completion of the Amended Credit Facility and Second Lien Facility as described in Recent Developments. +Exploration and Development Activities +Our 2013 total capital expenditures, on a cash basis and including acquisitions, were $171 million , representing a 17% increase over 2012 actual capital expenditures. Of the $171 million , approximately $145 million was allocated to onshore drilling, development and leasehold acquisition activity in the Permian basin. During 2013 , capital expenditures for exploration and development costs related to oil and natural gas properties included the following expenditures (in millions): +Southern Midland Basin +$ +111 +Central Midland Basin +20 +Northern Midland Basin +7 +Other +7 +Total capital expenditures +145 +Capitalized general and administrative costs allocated directly to exploration and development projects +11 +Capitalized interest +4 +Total capitalized expenses +15 +Total operational expenditures +160 +Acquisitions +11 +Total capital expenditures, including acquisitions +$ +171 +We expanded our horizontal pad development efforts from two to four fields in late 2013, adding Carpe Diem in Midland County and Garrison Draw in Reagan County. We expect our 2014 horizontal drilling program will be primarily focused on development of established Upper and Lower Wolfcamp zones in the Southern and Central Midland Basin. We also expect to drill two wells in the Southern Midland Basin to evaluate the Wolfcamp A shale and a test of the Lower Spraberry shale formation in the Central Midland Basin. Planned vertical drilling activity is anticipated to be limited to five deep Wolfberry wells in the Pecan Acres field and one well in the Garrison Draw field. In addition, our plans include three vertical exploration wells in the Northern Midland Basin, the timing and location of which being subject to change as results are evaluated during the course of 2014. +Recent Developments +Credit facilities +On March 11, 2014, we entered into an amended senior secured revolving credit facility (the “Amended Credit Facility”) in the amount of $500 million with JPMorgan Chase Bank, N.A. as Administrative Agent (“J.P. Morgan”). The Credit Facility will have an initial borrowing base amount of $95 million and a maturity date of March 11, 2019. In conjunction with the Amended Credit Facility, we entered into a senior secured second lien term loan facility (the “Second Lien Facility”) in an aggregate amount of up to $125 million with J.P. Morgan as Administrative Agent and with a maturity date of September 11, 2019. See Note 4 for additional information. +Acquisitions +During the first quarter of 2014, we added 1,280 net acres in Upton County near our existing core development fields for an aggregate purchase price of $7.0 million. This acreage added an estimated 96 gross potential horizontal well locations from seven prospective zones to our drilling inventory. In addition, we expect to leverage existing infrastructure from our East Bloxom field in the development of this new acreage. See Notes 6 and 12 to our financial statements for additional information regarding acquisitions. +7 +Table of Contents +Divestitures +Effective December 5, 2013, the Company closed on the sale of its 15.0% working interest in the Medusa field (Mississippi Canyon blocks 582 and 538), our 10.0% membership interest in Medusa Spar LLC, and substantially all of our remaining Gulf of Mexico shelf properties. The Company sold these assets to W&T Offshore, Inc., an unrelated third-party, for total net cash consideration of approximately $100 million before customary purchase price adjustments. The Medusa field had production net to Callon of 582 MBOE in 2013. Also during the fourth quarter of 2013, the Company closed on the sale of its 69% interest in the Swan Lake field for $2 million. This field included 429 net acres and produced approximately 107 MMcf during the year ended December 31, 2013 . This was the Company’s only field in the Haynesville shale. See Note 12 to our financial statements for additional information. +Oil and Natural Gas Properties +As of December 31, 2013 , our estimated net proved reserves totaled 14.9 MMBOE and included 11.9 MMBbls and 17.8 Bcf, with a pre-tax present value, discounted at 10%, of $301.1 million . Pre-tax present value is a non-GAAP financial measure, which we reconcile to the GAAP measure of standardized measure of $283.9 million in note (d) to the table below. Oil constituted approximately 80% of our total estimated equivalent net proved reserves and approximately 80% of our total estimated equivalent proved developed reserves. +The following table sets forth certain information about our estimated net proved reserves prepared by our independent petroleum reserve engineers by major area and for all other properties combined at December 31, 2013 : +Pre-tax +Discounted +Estimated Net Proved Reserves +Present +Oil +(MBbls) +Natural Gas +(MMcf) +Total +(MBOE) +Value +($000) +(a) +(b)(c)(d) +Southern Midland Basin +10,103 +15,021 +12,607 +$ +267,216 +Central Midland Basin +1,699 +2,730 +2,154 +39,336 +Northern Midland Basin +96 +— +96 +3,921 +Other (c) +— +— +— +(9,329 +) +Total +11,898 +17,751 +14,857 +$ +301,144 +(a) +We convert Mcf to BOE using a conversion ratio of six Mcf to one Bbl. This ratio, which is typical in the industry and represents the approximate energy equivalent of a Mcf to a Bbl, does not reflect to market price equivalence of Mcf of natural gas compared with a Bbl of oil or NGLs. On a market price equivalence basis, a barrel of oil or NGLs has a substantially higher price than six Mcf of natural gas. +(b) +Represents the present value of future net cash flows before deduction of federal income taxes, discounted at 10%, attributable to estimated net proved reserves as of December 31, 2013 , as set forth in the Company’s reserve reports prepared by its independent petroleum reserve engineers, Huddleston & Co., Inc. +(c) +Includes a reduction for estimated plugging and abandonment costs that are reflected as a liability on our balance sheet at December 31, 2013 , in accordance with accounting for asset retirement obligations rules. These obligations were retained following the sale of our offshore operations. The negative Pre-Tax Discounted Present Value of the “Other” reflects plugging and abandonment obligations exceeding the future net cash flows. +(d) +The Company uses the financial measure “Pre Tax Discounted Present Value” which is a non-GAAP financial measure. The Company believes that Pre Tax Discounted Present Value, while not a financial measure in accordance with GAAP, is an important financial measure used by investors and independent oil and gas producers for evaluating the relative value of oil and natural gas properties and acquisitions because the tax characteristics of comparable companies can differ materially. The total standardized measure calculated in accordance with the guidance issued by the FASB for disclosures about oil and gas producing activities for our proved reserves as of December 31, 2013 was $283.9 million inclusive of the $17.2 million discounted estimated future income taxes relating to such future net revenues. The projected per Mcf natural gas price of $5.45 used in the 2013 reserve estimates has been adjusted to reflect the Btu content, transportation charges and other fees specific to the individual properties. The projected per barrel oil price of $92.16 used in the 2013 reserve estimates has been adjusted to reflect all wellhead deductions and premiums on a property-by-property basis, including transportation costs, location differentials and crude quality. +8 +Permian Basin +As of December 31, 2013 , we owned approximately 31,829 net acres in the Permian Basin. Our reserves in the Permian Basin represent all of our proved reserves at year-end 2013 as compared to 67% at year-end 2012. Average net production from the Company’s Permian Basin properties increased 38% to 2,227 BOE/d in 2013 from 1,619 BOE/d in 2012. As of December 2013, our average daily net production from the Permian Basin was 3,611 BOE/d. +Southern Midland Basin +• +Counties (fields): Upton (East Bloxom), Reagan (Taylor Draw and Garrison Draw) and Crockett (Block 5) +• +8,904 net acres as of December 31, 2013 +• +77 producing wells ( 17 horizontal) +• +Initiated horizontal development in 2012 +• +4 th quarter 2013 net production: 2,334 BOE/d ( 72% horizontal) +The Southern Midland Basin is our largest operating area in terms of production. Following recently completed acquisitions in the first quarter of 2014, we currently have approximately 10,200 net acres in this area. We commenced horizontal drilling efforts at our East Bloxom field in 2012 and have expanded our efforts to two additional fields in the Southern Midland Basin using pad development. Our horizontal wells are currently producing from three zones of the Wolfcamp shale (Upper Wolfcamp B, Lower Wolfcamp B and Wolfcamp A). We plan to continue focusing on these intervals across our entire position in the Southern Midland Basin in 2014 and expect to test additional zones in future years. +Central Midland Basin +• +Counties (fields): Midland (Carpe Diem and Pecan Acres) and Ector (Kayleigh) +• +3,359 net acres as of December 31, 2013 +• +50 producing vertical wells +• +Initiated horizontal development in 2013 +• +4 th quarter 2013 net production: 564 BOE/d +The Central Midland Basin has been the focus of our high-graded vertical drilling program, targeting multiple zones down to the Woodford shale. We have recently shifted our focus to horizontal development of the Carpe Diem field. Our first Wolfcamp B wells were placed on production in the first quarter of 2014 and we plan to add Carpe Diem to our core development fields going forward. This area is prospective for multiple horizontal development zones and we plan to target the Lower Spraberry in 2014 as we delineate zones outside of the Wolfcamp B. +Northern Midland Basin +• +Counties (fields): Borden (Black Magic and Baird Ranch) and Lynn (Tahoka Prospect) +• +19,566 net acres as of December 31, 2013 +• +One producing vertical well +• +Ongoing going exploration and delineation activity +Our Northern Midland Basin position was established in 2012 with the acquisition of 21,617 net acres in Borden and Lynn Counties. We currently own approximately 17,433 net acres following our decision to allow certain acreage in the Northern Midland Basin to expire as we refine our targeted areas for exploration. We began our exploration program in Borden County during the second half of 2012, drilling one gross (0.75 net) vertical and two gross (1.5 net) horizontal wells, targeting the Cline and Mississippi lime. We have subsequently focused our exploration activity on the Mississippi chat, drilling a vertical well (Lacey Newton 2801) in late 2013. We plan to further evaluate the areal extent of this prospective play with at least one vertical exploration well in Borden County in 2014. We also plan to drill our first exploration well in Lynn County in the first half of 2014, testing several prospective zones, including the Spraberry. +For additional details regarding our Permian wells and related information, please see “Present Activities and Productive Wells” included below within this Item. +9 +Other Property +We own a leasehold in approximately 65,000 net acres located in various counties in Nevada. These leases are with the Bureau of Land Management and carry a primary term that expires in 2018. We are evaluating this acreage in conjunction with a third-party consultant and developing options for future activity. Callon does not have any drilling commitments related to this acreage during the primary term. +Proved Reserves +Estimates of volumes of proved reserves at year-end, net to our interest, are presented in MBbls for oil and in MMcf for natural gas, including NGLs, at a pressure base of 15.025 pounds per square inch. Total equivalent volumes are presented in BOE. For the BOE computation, 6,000 cubic feet of gas are the equivalent of one barrel of oil. The ratio of six Mcf of gas to one BOE is typically used in the oil and gas business and represents the approximate energy equivalent of a barrel of oil and an Mcf of natural gas. The price of a barrel of oil is much higher than the price of six Mcf of natural gas, so the ratio of six Mcf to one BOE does not reflect the economic equivalent of a barrel of oil to six Mcf of gas. +The following table sets forth certain information about our estimated net proved reserves. All of our proved reserves are currently located in the continental United States and also included volumes in federal and state waters in the Gulf of Mexico at year-end 2011 and 2012. +Years Ended December 31, +2013 +2012 +2011 +Proved developed: +Oil (MBbls) +5,960 +4,955 +5,069 +Natural gas (MMcf) +9,059 +10,680 +11,605 +MBOE +7,470 +6,735 +7,003 +Proved undeveloped: +Oil (MBbls) +5,938 +5,825 +5,006 +Natural gas (MMcf) +8,692 +9,073 +23,513 +MBOE +7,387 +7,337 +8,925 +Total proved: +Oil (MBbls) +11,898 +10,780 +10,075 +Natural gas (MMcf) +17,751 +19,753 +35,118 +MBOE +14,857 +14,072 +15,928 +Financial Information: +Estimated pre-tax future net cash flows (a) +$ +680,627 +$ +592,424 +$ +568,798 +Pre-tax discounted present value (a) (b) +$ +301,144 +$ +250,097 +$ +309,890 +Standardized measure of discounted future net cash flows (a) (b) +$ +283,946 +$ +231,148 +$ +270,357 +(a) +Includes a reduction for estimated plugging and abandonment costs that is reflected as a liability on our balance sheet at December 31, 2013 , in accordance with accounting for asset retirement obligations rules. +(b) +The Company uses the financial measure “Pre-tax discounted present value” which is a non-GAAP financial measure. The Company believes that Pre-tax discounted present value, while not a financial measure in accordance with GAAP, is an important financial measure used by investors and independent oil and gas producers for evaluating the relative value of oil and natural gas properties and acquisitions because the tax characteristics of comparable companies can differ materially. The total standardized measure calculated in accordance with the guidance issued by the FASB for disclosures about oil and gas producing activities for our proved reserves as of December 31, 2013 was $283.9 million inclusive of the $17.2 million discounted estimated future income taxes relating to such future net revenues. The natural gas Mcf prices of $5.45 used in the 2013 reserve estimates have been adjusted to reflect the Btu content, transportation charges and other fees specific to the individual properties. The projected oil prices of $92.16 used in the 2013 reserve estimates have been adjusted to reflect all wellhead deductions and premiums on a property-by-property basis, including transportation costs, location differentials and crude quality. +See Note 12 of our Consolidated Financial Statements for the additional information regarding the Company’s reserves including its estimates of proved reserves, PDPs, PUDs and the Company’s estimates of future net cash flows and discounted future net cash flows from proved reserves. +10 +The Company’s estimated net proved reserves increased 6% to 14,857 MBOE from 14,072 MBOE at December 31, 2013 and 2012 , respectively. Additions during the year were 9,979 MBOE, primarily due to the Company’s horizontal development of a portion of its Permian Basin properties. These increases were partially offset by (1) 4,057 MBOE related to the sale of the Company’s Gulf of Mexico assets and Haynesville field, (2) 3,724 MBOE of reductions in the Company’s PUD reserves, primarily related to the reclassification of certain vertical PUD locations to the horizontal probable category, and a small amount to the horizontal PDP and PUD categories at year end and (3) 1,413 MBOE related to the Company’s production during 2013. The reclassified vertical PUDs include Wolfberry PUD locations that included certain target zones that are now expected to be more efficiently developed by the Company’s multi-level horizontal drilling programs initiated in 2012. The vast majority of these previously booked vertical PUDs are now internally classified as horizontal probable reserves, with a small amount now captured in horizontal PDPs and PUDs. +Proved Undeveloped Reserves (PUDs) +Annually, the Company reviews its PUDs to ensure appropriate plans exist for development. PUD reserves are recorded only if the Company has plans to convert these reserves into PDPs within five years of the date they are first recorded. Our development plans include the allocation of capital to projects included within our 2014 capital budget and, in subsequent years, the allocation of capital within our long-range business plan to convert PUDs to PDPs within this five year period. In general, our 2014 capital budget and our long-range capital plans are primarily governed by our expectations of internally generated cash flow and credit facility borrowing availability. Reserve calculations at any end-of-year period are representative of our development plans at that time. Changes in commodity pricing, oilfield service costs and availability, and other economic factors may lead to changes in development plans. +The following table summarizes the Company’s recorded PUDs: +PUDs (MBOE) at December 31, +2013 +2012 +2011 +Permian Basin +7,387 +6,040 +4,861 +Haynesville shale +— +— +1,730 +Total Onshore +7,387 +6,040 +6,591 +Medusa (a) +— +1,297 +1,186 +Habanero (b) +— +— +1,148 +Total Offshore +— +1,297 +2,334 +Total +7,387 +7,337 +8,925 +(a) +Effective July 1, 2013, we sold our interest in the Medusa field. See Note 12 for additional information. +(b) +Effective December 28, 2012, we sold our interest in the Habanero field. See Note 12 for additional information. +Our PUDs increased 1% to 7,387 MBOE from 7,337 MBOE at December 31, 2013 and 2012 , respectively. We added 5,168 MBOE to the Company’s PUDs, primarily from the continued horizontal development of our Permian Basin properties. The increase in Permian Basin PUDs was partially offset by the reclassification of 3,724 MBOE, or 51% of volumes included in year-end 2012 PUD reserves related to vertical PUD locations that were moved to the horizontal probable category, and a small amount to the horizontal PDP and PUD categories, as we believe the previously booked Wolfberry PUD locations included certain target zones that we now expect can be more effectively developed over the next five years by our multi-level horizontal drilling program that was commenced during 2012. Also offsetting our PUD additions was the sale of 1,297 MBOE, or 18% included in the year-end 2012 PUD reserves related to our Medusa field, and the conversion of a small portion of our 2012 PUD reserves to PDPs during 2013 from vertical drilling for a net cost of approximately $6 million. Most of our PUDs at year-end 2012 were attributable to vertical well locations. During 2013, our drilling program was predominantly focused on horizontal wells as we continued to delineate our acreage for horizontal development of multiple zones that were previously the target of vertical development wells. Based on our horizontal drilling results and subsequent capital allocation decisions, only three of the vertical wells previously included as PUDs in our 2012 reserve report were drilled in 2013. Our horizontal drilling program converted 4,431 MBOE of reserves that were not classified as proved at year end 2012 to proved developed reserves at year end 2013. +The Company plans to develop its Permian Basin PUDs as part of a multi-year drilling program. At December 31, 2013, we had no reserves that remained undeveloepd for five or more years, and all PUD drilling locations are currently scheduled to be drilled within three to five years of their initial recording. +11 +Table of Contents +Controls Over Reserve Estimates +Compliance as it relates to reporting the Company’s reserves is the responsibility of our Senior Vice President of Operations, who has over 35 years of industry experience including 26 years as a manager and is our principal engineer. In addition to his years of experience, our principal engineer holds a degree in petroleum engineering and is experienced in asset evaluation and management. +Callon’s controls over reserve estimates included retaining Huddleston & Co., Inc. (“Huddleston”), a Texas registered engineering firm, as our independent petroleum and geological firm. The Company provided to Huddleston information about our oil and gas properties, including production profiles, prices and costs, and Huddleston prepared its own estimates of the reserves attributable to the Company’s properties. All of the information regarding reserves in this annual report is derived from Huddleston’s report. Huddleston’s reserve report letter is included as an Exhibit to this annual report. The principal engineer at Huddleston who is responsible for preparing the Company’s reserve estimates has over 30 years of experience in the oil and gas industry and is a Texas Licensed Professional Engineer. Further professional qualifications include a degree in petroleum engineering. +To further enhance the control environment over the reserve estimation process, our Board of Directors includes a Strategic Planning Committee whose purpose, as stated in the Committee’s charter, includes assisting management and the Board with its oversight of the integrity of the determination of the Company’s oil and natural gas reserves and the work of Huddleston. The Committee’s charter also specifies that the Committee shall perform, in consultation with the Company’s management and senior reserves and reservoir engineering personnel, the following responsibilities: +• +Oversee the appointment, qualification, independence, compensation and retention of the independent petroleum and geological firm (the “Firm”) engaged by the Company (including resolution of material disagreements between management and the Firm regarding reserve determination) for the purpose of preparing or issuing an annual reserve report. The Committee shall review any proposed changes in the appointment of the Firm, determine the reasons for such proposal, and whether there have been any disputes between the Firm and management. +• +Review the Company’s significant reserves engineering principles and policies and any material changes thereto, and any proposed changes in reserves engineering standards and principles which have, or may have, a material impact on the Company’s reserves disclosure. +• +Review with management and the Firm the proved reserves of the Company, and, if appropriate, the probable reserves, possible reserves and the total reserves of the Company, including: (i) reviewing significant changes from prior period reports; (ii) reviewing key assumptions used or relied upon by the Firm; (iii) evaluating the quality of the reserve estimates prepared by both the Firm and the Company relative to the Company’s peers in the industry; and (iv) reviewing any material reserves adjustments and significant differences between the Company’s and Firm’s estimates. +• +If the Committee deems it necessary, it shall meet in executive session with management and the Firm to discuss the oil and gas reserve determination process and related public disclosures, and any other matters of concern in respect of the evaluation of the reserves. +During our last fiscal year, we filed no reports with other federal agencies which contain an estimate of total proved net oil and natural gas reserves. +12 +Production Volumes, Average Sales Prices and Operating Costs +The following table sets forth certain information regarding the production volumes and average sales prices received for, and average production costs associated with, the Company’s sale of oil and natural gas for the periods indicated. +Years Ended December 31, +2013 +2012 +2011 +(in thousands, except per unit data) +Production +Oil (MBbls) +911 +977 +996 +Natural gas (Mcf) +3,011 +3,588 +5,081 +Total (MBOE) +1,413 +1,575 +1,843 +Revenues +Oil sales +$ +88,960 +$ +96,584 +$ +100,962 +Natural gas sales +13,609 +14,149 +26,682 +Total revenues +$ +102,569 +$ +110,733 +$ +127,644 +Operating costs +Lease operating expense +$ +19,779 +$ +23,330 +$ +18,285 +Production taxes +4,133 +3,224 +2,062 +Total operating costs +$ +23,912 +$ +26,554 +$ +20,347 +Realized prices +Oil ($/Bbl, including realized gains (losses) on derivatives) (a) +$ +97.65 +$ +98.86 +$ +101.34 +Oil ($/Bbl, excluding realized gains (losses) on derivatives) (a) +97.65 +97.41 +101.72 +Natural gas ($/Mcf, including realized gains (losses) on derivatives) (b) +4.52 +3.94 +5.25 +Natural gas ($/Mcf, excluding realized gains (losses) on derivatives) (b) +4.52 +3.94 +5.25 +Operating costs per BOE +Lease operating expense +$ +14.00 +$ +14.81 +$ +9.92 +Production taxes +2.92 +2.05 +1.12 +Total operating costs per BOE +$ +16.92 +$ +16.86 +$ +11.04 +(a) +Oil prices for production from our two divested deepwater fields reflect a premium over NYMEX pricing based on Mars WTI differential for Medusa production, prior to the sale of Medusa in December 2013, and Argus Bonita WTI differential for Habanero production, prior to the sale of Habanero during December 2012. +(b) +Natural gas prices exceeded the related NYMEX prices, which are quoted on an MMBtu basis, primarily due to the value of the NGLs in our liquids-rich natural gas stream, primarily from our Permian basin production. +13 +Present Activities and Productive Wells +The following table sets forth the wells drilled and completed during the periods indicated. All such wells were drilled in the continental United States. At December 31, 2013 , the Company had four wells awaiting fracture stimulation. +Drilled +Completed (a) +Awaiting Completion +Gross +Net +Gross +Net +Gross +Net +Southern Midland Basin +Vertical wells +1 +1.0 +1 +1.0 +— +— +Horizontal wells +17 +15.5 +15 +13.5 +3 +3.0 +Total +18 +16.5 +16 +14.5 +3 +3.0 +Central Midland Basin +Vertical wells +5 +3.0 +7 +4.4 +— +— +Horizontal wells +2 +1.7 +— +— +2 +1.7 +Total +7 +4.7 +7 +4.4 +2 +1.7 +Northern Midland Basin +Vertical wells +1 +1.0 +2 +1.8 +— +— +Horizontal wells +— +— +1 +0.8 +— +— +Total +1 +1.0 +3 +2.5 +— +— +Total +26 +22.2 +26 +21.4 +5 +4.7 +Total vertical wells +7 +5.0 +10 +7.1 +— +— +Total horizontal wells +19 +17.2 +16 +14.3 +5 +4.7 +Total +26 +22.2 +26 +21.4 +5 +4.7 +(a) Completions include wells drilled prior to 2013. +The following table sets forth the Company’s drilled and completed wells, none of which were natural gas or nonproductive for the periods reflected: +2013 +2012 +2011 +Gross +Net +Gross +Net +Gross +Net +Oil +Development +25 +21.2 +14 +9.7 +36 +32.8 +Exploratory +1 +1.0 +7 +6.2 +— +— +Total +26 +22.2 +21 +15.9 +36 +32.8 +Wells drilled within the productive boundaries of statistical plays, such as on our Southern Midland Basin acreage, have been classified as development wells. +The following table sets forth productive wells as of December 31, 2013 : +Oil Wells +Natural Gas Wells +Gross +Net +Gross +Net +Working interest +128 +107.7 +— +— +Royalty interest +3 +0.1 +— +— +Total +131 +107.8 +— +— +A well is categorized as an oil well or a natural gas well based upon the ratio of oil to natural gas reserves on a Mcfe basis. However, most of our wells produce both oil and natural gas. +14 +For the periods presented, the following table sets forth by major field(s) net production volumes and estimated proved reserves: +Year ended December 31, +Production Volumes (MBOE) +% of Total Proved Reserves +2013 +2012 +2011 +2013 +2012 +2011 +Onshore +Permian Basin +Southern Midland Basin +612 +402 +254 +85 +% +51 +% +31 +% +Central Midland Basin +193 +189 +99 +14 +% +16 +% +17 +% +Northern Midland Basin +8 +— +— +1 +% +— +% +— +% +Total Permian Basin +813 +591 +353 +100 +% +67 +% +48 +% +Haynesville shale +18 +46 +101 +— +% +1 +% +13 +% +Total onshore +831 +637 +454 +100 +% +68 +% +61 +% +Offshore +Medusa +302 +464 +641 +— +% +28 +% +27 +% +Habanero +— +134 +197 +— +% +— +% +8 +% +Gulf of Mexico shelf and other +280 +340 +551 +— +% +4 +% +4 +% +Total offshore +582 +938 +1,389 +— +% +32 +% +39 +% +Total +1,413 +1,575 +1,843 +100 +% +100 +% +100 +% +Leasehold Acreage +The following table shows our approximate developed and undeveloped (gross and net) leasehold acreage as of December 31, 2013 . +Developed +Undeveloped +Total +Gross +Net +Gross +Net +Gross +Net +Louisiana +1,091 +158 +233 +167 +1,324 +325 +Texas (a) +13,038 +11,144 +22,889 +20,685 +35,927 +31,829 +Federal onshore (b) +— +— +64,963 +64,963 +64,963 +64,963 +Total +14,129 +11,302 +88,085 +85,815 +102,214 +97,117 +(a) +A portion of our Texas acreage requires continued drilling to hold the acreage for which we have included in our development plans, though the cost to renew this acreage, if necessary, is not considered material. +(b) +The Company’s lease of this acreage, located in Nevada, has approximate ly four years rema ining, and had a carrying value at December 31, 2013 of approximately $2.6 million included in the Company’s unevaluated properties balance. The lease requires no drilling activity to hold the acreage, and we continue to evaluate our position and monitor the activity of other operators conducting drilling in the area. +15 +Table of Contents +Undeveloped Acreage Expirations +The following table sets forth by geographic area as of December 31, 2013 the number of our leased gross and net undeveloped acres that will expire over the next three years unless production begins before lease expiration dates. Gross amounts may be more than net amounts in a particular year due to timing of expirations. +Net +Gross +2014 +2015 +2016 +Total +Texas: +Southern Permian Basin +165 +— +— +165 +165 +Central Permian Basin +— +— +— +— +— +Northern Permian Basin (a) +10,586 +7,282 +327 +18,195 +19,755 +Nevada: (b) +— +— +— +— +— +Total acreage +10,751 +7,282 +327 +18,360 +19,920 +(a) 2,133 net acres have expired as of March 7, 2014. 16,062 of the total remaining net acres include extension options that would allow us to extend the primary term for a period of two years. +(b) The Company’s lease of this acreage does not expire until 2018. +The expiring acreage set forth in the table above accounts for 21% of our net undeveloped acreage ( 85,815 total net acres). We are continually engaged in a combination of drilling and development and discussions with mineral lessors for lease extensions, renewals, new drilling and development units and new leases to address the expiration of undeveloped acreage that occurs in the normal course of our business. +Title to Properties +The Company believes that the title to its oil and natural gas properties is good and defensible in accordance with standards generally accepted in the oil and gas industry, subject to such exceptions which, in our opinion, are not so material as to detract substantially from the use or value of such properties. The Company’s properties are typically subject, in one degree or another, to one or more of the following: +• +royalties and other burdens and obligations, express or implied, under oil and natural gas leases, +• +overriding royalties and other burdens created by us or our predecessors in title, +• +a variety of contractual obligations (including, in some cases, development obligations) arising under operating agreements, farm-out agreements, production sales contracts and other agreements that may affect the properties or their titles, +• +back-ins and reversionary interests existing under purchase agreements and leasehold assignments, +• +liens that arise in the normal course of operations, such as those for unpaid taxes, statutory liens securing obligations to unpaid suppliers and contractors and contractual liens under operating agreements, +• +pooling, unitization and communitization agreements, declarations and orders, and +• +easements, restrictions, rights-of-way and other matters that commonly affect property. +To the extent that such burdens and obligations affect the Company’s rights to production revenues, these characteristics have been taken into account in calculating Callon’s net revenue interests and in estimating the size and value of its reserves. The Company believes that the burdens and obligations affecting our properties are typical within the industry for properties of the kind owned by Callon. +Insurance +In accordance with industry practice, the Company maintains insurance against some, but not all, of the operating risks to which its business is exposed. While not all inclusive, the Company’s insurance policies include coverage for general liability insuring onshore operations (including sudden and accidental pollution), aviation liability, auto liability, worker’s compensation, and employer’s liability. The company carries control of well insurance for only those onshore operations that it is contractually bound to do so. At the depths and in the areas in which the Company operates, and in light of the vertical and horizontal drilling that it undertakes, the Company typically does not encounter high pressures or extreme drilling conditions onshore. +16 +Table of Contents +Currently, the Company has general liability insurance coverage up to $1 million per occurrence and $2 million per policy in the aggregate, which includes sudden and accidental environmental liability coverage for the effects of pollution on third parties arising from its operations. The Company’s insurance policies contain high policy limits, and in most cases, deductibles (generally ranging from $0 to $250,000) that must be met prior to recovery. These insurance policies are subject to certain customary exclusions and limitations. In addition, the Company maintains up to $100 million in excess liability coverage, which is in addition to and triggered if the underlying liability limits have been reached. +The Company requires all of its third-party contractors to sign master service agreements in which they agree to indemnify the Company for injuries and deaths of the service provider’s employees, as well as contractors and subcontractors hired by the service provider. Similarly, the Company generally agrees to indemnify each third-party contractor against claims made by employees of the Company and the Company’s other contractors. Additionally, each party generally is responsible for damage to its own property. +The third-party contractors that perform hydraulic fracturing operations for the Company sign master service agreements generally containing the indemnification provisions noted above. The Company does not currently have any insurance policies in effect that are intended to provide coverage for losses solely related to hydraulic fracturing operations. However, the Company believes its general liability and excess liability insurance policies would cover foreseeable third party claims related to hydraulic fracturing operations and associated legal expenses, in accordance with, and subject to, the terms of such policies. +The Company re-evaluates the purchase of insurance, coverage limits and deductibles annually. Future insurance coverage for the oil and natural gas industry could increase in cost and may include higher deductibles or retentions. In addition, some forms of insurance may become unavailable in the future or unavailable on terms that are economically acceptable. While based on the Company’s risk analysis, it believes that it is properly insured, no assurance can be given that the Company will be able to maintain insurance in the future at rates that it considers reasonable. In such circumstances, the Company may elect to self-insure or maintain only catastrophic coverage for certain risks in the future. +Major Customers +Our production is sold generally on month-to-month contracts at prevailing prices. The following table identifies customers to whom we sold a significant percentage of our total oil and natural gas production, on an equivalent basis, during each of the 12-month periods ended: +December 31, +2013 +2012 +2011 +Enterprise Crude Oil, LLC +38 +% +32 +% +16 +% +Shell Trading Company +31 +% +39 +% +45 +% +Plains Marketing, L.P. +15 +% +15 +% +17 +% +Other +16 +% +14 +% +22 +% +Total +100 +% +100 +% +100 +% +Because alternative purchasers of oil and natural gas are readily available, the Company believes that the loss of any of these purchasers would not result in a material adverse effect on Callon’s ability to market future oil and natural gas production. We are not currently committed to provide a fixed and determinable quantity of oil or gas in the near future under our contracts. +Corporate Offices +The Company’s headquarters are located in Natchez, Mississippi, in approximately 51,500 square feet of owned space. We also maintain leased business offices in Houston and Midland, Texas. Because alternative locations to our leased spaces are readily available, the replacement of any of our leased offices would not result in material expenditures . +Employees +Callon had 94 employees as of December 31, 2013 . None of the Company’s employees are currently represented by a union, and the Company believes that it has good relations with its employees. +17 +Regulations +General. Oil and natural gas operations such as ours are subject to various types of legislation, regulation and other legal requirements enacted by governmental authorities. This legislation and regulation affecting the entire oil and natural gas industry is continuously being reviewed for amendment or expansion. Some of these requirements carry substantial penalties for failure to comply. +Exploration and Production . Our operations are subject to federal, state and local regulations that include requirements for permits to drill and to conduct other operations and for provision of financial assurances (such as bonds and letters of credit) covering drilling and well operations. Other activities subject to regulation are: +• +the location and spacing of wells, +• +the method of drilling and completing and operating wells, +• +the rate and method of production, +• +the surface use and restoration of properties upon which wells are drilled and other exploration activities, +• +notice to surface owners and other third parties, +• +the plugging and abandoning of wells, +• +the discharge of contaminants into water and the emission of contaminants into air, +• +the disposal of fluids used or other wastes obtained in connection with operations, +• +the marketing, transportation and reporting of production, and +• +the valuation and payment of royalties. +Operations conducted on federal or state oil and natural gas leases must comply with numerous regulatory restrictions, including various nondiscrimination statutes, royalty and related valuation requirements, and certain of these operations must be conducted pursuant to certain on-site security regulations and other appropriate permits issued by the Department of the Interior (“DOI”) Bureaus or other appropriate federal or state agencies. +Our sales of oil and natural gas are affected by the availability, terms and cost of pipeline transportation. The price and terms for access to pipeline transportation remain subject to extensive federal and state regulation. If these regulations change, we could face higher transmission costs for our production and, possibly, reduced access to transmission capacity. +Various proposals and proceedings that might affect the petroleum industry are pending before Congress, the Federal Energy Regulatory Commission, or FERC, various state legislatures, and the courts. The industry historically has been heavily regulated and we can offer you no assurance that the less stringent regulatory approach recently pursued by the FERC and Congress will continue nor can we predict what effect such proposals or proceedings may have on our operations. +We do not currently anticipate that compliance with existing laws and regulations governing exploration and production will have a significantly adverse effect upon our capital expenditures, earnings or competitive position. +Environmental Matters and Regulation. Our oil and natural gas exploration, development and production operations are subject to stringent laws and regulations governing the discharge of materials into the environment or otherwise relating to environmental protection. Numerous federal, state and local governmental agencies, such as the U.S. Environmental Protection Agency, or the EPA, issue regulations which often require difficult and costly compliance measures that carry substantial administrative, civil and criminal penalties and may result in injunctive obligations for non-compliance. These laws and regulations may require the acquisition of a permit before drilling commences, restrict the types, quantities and concentrations of various substances that can be released into the environment in connection with drilling and production activities, limit or prohibit construction or drilling activities on certain lands lying within wilderness, wetlands, ecologically sensitive and other protected areas, require action to prevent or remediate pollution from current or former operations, such as plugging abandoned wells or closing pits, result in the suspension or revocation of necessary permits, licenses and authorizations, require that additional pollution controls be installed and impose substantial liabilities for pollution resulting from our operations or relate to our owned or operated facilities. Violations of environmental laws could result in administrative, civil or criminal fines and injunctive relief. The strict and joint and several liability nature of such laws and regulations could impose liability upon us regardless of fault. Moreover, it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by the release of hazardous substances, hydrocarbons or other waste products into the environment. Changes in environmental laws and regulations occur frequently, and any changes that result in more stringent and costly pollution control or waste handling, storage, transport, disposal or cleanup requirements could materially adversely affect our operations and financial position, as well as the oil and natural gas industry in general. Our management believes that we are in substantial compliance with applicable environmental laws and regulations and we have not experienced any material adverse effect from compliance with these +18 +environmental requirements. Our management believes that we are in substantial compliance with applicable environmental laws and regulations and we have not experienced any material adverse effect from compliance with these environmental requirements. +Waste Handling. The Resource Conservation and Recovery Act, as amended, or RCRA, and comparable state statutes and regulations promulgated thereunder, affect oil and natural gas exploration, development and production activities by imposing requirements regarding the generation, transportation, treatment, storage, disposal and cleanup of hazardous and non-hazardous wastes. With federal approval, the individual states administer some or all of the provisions of RCRA, sometimes in conjunction with their own, more stringent requirements. Although most wastes associated with the exploration, development and production of oil and natural gas are exempt from regulation as hazardous wastes under RCRA, such wastes may constitute “solid wastes” that are subject to the less stringent requirements of non-hazardous waste provisions may not be exempt under state programs. However, we cannot assure you that the EPA or state or local governments will not adopt more stringent requirements for the handling of non-hazardous wastes or categorize some non-hazardous wastes as hazardous for future regulation. Indeed, legislation has been proposed from time to time in Congress to re-categorize certain oil and natural gas exploration, development and production wastes as “hazardous wastes.” Any such changes in the laws and regulations could have a material adverse effect on our capital expenditures and operating expenses. +Administrative, civil and criminal penalties can be imposed for failure to comply with waste handling requirements. We believe that we are in substantial compliance with applicable requirements related to waste handling, and that we hold all necessary and up-to-date permits, registrations and other authorizations to the extent that our operations require them under such laws and regulations. We believe that we are in substantial compliance with applicable requirements related to waste handling, and that we hold all necessary and up-to-date permits, registrations and other authorizations to the extent that our operations require them under such laws and regulations. Although we do not believe the current costs of managing our wastes, as presently classified, to be significant, any legislative or regulatory reclassification of oil and natural gas exploration and production wastes could increase our costs to manage and dispose of such wastes. +Water Discharges. The Federal Water Pollution Control Act of 1972, as amended, also known as the “Clean Water Act,” the Safe Drinking Water Act, the Oil Pollution Act, or OPA, and analogous state laws and regulations promulgated thereunder impose restrictions and strict controls regarding the unauthorized discharge of pollutants, including produced waters and other gas and oil wastes, into navigable waters of the United States, as well as state waters for analogous state programs. The discharge of pollutants into regulated waters is prohibited, except in accordance with the terms of a permit issued by the EPA or the state. The Clean Water Act and regulations implemented thereunder also prohibit the discharge of dredge and fill material into regulated waters, including jurisdictional wetlands, unless authorized by an appropriately issued permit. Spill prevention, control and countermeasure plan requirements under federal law require appropriate containment berms and similar structures to help prevent the contamination of navigable waters in the event of a petroleum hydrocarbon tank spill, rupture or leak. These laws and regulations also prohibit certain activity in wetlands unless authorized by a permit issued by the U.S. Army Corps of Engineers. The EPA has also adopted regulations requiring certain oil and natural gas exploration and production facilities to obtain individual permits or coverage under general permits for storm water discharges. In addition, on October 20, 2011, the EPA announced a schedule to develop pre-treatment standards for wastewater discharges produced by natural gas extraction from underground coalbed and shale formations. The EPA stated that it will gather data, consult with stakeholders, including ongoing consultation with industry, and solicit public comment on a proposed rule for coalbed methane and shale gas in 2014. Costs may be associated with the treatment of wastewater or developing and implementing storm water pollution prevention plans, as well as for monitoring and sampling the storm water runoff from certain of our facilities. Some states also maintain groundwater protection programs that require permits for discharges or operations that may impact groundwater conditions. +The Oil Pollution Act is the primary federal law for oil spill liability. The OPA contains numerous requirements relating to the prevention of and response to petroleum releases into waters of the United States, including the requirement that operators of offshore facilities and certain onshore facilities near or crossing waterways must develop and maintain facility response contingency plans and maintain certain significant levels of financial assurance to cover potential environmental cleanup and restoration costs. The OPA subjects owners of facilities to strict, joint and several liability for all containment and cleanup costs and certain other damages arising from a release, including, but not limited to, the costs of responding to a release of oil to surface waters. +Noncompliance with the Clean Water Act or OPA may result in substantial administrative, civil and criminal penalties, as well as injunctive obligations. We believe we are in material compliance with the requirements of each of these laws. We believe we are in material compliance with the requirements of each of these laws. +Air Emissions. The federal Clean Air Act, as amended, and comparable state laws and regulations, regulate emissions of various air pollutants through the issuance of permits and the imposition of other requirements. The EPA has developed, and continues to develop, stringent regulations governing emissions of air pollutants at specified sources. New facilities may be required to obtain permits before work can begin, and existing facilities may be required to obtain additional permits and incur capital costs in order to remain in compliance. For example, on August 16, 2012, the EPA published final regulations under the federal Clean Air Act +19 +that establish new emission controls for oil and natural gas production and processing operations, which regulations are discussed in more detail below in “-Regulation of Hydraulic Fracturing.” These laws and regulations may increase the costs of compliance for some facilities we own or operate, and federal and state regulatory agencies can impose administrative, civil and criminal penalties and seek injunctive relief for non-compliance with air permits or other requirements of the federal Clean Air Act and associated state laws and regulations. We believe that we are in substantial compliance with all applicable air emissions regulations and that we hold all necessary and valid construction and operating permits for our operations. We believe that we are in substantial compliance with all applicable air emissions regulations and that we hold all necessary and valid construction and operating permits for our operations. Obtaining or renewing permits has the potential to delay the development of oil and natural gas projects. +Greenhouse Gas (GHG) Regulation. Although federal legislation regarding the control of greenhouse gasses, or GHGs, thus far has been unsuccessful, the EPA has moved forward with rulemaking to regulate GHGs as pollutants under the CAA. These GHG regulations may require us to incur increased operating costs and may have an adverse effect on demand for the oil and natural gas we produce. +The EPA, as of January 2, 2011, requires the permitting of GHG emissions from stationary sources under the Prevention of Significant Deterioration (“PSD”) and Title V permitting programs in a multi-step process, with the largest sources first subject to permitting. Those permitting provisions, should they become applicable to our operations, could require controls or other measures to reduce GHG emissions from new or modified sources, and we could incur additional costs to satisfy those requirements. EPA has adopted a rule establishing GHG reporting requirements for sources in the petroleum and natural gas industry, requiring those sources to monitor, maintain records on, and annually report their GHG emissions if the total emissions within a basin exceed 25,000 metric tons CO 2 equivalent per year. Although this rule does not limit the amount of GHGs that can be emitted, it requires us to incur costs to monitor, keep records of, and potentially report GHG emissions associated with our operations if the reporting threshold is reached with production growth. +In addition to federal regulation, a number of states, individually and regionally, also are considering or have implemented GHG regulatory programs. These potential regional and state initiatives may result in so-called “Cap-and-Trade programs”, under which overall GHG emissions are limited and GHG emissions are then allocated and sold, and possibly other regulatory requirements, that could result in our incurring material expenses to comply, such as by being required to purchase or to surrender allowances for GHGs resulting from our operations. The federal, regional and local regulatory initiatives also could adversely affect the marketability of the oil and natural gas we produce. The impact of such future programs cannot be predicted, but we do not expect our operations to be affected any differently than other similarly situated domestic competitors. +Regulation of Hydraulic Fracturing. Hydraulic fracturing is an important common practice that is used to stimulate production of hydrocarbons, particularly natural gas, from tight formations, including shales. The process involves the injection of water, sand and chemicals under pressure into formations to fracture the surrounding rock and stimulate production. The federal Safe Drinking Water Act, or SDWA, regulates the underground injection of substances through the Underground Injection Control, or UIC, program. Hydraulic fracturing generally is exempt from regulation under the UIC program, and the hydraulic fracturing process is typically regulated by state oil and gas commissions. Legislation to amend the SDWA to repeal the exemption for hydraulic fracturing from the definition of “underground injection” and require federal permitting and regulatory control of hydraulic fracturing, as well as legislative proposals to require disclosure of the chemical constituents of the fluids used in the fracturing process, have been proposed in recent sessions of Congress but have not passed. +The EPA, however, issued guidance on permitting hydraulic fracturing that uses fluids containing diesel fuel under the UIC program, specifically as “Class II” UIC wells. At the same time, the White House Council on Environmental Quality is coordinating an administration-wide review of hydraulic fracturing practices and the EPA has commenced a study of the potential impacts of hydraulic fracturing activities on drinking water resources. The EPA has announced that it plans to propose standards in 2014 that such wastewater must meet before being transported to a treatment plant. As part of these studies, the EPA has requested that certain companies provide them with information concerning the chemicals used in the hydraulic fracturing process. These studies, depending on their results, could spur initiatives to regulate hydraulic fracturing under the SDWA or otherwise. +On August 16, 2012, the EPA approved final regulations under the federal Clean Air Act that establish new air emission controls for oil and natural gas production and natural gas processing operations. Specifically, the EPA’s rule package includes New Source Performance Standards to address emissions of sulfur dioxide and volatile organic compounds, or VOCs, and a separate set of emission standards to address hazardous air pollutants frequently associated with oil and natural gas production and processing activities. The final rule seeks to achieve a 95% reduction in VOCs emitted by requiring the use of reduced emission completions or “green completions” on all hydraulically-fractured wells constructed or refractured after January 1, 2015. The rules also establish specific new requirements regarding emissions from compressors, controllers, dehydrators, storage tanks and other production equipment. These rules will require a number of modifications to our operations, including the installation of new equipment to control emissions from our wells by January 1, 2015. The EPA received numerous requests for reconsideration of these rules from +20 +both industry and the environmental community, and court challenges to the rules were also filed. The EPA may issue revised rules that are likely responsive to some of these requests. For example, on April 12, 2013, the EPA published a proposed amendment extending compliance dates for certain storage vessels. The final revised rules could require modifications to our operations or increase our capital and operating costs without being offset by increased product capture. At this point, we cannot predict the final regulatory requirements or the cost to comply with such requirements with any certainty. In addition, the U.S. Department of the Interior published a revised proposed rule on May 24, 2013 that would update existing regulation for hydraulic fracturing activities on federal lands, including requirements for disclosure, well bore integrity and handling of flowback water. EPA has announced that it is considering regulations under the Toxic Substance Control Act to require evaluation and disclsoure of hydraulic fracturing. +In addition, there are certain governmental reviews either underway or being proposed that focus on environmental aspects of hydraulic fracturing practices. The federal government is currently undertaking several studies of hydraulic fracturing’s potential impacts, the results of which are expected in 2014. These ongoing or proposed studies, depending on their degree of pursuit and whether any meaningful results are obtained, could spur initiatives to further regulate hydraulic fracturing under the SDWA or other regulatory authorities. +Several states, including Texas, have adopted, or are considering adopting, regulations that could restrict or prohibit hydraulic fracturing in certain circumstances and/or require the disclosure of the composition of hydraulic fracturing fluids. The Texas Legislature adopted new legislation requiring oil and gas operators to publicly disclose the chemicals used in the hydraulic fracturing process, effective as of September 1, 2011. The Texas Railroad Commission has adopted rules and regulations implementing this legislation that apply to all wells for which the Railroad Commission issues an initial drilling permit after February 1, 2012. The new law requires that the well operator disclose the list of chemical ingredients subject to the requirements of the federal Occupational Safety and Health Act (OSHA) for disclosure on an internet website and also file the list of chemicals with the Texas Railroad Commission with the well completion report. The total volume of water used to hydraulically fracture a well must also be disclosed to the public and filed with the Texas Railroad Commission. +There has been increasing public controversy regarding hydraulic fracturing with regard to the use of fracturing fluids, impacts on drinking water supplies, use of water and the potential for impacts to surface water, groundwater and the environment generally. A number of lawsuits and enforcement actions have been initiated across the country implicating hydraulic fracturing practices. If new laws or regulations that significantly restrict hydraulic fracturing are adopted, such laws could make it more difficult or costly for us to perform fracturing to stimulate production from tight formations as well as make it easier for third parties opposing the hydraulic fracturing process to initiate legal proceedings based on allegations that specific chemicals used in the fracturing process could adversely affect groundwater. In addition, if hydraulic fracturing is further regulated at the federal or state level, our fracturing activities could become subject to additional permitting and financial assurance requirements, more stringent construction specifications, increased monitoring, reporting and recordkeeping obligations, plugging and abandonment requirements and also to attendant permitting delays and potential increases in costs. Such legislative changes could cause us to incur substantial compliance costs, and compliance or the consequences of any failure to comply by us could have a material adverse effect on our financial condition and results of operations. At this time, it is not possible to estimate the impact on our business of newly enacted or potential federal or state legislation governing hydraulic fracturing. +Surface Damage Statutes (“SDAs”) . In addition, a number of states and some tribal nations have enacted SDAs. These laws are designed to compensate for damage caused by oil and gas development operations. Most SDAs contain entry notification and negotiation requirements to facilitate contact between operators and surface owners/users. Most also contain binding requirements for payments to the operator in connection with exploration and operating activities. Costs and delays associated with SDAs could impair operational effectiveness and increase development costs. +National Environmental Policy Act and Endangered Species Act . Oil and natural gas exploration and production activities on federal lands may be subject to the National Environmental Policy Act, or NEPA, which requires federal agencies, including the Department of Interior, to evaluate major agency actions having the potential to significantly impact the environment. In the course of such evaluations, an agency will prepare an Environmental Assessment that assesses the potential direct, indirect and cumulative impacts of a proposed project and, if necessary, will prepare a more detailed Environmental Impact Statement that may be made available for public review and comment. To the extent that our current exploration and production activities, as well as proposed exploration and development plans, on federal lands require governmental permits that are subject to the requirements of NEPA, this process has the potential to delay or impose additional conditions upon the development of oil and natural gas projects. +The Endangered Species Act (“ESA”) was established to protect endangered and threatened species. Pursuant to that act, if a species is listed as threatened or endangered, restrictions may be imposed on activities adversely affecting that species’ habitat. Similar protections are offered to migratory birds under the Migratory Bird Treaty Act. The U.S. Fish and Wildlife Service must also designate the species’ critical habitat and suitable habitat as part of the effort to ensure survival of the species. A critical habitat +21 +or suitable habitat designation could result in further material restrictions to land use and may materially delay or prohibit land access for oil and natural gas development. If the Company were to have a portion of its leases designated as critical or suitable habitat, it may adversely impact the value of the affected leases. +Mineral Leasing Act of 1920 (“Mineral Act”) . The Mineral Act prohibits direct or indirect ownership of any interest in federal onshore oil and natural gas leases by a foreign citizen or a foreign corporation except through stock ownership in a corporation formed under the laws of the United States or of any U.S. state or territory, and only if the laws, customs, or regulations of their country of origin or domicile do not deny similar or like privileges to citizens or corporations of the United States. If these restrictions are violated, the oil and gas lease or leases can be canceled in a proceeding instituted by the United States Attorney General. Although the regulations of the Bureau of Land Management (“BLM”) (which administers the Mineral Act) provide for agency designations of non-reciprocal countries, there are presently no such designations in effect. The Company owns an interest in federal leaseholds in Nevada. It is possible that holders of the Company’s equity interests may be citizens of foreign countries, which could be determined to be citizens of a non-reciprocal country under the Mineral Act. In such event, the federal onshore oil and gas leases held by the Company could be subject to cancellation based on such determination. +Other Regulation of the Oil and Natural Gas Industry. The oil and natural gas industry is extensively regulated by numerous federal, state and local authorities. Legislation affecting the oil and natural gas industry is under constant review for amendment or expansion, frequently increasing the regulatory burden. Also, numerous departments and agencies, both federal and state, are authorized by statute to issue rules and regulations that are binding on the oil and natural gas industry and its individual members, some of which carry substantial penalties for failure to comply. Although the regulatory burden on the oil and natural gas industry increases our cost of doing business and, consequently, affects our profitability, these burdens generally do not affect us any differently or to any greater or lesser extent than they affect other companies in the industry with similar types, quantities and locations of production. +The availability, terms and cost of transportation significantly affect sales of oil and natural gas. The interstate transportation and sale for resale of oil and natural gas is subject to federal regulation, including regulation of the terms, conditions and rates for interstate transportation, storage and various other matters, primarily by the Federal Energy Regulatory Commission, or FERC. Federal and state regulations govern the price and terms for access to oil and natural gas pipeline transportation. FERC’s regulations for interstate oil and natural gas transmission in some circumstances may also affect the intrastate transportation of oil and natural gas. +Although oil and natural gas prices are currently unregulated, Congress historically has been active in the area of oil and natural gas regulation. We cannot predict whether new legislation to regulate oil and natural gas might be proposed, what proposals, if any, might actually be enacted by Congress or the various state legislatures, and what effect, if any, the proposals might have on our operations. Sales of condensate and oil and natural gas liquids are not currently regulated and are made at market prices. +Drilling and Production. Our operations are subject to various types of regulation at the federal, state and local level. These types of regulation include requiring permits for the drilling of wells, drilling bonds and reports concerning operations. The state, and some counties and municipalities, in which we operate also regulate one or more of the following: +• +the location of wells; +• +the method of drilling and casing wells; +• +the timing of construction or drilling activities, including seasonal wildlife closures; +• +the rates of production or “allowables”; +• +the surface use and restoration of properties upon which wells are drilled; +• +the plugging and abandoning of wells; and +• +notice to, and consultation with, surface owners and other third parties. +State laws regulate the size and shape of drilling and spacing units or proration units governing the pooling of oil and natural gas properties. Some states allow forced pooling or integration of tracts to facilitate exploration while other states rely on voluntary pooling of lands and leases. In some instances, forced pooling or unitization may be implemented by third parties and may reduce our interest in the unitized properties. In addition, state conservation laws establish maximum rates of production from oil and natural gas wells, generally prohibit the venting or flaring of natural gas and impose requirements regarding the ratability of production. These laws and regulations may limit the amount of oil and natural gas we can produce from our wells or limit the number of wells or the locations at which we can drill. Moreover, each state generally imposes a production or severance tax with respect to the production and sale of oil, natural gas and natural gas liquids within its jurisdiction. States do not regulate wellhead prices or engage in other similar direct regulation, but we cannot assure you that they will not do so in the future. The effect of +22 +such future regulations may be to limit the amounts of oil and natural gas that may be produced from our wells, negatively affect the economics of production from these wells or to limit the number of locations we can drill. +Federal, state and local regulations provide detailed requirements for the abandonment of wells, closure or decommissioning of production facilities and pipelines and for site restoration in areas where we operate. The U.S. Army Corps of Engineers and many other state and local authorities also have regulations for plugging and abandonment, decommissioning and site restoration. Although the U.S. Army Corps of Engineers does not require bonds or other financial assurances, some state agencies and municipalities do have such requirements. +Natural Gas Sales and Transportation. Historically, federal legislation and regulatory controls have affected the price of the natural gas we produce and the manner in which we market our production. FERC has jurisdiction over the transportation and sale for resale of natural gas in interstate commerce by natural gas companies under the Natural Gas Act of 1938 and the Natural Gas Policy Act of 1978. Since 1978, various federal laws have been enacted which have resulted in the complete removal of all price and non-price controls for sales of domestic natural gas sold in “first sales,” which include all of our sales of our own production. Under the Energy Policy Act of 2005, FERC has substantial enforcement authority to prohibit the manipulation of natural gas markets and enforce its rules and orders, including the ability to assess substantial civil penalties. +FERC also regulates interstate natural gas transportation rates and service conditions and establishes the terms under which we may use interstate natural gas pipeline capacity, which affects the marketing of natural gas that we produce, as well as the revenues we receive for sales of our natural gas and release of our natural gas pipeline capacity. Commencing in 1985, FERC promulgated a series of orders, regulations and rule makings that significantly fostered competition in the business of transporting and marketing gas. Today, interstate pipeline companies are required to provide nondiscriminatory transportation services to producers, marketers and other shippers, regardless of whether such shippers are affiliated with an interstate pipeline company. FERC’s initiatives have led to the development of a competitive, open access market for natural gas purchases and sales that permits all purchasers of natural gas to buy gas directly from third-party sellers other than pipelines. However, the natural gas industry historically has been very heavily regulated; therefore, we cannot guarantee that the less stringent regulatory approach currently pursued by FERC and Congress will continue indefinitely into the future nor can we determine what effect, if any, future regulatory changes might have on our natural gas related activities. +Under FERC’s current regulatory regime, transmission services must be provided on an open-access, non-discriminatory basis at cost-based rates or at market-based rates if the transportation market at issue is sufficiently competitive. Gathering service, which occurs upstream of jurisdictional transmission services, is regulated by the states onshore and in state waters. Although its policy is still in flux, FERC has in the past reclassified certain jurisdictional transmission facilities as non-jurisdictional gathering facilities, which has the tendency to increase our costs of transporting gas to point-of-sale locations. +Oil and NGLs Sales and Transportation. Sales of oil and condensate and natural gas liquids are not currently regulated and are made at negotiated prices. Nevertheless, Congress could reenact price controls in the future. +Our oil sales are affected by the availability, terms and cost of transportation. The transportation of oil in common carrier pipelines is also subject to rate regulation. FERC regulates interstate oil pipeline transportation rates under the Interstate Commerce Act and intrastate oil pipeline transportation rates are subject to regulation by state regulatory commissions. The basis for intrastate oil pipeline regulation, and the degree of regulatory oversight and scrutiny given to intrastate oil pipeline rates, varies from state to state. Insofar as effective interstate and intrastate rates are equally applicable to all comparable shippers, we believe that the regulation of oil transportation rates will not affect our operations in any materially different way than such regulation will affect the operations of our competitors. +Further, interstate and intrastate common carrier oil pipelines must provide service on a non-discriminatory basis. Under this open access standard, common carriers must offer service to all shippers requesting service on the same terms and under the same rates. When oil pipelines operate at full capacity, access is governed by prorationing provisions set forth in the pipelines’ published tariffs. Accordingly, we believe that access to oil pipeline transportation services generally will be available to us to the same extent as to our competitors. +State Regulation. Texas regulates the drilling for, and the production, gathering and sale of, oil and natural gas, including imposing severance taxes and requirements for obtaining drilling permits. Texas currently imposes a 4.6% severance tax on oil production and a 7.5% severance tax on natural gas production. States also regulate the method of developing new fields, the spacing and operation of wells and the prevention of waste of oil and natural gas resources. States may regulate rates of production and may establish maximum daily production allowables from oil and natural gas wells based on market demand or resource conservation, or both. States do not regulate wellhead prices or engage in other similar direct economic regulation, but we cannot assure you that they will not do so in the future. The effect of these regulations may be to limit the amount of oil and natural gas that may be produced from our wells and to limit the number of wells or locations we can drill. +23 +The petroleum industry is also subject to compliance with various other federal, state and local regulations and laws. Some of those laws relate to resource conservation and equal employment opportunity. We do not believe that compliance with these laws will have a material adverse effect on us. +Commitments and Contingencies +The Company’s activities are subject to federal, state and local laws and regulations governing environmental quality and pollution control. Although no assurances can be made, the Company believes that, absent the occurrence of an extraordinary event, compliance with existing federal, state and local laws, rules and regulations governing the release of materials into the environment or otherwise relating to the protection of the environment will not have a material effect upon the capital expenditures, earnings or the competitive position of the Company with respect to its existing assets and operations. The Company cannot predict what effect additional regulation or legislation, enforcement policies included, and claims for damages to property, employees, other persons, and the environment resulting from the Company’s operations could have on its activities. See Note 13 for additional information. +Available Information +We make available free of charge on our Internet web site (www.callon.com) our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and other filings pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and amendments to such filings, as soon as reasonably practicable after each are electronically filed with, or furnished to, the SEC. You may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE., Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers, like Callon, that file electronically with the SEC. +We also make available within the Investors section of our Internet web site our Code of Business Conduct and Ethics, Corporate Governance Guidelines, and Audit, Compensation and Nominating and Governance Committee Charters, which have been approved by our board of directors. We will make timely disclosure by a Current Report on Form 8-K and on our web site of any change to, or waiver from, the Code of Business Conduct and Ethics for our principal executive and senior financial officers. A copy of our Code of Business Conduct and Ethics is also available, free of charge by writing us at: Chief Financial Officer, Callon Petroleum Company, P.O. Box 1287, Natchez, MS 39121. +24 +Table of Contents +Item 1A. Risk Factors +Risk Factors +Depressed oil and natural gas prices may adversely affect our results of operations and financial condition . Our success is highly dependent on prices for oil and natural gas, which are extremely volatile, and the oil and natural gas markets are cyclical. Extended periods of low prices for oil or natural gas will have a material adverse effect on us. The prices of oil and natural gas depend on factors we cannot control such as weather, economic conditions, and levels of production, actions by OPEC and other countries and government actions. Prices of oil and natural gas will affect the following aspects of our business: +• +our revenues, cash flows and earnings; +• +the amount of oil and natural gas that we are economically able to produce; +• +our ability to attract capital to finance our operations and the cost of the capital; +• +the amount we are allowed to borrow under our credit facilities; +• +the profit or loss we incur in exploring for and developing our reserves; and +• +the value of our oil and natural gas properties. +Any substantial and extended decline in the price of oil or natural gas could have an adverse effect on our borrowing capacity, our ability to obtain additional capital, and our revenues, profitability and cash flows. +If oil and natural gas prices decrease and remain depressed for extended periods of time, we may be required to take additional writedowns of the carrying value of our oil and natural gas properties. We may be required to writedown the carrying value of our oil and natural gas properties when oil and natural gas prices are low. Under the full-cost method, which we use to account for our oil and natural gas properties, the net capitalized costs of our oil and natural gas properties may not exceed the present value, discounted at 10%, of future net cash flows from estimated net proved reserves, using the preceding 12-months’ average oil and natural gas prices based on closing prices on the first day of each month, plus the lower of cost or fair market value of our unproved properties. If net capitalized costs of our oil and natural gas properties exceed this limit, we must charge the amount of the excess to earnings. This type of charge will not affect our cash flows, but will reduce the book value of our stockholders’ equity. We review the carrying value of our properties quarterly and once incurred, a writedown of oil and natural gas properties is not reversible at a later date, even if prices increase. See Note 12 to our Consolidated Financial Statements. +Our actual recovery of reserves may substantially differ from our proved reserve estimates and our proved reserve estimates may change over time. This Form 10-K contains estimates of our proved oil and natural gas reserves and the estimated future net cash flows from such reserves. These estimates are based upon various assumptions, including assumptions required by the SEC relating to oil and natural gas prices, drilling and operating expenses, capital expenditures, taxes and availability of funds. The process of estimating oil and natural gas reserves is complex. This process requires significant decisions and assumptions in the evaluation of available geological, geophysical, engineering and economic data for each reservoir and is therefore inherently imprecise. In addition, drilling, testing and production data acquired since the date of an estimate may justify revising an estimate. +Actual future production, oil and natural gas prices, revenues, taxes, development expenditures, operating expenses and quantities of recoverable oil and natural gas reserves most likely will vary from the estimates. Any significant variance could materially affect the estimated quantities and present value of reserves shown in this report. Additionally, reserves and future cash flows may be subject to material downward or upward revisions, based on production history, development drilling and exploration activities and prices of oil and natural gas. We incorporate many factors and assumptions into our estimates including: +• +Expected reservoir characteristics based on geological, geophysical and engineering assessments; +• +Future production rates; +• +Future oil and natural gas prices and quality and locational differences; and +• +Future development and operating costs. +You should not assume that any present value of future net cash flows from our estimated net proved reserves contained in this Form 10-K represents the market value of our oil and natural gas reserves. We base the estimated discounted future net cash flows from our proved reserves at December 31, 2013 on average 12-month prices and costs as of the date of the estimate. Actual future prices and costs may be materially higher or lower. Further, actual future net revenues will be affected by factors such as the amount and timing of actual development expenditures, the rate and timing of production, and changes in governmental regulations or taxes. At December 31, 2013 , approximately 33% of the discounted present value of our estimated net proved reserves consisted of PUDs. PUDs represented 50% of total proved reserves by volume. Recovery of PUDs generally requires significant capital expenditures and successful drilling operations. Our reserve estimates include the assumption that we will make significant capital expenditures to develop these undeveloped reserves and the actual costs, development schedule, and results associated with these +25 +Table of Contents +properties may not be as estimated. In addition, the 10% discount factor that we use to calculate the net present value of future net revenues and cash flows may not necessarily be the most appropriate discount factor based on our cost of capital in effect from time to time and the risks associated with our business and the oil and gas industry in general. +Information about reserves constitutes forward-looking information. See “Forward-Looking Statements” for information regarding forward-looking information. +Unless we replace our oil and gas reserves, our reserves and production will decline. Our future oil and gas production depends on our success in finding or acquiring additional reserves. If we fail to replace reserves through drilling or acquisitions, our production, revenues, reserve quantities and cash flows will decline. In general, production from oil and gas properties declines as reserves are depleted, with the rate of decline depending on reservoir characteristics. Our ability to make the necessary capital investment to maintain or expand our asset base of oil and gas reserves would be limited to the extent cash flow from operations is reduced and external sources of capital become limited or unavailable. We may not be successful in exploring for, developing or acquiring additional reserves. +Exploring for, developing, or acquiring reserves is capital intensive and uncertain. We may not be able to economically find, develop, or acquire additional reserves, or may not be able to make the necessary capital investments to develop our reserves, if our cash flows from operations decline or external sources of capital become limited or unavailable. As part of our exploration and development operations, we have expanded, and expect to further expand, the application of horizontal drilling and multi-stage hydraulic fracture stimulation techniques. The utilization of these techniques requires substantially greater capital expenditures, currently expected to be in excess of three times the cost, as compared to the drilling of a traditional vertical well. If we do not replace the reserves we produce, our reserves revenues and cash flow will decrease over time, which will have an adverse effect on our business. +Our business requires significant capital expenditures and we may not be able to obtain needed capital or financing on satisfactory terms or at all . Our exploration and development activities are capital intensive. We make and expect to continue to make substantial capital expenditures in our business for the development, exploitation, production and acquisition of oil and natural gas reserves. Historically, we have funded our capital expenditures through a combination of cash flows from operations, borrowings under our credit facility and public debt and equity financings. In 2013, our total capital expenditures, including expenditures for leasehold interests and property acquisitions, drilling, seismic and infrastructure, were approximately $171 million . Our 2014 capital budget for drilling, completion and infrastructure is estimated to be approximately $185 million . The actual amount and timing of our future capital expenditures may differ materially from our estimates as a result of, among other things, commodity prices, actual drilling results, the availability of drilling rigs and other services and equipment, and regulatory, technological and competitive developments. +If the borrowing base under our revolving credit facility or our revenues decrease as a result of lower oil or natural gas prices, operating difficulties, declines in reserves or for any other reason, we may have limited ability to obtain the capital necessary to sustain our operations at current levels. If additional capital is needed, we may not be able to obtain debt or equity financing on terms favorable to us, or at all. If cash generated by operations or cash available under our revolving credit facility is not sufficient to meet our capital requirements, the failure to obtain additional financing could result in a curtailment of our operations relating to development of our drilling locations, which in turn could lead to a possible expiration of our leases and a decline in our estimated net proved reserves, and could adversely affect our business, financial condition and results of operations. +Our revolving credit facility and second lien term loan facility contain restrictive covenants that may limit our ability to respond to changes in market conditions or pursue business opportunities. Our credit facilities restrictive covenants that limit our ability to, among other things: +• +incur additional indebtedness; +• +create additional liens; +• +sell assets; +• +merge or consolidate with another entity; +• +pay dividends or make other distributions; +• +engage in transactions with affiliates; and +• +enter into certain swap agreements. +In addition, we will be required to use substantial portions of our future cash flow to repay principal and interest on our indebtedness. Our credit facilities require us to maintain certain financial ratios and tests, including a minimum asset value coverage ratio of total debt. The requirement that we comply with these provisions may materially adversely affect our ability to react to changes +26 +Table of Contents +in market conditions, take advantage of business opportunities we believe to be desirable, obtain future financing, fund needed capital expenditures or withstand a continuing or future downturn in our business. +Our borrowings under our revolving credit facility and second lien term loan facility expose us to interest rate risk. Our earnings are exposed to interest rate risk associated with borrowings under our revolving credit facility, which bear interest at a rate elected by us that is based on the prime, LIBOR or federal funds rate plus margins ranging from 0.75% to 2.75% depending on the base rate used and the amount of the loan outstanding in relation to the borrowing base. Our second lien term loan facility bears interest at a rate of LIBOR plus 7.75%. If interest rates increase, so will our interest costs, which may have a material adverse effect on our results of operations and financial condition. +The unavailability or high cost of drilling rigs, pressure pumping equipment and crews, other equipment, supplies, water, personnel and oil field services could adversely affect our ability to execute our exploration and development plans on a timely basis and within our budget. From time to time, our industry has experiences a shortage of drilling rigs, equipment, supplies, water or qualified personnel. During these periods, the costs and delivery times of rigs, equipment and supplies are substantially greater. In addition, the demand for, and wage rates of, qualified drilling rig crews rise as the number of active rigs in service increases. Increasing levels of exploration and production may increase the demand for oilfield services and equipment, and the costs of these services and equipment may increase, while the quality of these services and equipment may suffer. The unavailability or high cost of drilling rigs, pressure pumping equipment, supplies or qualified personnel can materially and adversely affect our operations and profitability. +Our operations substantially depend on the availability of water. Restrictions on our ability to obtain, dispose of or recycle water may impact our ability to execute our drilling and development plans in a timely or cost-effective manner. Water is an essential component of our drilling and hydraulic fracturing processes. Historically, we have been able to secure water from local landowners and other sources for use in our operations. During the last few years, West Texas has experienced extreme drought conditions. As a result of the severe drought, some local water districts may begin restricting the use of water under their jurisdiction for drilling and hydraulic fracturing to protect the local water supply. If we are unable to obtain water to use in our operations from local sources, we may be unable to economically produce oil, NGLs and natural gas, which could have an adverse effect on our business, financial condition and results of operations. +Our producing properties are located in the Permian Basin of West Texas, making us vulnerable to risks associated with operating in a single geographic area. In addition, we have a large amount of proved reserves attributable to a small number of producing horizons within this area. All of our producing properties are geographically concentrated in the Permian Basin of West Texas. As a result of this concentration, we may be disproportionately exposed to the impact of regional supply and demand factors, delays or interruptions of production from wells in this area caused by governmental regulation, processing or transportation capacity constraints, availability of equipment, facilities, personnel or services market limitations or interruption of the processing or transportation of oil, natural gas or natural gas liquids. In addition, the effect of fluctuations on supply and demand may become more pronounced within specific geographic oil and natural gas producing areas such as the Permian Basin, which may cause these conditions to occur with greater frequency or magnify the effects of these conditions. Due to the concentrated nature of our portfolio of properties, a number of our properties could experience any of the same conditions at the same time, resulting in a relatively greater impact on our results of operations than they might have on other companies that have a more diversified portfolio of properties. Such delays or interruptions could have a material adverse effect on our financial condition and results of operations. +Our exploration projects increase the risks inherent in our oil and natural gas activities. We may seek to replace reserves through exploration, where the risks are greater than in acquisitions and development drilling. During 2012, we purchased 21,419 net acres in the Northern Midland basin, an area that has seen only limited drilling activity. We expect to continue exploration of this acreage over the next several years, although our position is subject to meaningful lease expirations through 2015. Our exploration drilling operations may be curtailed, delayed or canceled as a result of a variety of factors, including: +• +the results of our exploration drilling activities; +• +receipt of additional seismic data or other geophysical data or the reprocessing of existing data; +• +material changes in oil or natural gas prices; +• +the costs and availability of drilling rigs; +• +the success or failure of wells drilled in similar formations or which would use the same production facilities; +• +availability and cost of capital; +• +changes in the estimates of the costs to drill or complete wells; and +• +changes to governmental regulations. +27 +Table of Contents +Delays in exploration, cost overruns or unsuccessful drilling results could have a material adverse effect on our business and future growth. +Our exploration and development drilling efforts and the operation of our wells may not be profitable or achieve our targeted returns. Exploration, development, drilling and production activities are subject to many risks, including the risk that commercially productive deposits will not be discovered. We may invest in property, including undeveloped leasehold acreage, which we believe will result in projects that will add value over time. However, we cannot guarantee that any leasehold acreage acquired will be profitably developed, that new wells drilled will be productive or that we will recover all or any portion of our investment in such leasehold acreage or wells. Drilling for oil and natural gas may involve unprofitable efforts, not only from dry wells but also from wells that are productive but do not produce sufficient net reserves to return a profit after deducting operating and other costs. In addition, wells that are profitable may not achieve our targeted rate of return. +In addition, we may not be successful in controlling our drilling and production costs to improve our overall return. We may be forced to limit, delay or cancel drilling operations as a result of a variety of factors, including: +• +unexpected drilling conditions; +• +pressure or irregularities in formations; +• +equipment failures or accidents and shortages or delays in the availability of drilling rigs and the delivery of equipment; and +• +compliance with governmental requirements. +Failure to conduct our oil and gas operations in a profitable manner may result in write downs of our proved reserves quantities, impairment of our oil and gas properties, and a write down in the carrying value of our unproved properties, and over time may adversely affect our growth, revenues and cash flows. +Our identified drilling locations are scheduled to be drilled over many years, making them susceptible to uncertainties that could prevent them from being drilled or delay their drilling. Our management team has identified drilling locations as an estimation of our future development activities on our existing acreage. These identified drilling locations represent a significant part of our growth strategy. Our ability to drill and develop these identified drilling locations depends on a number of uncertainties, including oil and natural gas prices, the availability and cost of capital, drilling and production costs, availability of drilling services and equipment, drilling results, lease expirations, gathering system, marketing and transportation constraints, regulatory approvals and other factors. Because of these uncertain factors, we do not know if the identified drilling locations will ever be drilled or if we will be able to produce oil or natural gas from these drilling locations. In addition, unless production is established within the spacing units covering the undeveloped acres on which some of the identified locations are located, the leases for such acreage will expire. Therefore, our actual drilling activities may materially differ from those presently identified. +We may be unable to integrate successfully the operations of future acquisitions with our operations, and we may not realize all the anticipated benefits of these acquisitions. Our business may include producing property acquisitions that would include undeveloped acreage. We can offer no assurance that we will achieve the desired profitability from any acquisitions we may complete in the future. In addition, failure to assimilate recent and future acquisitions successfully could adversely affect our financial condition and results of operations. Our acquisitions may involve numerous risks, including: +• +operating a larger combined organization and adding operations; +• +difficulties in the assimilation of the assets and operations of the acquired business, especially if the assets acquired are in a new geographic area; +• +risk that oil and natural gas reserves acquired may not be of the anticipated magnitude or may not be developed as anticipated; +• +loss of significant key employees from the acquired business: +• +diversion of management’s attention from other business concerns; +• +failure to realize expected profitability or growth; +• +failure to realize expected synergies and cost savings; +• +coordinating geographically disparate organizations, systems and facilities; and +• +coordinating or consolidating corporate and administrative functions. +Further, unexpected costs and challenges may arise whenever businesses with different operations or management are combined, and we may experience unanticipated delays in realizing the benefits of an acquisition. If we consummate any future acquisition, our capitalization and results of operation may change significantly, and you may not have the opportunity to evaluate the economic, financial and other relevant information that we will consider in evaluating future acquisitions. The inability to effectively manage the integration of acquisitions could reduce our focus on subsequent acquisition and current operations, which in turn, could negatively impact our results of operations. +28 +Table of Contents +We may fail to fully identify problems with any properties we acquire, and as such, assets we acquire may prove to be worth less than we paid because of uncertainties in evaluating recoverable reserves and potential liabilities. We are actively seeking to acquire additional acreage in Texas or other regions in the future. Successful acquisitions require an assessment of a number of factors, including estimates of recoverable reserves, exploration potential, future oil and natural gas prices, operating and capital costs and potential environmental and other liabilities. Although we conduct a review of properties we acquire which we believe is consistent with industry practices, we can give no assurance that we have identified or will identify all existing or potential problems associated with such properties or that we will be able to mitigate any problems we do identify. Such assessments are inexact and their accuracy is inherently uncertain. In addition, our review may not permit us to become sufficiently familiar with the properties to fully assess their deficiencies and capabilities. We do not inspect every well. Even when we inspect a well, we do not always discover structural, subsurface and environmental problems that may exist or arise. We are generally not entitled to contractual indemnification for preclosing liabilities, including environmental liabilities. Normally, we acquire interests in properties on an “as is” basis with limited remedies for breaches of representations and warranties. As a result of these factors, we may not be able to acquire oil and natural gas properties that contain economically recoverable reserves or be able to complete such acquisitions on acceptable terms. +Unexpected subsurface conditions and other unforeseen operating hazards may adversely impact our ability to conduct business. There are many operating hazards in exploring for and producing oil and natural gas, including: +• +our drilling operations may encounter unexpected formations or pressures, which could cause damage to equipment or personal injury; +• +we may experience equipment failures which curtail or stop production; +• +we could experience blowouts or other damages to the productive formations that may require a well to be re-drilled or other corrective action to be taken; +• +storms and other extreme weather conditions could cause damages to our production facilities or wells. +Because of these or other events, we could experience environmental hazards, including release of oil and natural gas from spills, natural gas-leaks, accidental leakage of toxic or hazardous materials, such as petroleum liquids, drilling fluids or fracturing fluids, including chemical additives, underground migration, and ruptures. +If we experience any of these problems, it could affect well bores, gathering systems and processing facilities, which could adversely affect our ability to conduct operations. We could also incur substantial losses in excess of our insurance coverage as a result of: +• +injury or loss of life; +• +severe damage to and destruction of property, natural resources and equipment; +• +pollution and other environmental damage; +• +clean-up responsibilities; +• +regulatory investigation and penalties; +• +suspension of our operations; and +• +repairs to resume operations. +We cannot assure you that we will be able to maintain adequate insurance at rates we consider reasonable to cover our possible losses from operating hazards. The occurrence of a significant event not fully insured or indemnified against could materially and adversely affect our financial condition and results of operations. +Factors beyond our control affect our ability to market production and our financial results. The ability to market oil and natural gas from our wells depends upon numerous factors beyond our control. These factors could negatively affect our ability to market all of the oil or natural gas we produce. In addition, we may be unable to obtain favorable prices for the oil and natural gas we produce. These factors include: +• +the extent of domestic production and imports of oil and natural gas; +• +the proximity of the natural gas production to natural gas and NGL pipelines; +• +the availability of pipeline capacity; +• +the demand for oil and natural gas by utilities and other end users; +• +the availability of alternative fuel sources; +• +the effects of inclement weather; +• +state and federal regulation of oil and natural gas marketing; and +• +federal regulation of natural gas sold or transported in interstate commerce. +29 +Table of Contents +In particular, in areas with increasing non-conventional shale drilling activity, capacity may be limited and it may be necessary for new interstate and intrastate pipelines and gathering systems to be built. +Part of our strategy involves drilling in new or emerging shale formations using horizontal drilling and completion techniques. The results of our planned drilling program in these formations may be subject to more uncertainties than conventional drilling programs in more established formations and may not meet our expectations for reserves or production. The results of our recent horizontal drilling efforts in new or emerging formations, including the Wolfcamp shale, Cline shale, and Mississippian lime in the Permian basin, are generally more uncertain than drilling results in areas that are developed and have established production. Because new or emerging formations have limited or no production history, we are less able to rely on past drilling results in those areas as a basis predict our future drilling results. Further, access to adequate gathering systems or pipeline takeaway capacity and the availability of drilling rigs and other services may be more challenging in new or emerging areas. If our drilling results are less than anticipated or we are unable to execute our drilling program because of capital constraints, access to gathering systems and takeaway capacity or otherwise, and/or natural gas and oil prices decline, our investment in these areas may not be as economic as we anticipate, we could incur material writedowns of unevaluated properties and the value of our undeveloped acreage could decline in the future. +The loss of key personnel could adversely affect our ability to operate. We depend, and will continue to depend in the foreseeable future, on the services of our senior officers and other key employees, as well as other third-party consultants with extensive experience and expertise in evaluating and analyzing drilling prospects and producing oil and natural gas from proved properties and maximizing production from oil and natural gas properties. Our ability to retain our senior officers, other key employees and our third party consultants, none of whom are subject to employment agreements, is important to our future success and growth. The unexpected loss of the services of one or more of these individuals could have a detrimental effect on our business. +We may not be insured against all of the operating risks to which our business is exposed. In accordance with industry practice, we maintain insurance against some, but not all, of the operating risks to which our business is exposed. We cannot assure you that our insurance will be adequate to cover losses or liabilities. Also, we cannot predict the continued availability of insurance at premium levels that justify its purchase. No assurance can be given that we will be able to maintain insurance in the future at rates we consider reasonable and may elect none or minimal insurance coverage. The occurrence of a significant event, not fully insured or indemnified against, could have a material adverse effect on our financial condition and operations. +Competitive industry conditions may negatively affect our ability to conduct operations. We compete with numerous other companies in virtually all facets of our business. Our competitors in development, exploration, acquisitions and production include major integrated oil and gas companies and smaller independents as well as numerous financial buyers, including many that have significantly greater resources. Therefore, competitors may be able to pay more for desirable leases and evaluate, bid for and purchase a greater number of properties or prospects than our financial or personnel resources permit. We also compete for the materials, equipment and services that are necessary for the exploration, development and operation of our properties. Our ability to increase reserves in the future will be dependent on our ability to select and acquire suitable prospects for future exploration and development. Factors that affect our ability to compete in the marketplace include: +• +our access to the capital necessary to drill wells and acquire properties; +• +our ability to acquire and analyze seismic, geological and other information relating to a property; +• +our ability to retain the personnel necessary to properly evaluate seismic and other information relating to a property; +• +our ability to procure materials, equipment and services required to explore, develop and operate our properties, including the ability to procure fracture stimulation services on wells drilled; and +• +our ability to access pipelines, and the location of facilities used to produce and transport oil and natural gas production. +Current or proposed financial legislation and rulemaking could have an adverse effect on our ability to use derivative instruments to reduce the effect of commodity price, interest rate and other risks associated with our business. +Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) establishes federal oversight and regulation of over-the-counter derivatives and requires the Commodity Futures Trading Commission (the “CFTC”) and the SEC to enact further regulations affecting derivative contracts, including the derivative contracts we use to hedge our exposure to price volatility through the over-the-counter market. +In its rulemaking under the new legislation, the CFTC has issued a final rule on position limits for certain futures and option contracts in the major energy markets and for swaps that are their economic equivalents (with exemptions for certain bona fide hedging transactions); the CFTC’s final rule was set aside by the U.S. District Court for the District of Columbia on September 28, 2012 and remanded to the CFTC to resolve ambiguity as to whether statutory requirements for such limits to be determined +30 +Table of Contents +necessary and appropriate were satisfied. The CFTC appealed this ruling but subsequently withdrew its appeal. On November 5, 2013, the CFTC approved a Notice of Proposed Rulemaking designed to implement new position limits regulation. The impact of such regulations upon our business is not yet clear. Certain of our hedging and trading activities and those of our counterparties may be subject to the position limits, which may reduce our ability to enter into hedging transactions. +The Act provides a limited exception to end users (such as us) from the requirement to use cleared exchanges, rather than hedging over-the-counter and authorizes the CFTC to set requirements to post margin in connection with hedging activities. While it is not possible at this time to predict when the CFTC will finalize certain other related rules and regulations, the Act and related regulations may require us to comply with margin requirements and with certain clearing and trade-execution requirements in connection with our derivative activities, although whether these requirements will apply to our business is uncertain at this time. If the regulations ultimately adopted require that we post margin for our hedging activities or require our counterparties to hold margin or maintain capital levels, the cost of which could be passed through to us, or impose other requirements that are more burdensome than current regulations, hedging transactions in the future would become more expensive than we experienced in the past. +We may not have production to offset hedges. Part of our business strategy is to reduce our exposure to the volatility of oil and natural gas prices by hedging a portion of our production. In a typical hedge transaction, we will have the right to receive from the other parties to the hedge the excess of the fixed price specified in the hedge over a floating price based on a market index, multiplied by the quantity hedged. If the floating price exceeds the fixed price, we are required to pay the other parties this difference multiplied by the quantity hedged. Additionally, we are required to pay the difference between the floating price and the fixed price when the floating price exceeds the fixed price regardless of whether we have sufficient production to cover the quantities specified in the hedge. Significant reductions in production at times when the floating price exceeds the fixed price could require us to make payments under the hedge agreements even though such payments are not offset by sales of production. +By hedging, we may not benefit from price increases. Hedging can prevent us from receiving the full advantage of increases in oil or natural gas prices above the fixed amount specified in a hedge transaction in the case of a swap. We also enter into price “collars” to reduce the risk of changes in oil and natural gas prices. Under a collar, no payments are due by either party so long as the market price is above a floor set in the collar and below a ceiling. If the price falls below the floor, the counter-party to the collar pays the difference to us and if the price is above the ceiling, we pay the counter-party the difference. Another type of hedging contract we have entered into is a put contract. Under a put, if the price falls below the set floor price, the counter-party to the contract pays the difference to us. See “Quantitative and Qualitative Disclosures About Market Risks” for a discussion of our hedging practices. +Our hedging transactions expose us to counterparty credit risk. Our hedging transactions expose us to risk of financial loss if a counterparty fails to perform under a derivative contract. Disruptions in the financial markets could lead to sudden decreases in a counterparty’s liquidity, which could make them unable to perform under the terms of the derivative contract and we may not be able to realize the benefit of the derivative contract. +The inability of one or more of our customers to meet their obligations to us may adversely affect our financial results . Our principal exposures to credit risk are through receivables resulting from the sale of our oil and natural gas production, which we market to energy marketing companies, refineries and affiliates, advances to joint interest parties and joint interest receivables. We are also subject to credit risk due to the concentration of our oil and natural gas receivables with several significant customers. The largest purchaser of our oil and natural gas accounted for approximately 38% of our total oil and natural gas revenues for the year ended December 31, 2013. We do not require any of our customers to post collateral. The inability or failure of our significant customers to meet their obligations to us or their insolvency or liquidation may adversely affect our financial results. Joint interest receivables arise from billing entities who own a partial interest in the wells we operate. These entities participate in our wells primarily based on their ownership in leases on which we choose to drill. We have limited ability to control participation in our wells. +Compliance with environmental and other government regulations could be costly and could negatively impact production. Our operations are subject to numerous laws and regulations governing the operation and maintenance of our facilities and the discharge of materials into the environment or otherwise relating to environmental protection. For a discussion of the material regulations applicable to us, see “Regulations.” These laws and regulations may: +• +require that we acquire permits before commencing drilling; +• +impose operational, emissions control and other conditions on our activities; +• +restrict the substances that can be released into the environment in connection with drilling and production activities; +• +limit or prohibit drilling activities on protected areas such as wetlands and wilderness areas; and +31 +Table of Contents +• +require measures to remediate or mitigate pollution and environmental impacts from current and former operations, such as cleaning up spills or dismantling abandoned production facilities. +Under these laws and regulations, we could be liable for costs of investigation, removal and remediation, damages to and loss of use of natural resources, loss of profits or impairment of earning capacity, property damages, costs of and increased public services, as well as administrative, civil and criminal fines and penalties, and injunctive relief. We could also be affected by more stringent laws and regulations adopted in the future, including any related climate change, greenhouse gases and hydraulic fracturing. Under the common law, we could be liable for injuries to people and property. We maintain limited insurance coverage for sudden and accidental environmental damages. We do not believe that insurance coverage for environmental damages that occur over time is available at a reasonable cost. Also, we do not believe that insurance coverage for the full potential liability that could be caused by sudden and accidental environmental damages is available at a reasonable cost. Accordingly, we may be subject to liability or we may be required to cease production from properties in the event of environmental incidents. +Climate change legislation or regulations restricting emissions of “greenhouse gasses” could result in increased operating costs and reduced demand for the oil and natural gas we produce. The EPA has adopted its so-called “GHG tailoring rule” that phases in federal PSD permit requirements for GHG emissions from new sources and modification of existing sources, federal Title V operating permit requirements for all sources, based upon their potential to emit specific quantities of GHGs. These permitting provisions to the extent applicable to our operations could require us to implement emission controls or other measures to reduce GHG emissions and we could incur additional costs to satisfy those requirements. +In addition, , the EPA requires the reporting of GHG emissions from specified large GHG emission sources in the United States beginning in 2011 for emissions occurring in 2010. In November 2010, the EPA published its amendments to the GHG reporting rule to include onshore and offshore oil and natural gas production facilities and onshore oil and natural gas processing, transmission, storage and distribution facilities, which may include facilities we operate. Reporting of GHG emissions from such facilities is required on an annual basis, beginning in 2012 for emissions occurring in 2011, if the total emissions within a basin exceed 25,000 metric tons CO 2 equivalent per year . We will incur costs associated with this monitoring obligation and potentially additional reporting costs if production growth triggers the emission threshold. +In addition, the United States Congress has considered legislation to reduce emissions of GHGs and many states have already taken or have considered legal measures to reduce or measure GHG emissions, often involving the planned development of GHG emission inventories and/or cap and trade programs. Most of these cap and trade programs would require major sources of emissions or major producers of fuels to acquire and surrender emission allowances. The number of allowances available for purchase is reduced each year in an effort to achieve the overall GHG emission reduction goal. These allowances would be expected to escalate significantly in cost over time. The adoption and implementation of any legislation or regulatory programs imposing GHG reporting obligations on, or limiting emissions of GHGs from, our equipment and operations could require us to incur costs to reduce emissions of GHGS associated with our operations or could adversely affect demand for the oil and natural gas that we produce. +Significant physical effects of climatic change have the potential to damage our facilities, disrupt our production activities and cause us to incur significant costs in preparing for or responding to those effects. In an interpretative guidance on climate change disclosures, the SEC indicates that climate change could have an effect on the severity of weather (including storms and floods), the arability of farmland, and water availability and quality. If such effects were to occur, our exploration and production operations have the potential to be adversely affected. Potential adverse effects could include damages to our facilities from powerful winds or rising waters in low-lying areas, disruption of our production activities either because of climate-related damages to our facilities in our costs of operation potentially arising from such climatic effects, less efficient or non-routine operating practices necessitated by climate effects or increased costs for insurance coverages in the aftermath of such effects. Significant physical effects of climate change could also have an indirect affect on our financing and operations by disrupting the transportation or process-related services provided by midstream companies, service companies or suppliers with whom we have a business relationship. We may not be able to recover through insurance some or any of the damages, losses or costs that may result from potential physical effects of climate change. In addition, our hydraulic fracturing operations require large amounts of water. Should drought conditions occur, our ability to obtain water in sufficient quality and quantity could be impacted and in turn, our ability to perform hydraulic fracturing operations could be restricted or made more costly. +Federal legislation and state legislative and regulatory initiatives relating to hydraulic fracturing could result in increased costs and additional operating restrictions or delays. Hydraulic fracturing is used to stimulate production of hydrocarbons, particularly natural gas, from tight formations. The process involves the injection of water, sand and chemicals under pressure into formations to fracture the surrounding rock and stimulate production. The process is typically regulated by state oil and gas commissions but is not subject to regulation at the federal level (except for fracturing activity involving the use of diesel). We engage third parties to provide hydraulic fracturing or other well stimulation services to us in connection with the wells for which we are the operator. Contamination of groundwater by oil and natural gas drilling, production, and related operations may result +32 +Table of Contents +in fines, penalties, and remediation costs, among other sanctions and liabilities under federal and state laws. In addition, third party claims may be filed by landowners and other parties claiming damages for alternative water supplies, property damages, and bodily injury. In March 2010, the EPA announced that it would conduct a wide-ranging study on the effects of hydraulic fracturing on drinking water resources. A progress report was issued in December 2012, with final results expected in 2014. The agency also announced that one of its enforcement initiatives for 2011 to 2013 would be to focus on environmental compliance by the energy extraction sector. This study and enforcement initiative, could result in additional regulatory scrutiny that could make it difficult to perform hydraulic fracturing and increase our costs of compliance and doing business. +A committee of the U.S. House of Representatives conducted an investigation of hydraulic fracturing practices. Legislation was introduced before Congress, but not passed to provide for federal regulation of hydraulic fracturing and to require disclosure of the chemicals used in the fracturing process. In addition, some states and local or regional regulatory authorities have adopted or are considering adopting, regulations that could restrict hydraulic fracturing in certain circumstances. For example, New York has imposed a de facto moratorium on the issuance of permits for high-volume, horizontal hydraulic fracturing until state-administered environmental studies are finalized. Further, Pennsylvania has adopted a variety of regulations limiting how and where fracturing can be performed. While we have no operations in either New York or Pennsylvania, any other new laws or regulations that significantly restrict hydraulic fracturing in areas in which we do operate could make it more difficult or costly for us to perform hydraulic fracturing activities and thereby affect the determination of whether a well is commercially viable. Further, EPA has announced initiatives under the CWA to establish standards of wastewater from hydraulic fracturing and under TSCA to develop regulations governing the disclosure and evaluation of hydraulic fracturing chemicals, and the BLM has indicated that it will continue with rulemaking to regulate hydraulic fracturing on federal lands. In addition, if hydraulic fracturing is regulated at the federal level, our fracturing activities could become subject to additional permit requirements or operational restrictions and also to associated permitting delays and potential increases in costs. Such federal or state legislation could require the disclosure of chemical constituents used in the fracturing process to state or federal regulatory authorities who could then make such information publicly available. In addition, restrictions on hydraulic fracturing could reduce the amount of oil and natural gas that we are ultimately able to produce in commercial quantities. +Certain U.S. federal income tax preferences currently available with respect to oil and natural gas production may be eliminated as a result of future legislation. In recent years, the Obama administration’s budget proposals and other proposed legislation have included the elimination of certain key U.S. federal income tax incentives currently available to oil and gas exploration and production. If enacted into law, these proposals would eliminate certain tax preferences applicable to taxpayers engaged in the exploration or production of natural resources. These changes include, but are not limited to (1) the repeal of the percentage depletion allowance for oil and gas properties, (2) the elimination of current deductions for intangible drilling and development costs, (3) the elimination of the deduction for U.S. production activities and (4) the increase in the amortization period from two years to seven years for geophysical costs paid or incurred in connection with the exploration for or development of, oil and gas within the United States. It is unclear whether any such changes will be enacted or how soon any such changes would become effective. The passage of any legislation as a result of these proposals or any other similar changes in U.S. federal income tax laws could negatively affect the Company’s financial condition and results of operations. +There are inherent limitations in all control systems, and misstatements due to error or fraud that could seriously harm our business may occur and not be detected. Our management, including our Chief Executive Officer and Chief Financial Officer, do not expect that our internal controls and disclosure controls will prevent all possible error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. In addition, the design of a control system must reflect the fact that there are resource constraints and the benefit of controls must be relative to their costs. Because of the inherent limitations in all control systems, an evaluation of controls can only provide reasonable assurance that all material control issues and instances of fraud, if any, in our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Further, controls can be circumvented by the individual acts of some persons or by collusion of two or more persons. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. A failure of our controls and procedures to detect error or fraud could seriously harm our business and results of operations. +We have no plans to pay cash dividends on our common stock in the foreseeable future. We have no plans to pay cash dividends in the foreseeable future. Any future determination as to the declaration and payment of cash dividends will be at the discretion of our board of directors and will depend upon our financial condition, results of operations, contractual restrictions, capital requirements, business prospects and other factors deemed relevant by our board of directors. In addition, the terms of our credit facilities prohibit us from paying dividends and making other distributions. +33 +Table of Contents +Cyber-attacks targeting systems and infrastructure used by the oil and gas industry may adversely impact our operations. Our business has become increasingly dependent on digital technologies to conduct certain exploration, development, production and financial activities. We depend on digital technology to estimate quantities of oil and gas reserves, process and record financial and operating data, analyze seismic and drilling information, and communicate with our employees and third party partners. Unauthorized access to our seismic data, reserves information or other proprietary information could lead to data corruption, communication interruption, or other operational disruptions in our exploration or production operations. Also, computers control nearly all of the oil and gas distribution systems in the United States and abroad, which are necessary to transport our production to market. A cyber-attack directed at oil and gas distribution systems could damage critical distribution and storage assets or the environment, delay or prevent delivery of production to markets and make it difficult or impossible to accurately account for production and settle transactions. +While we have not experienced cyber-attacks, there is no assurance that we will not suffer such attacks and resulting losses in the future. Further, as cyber-attacks continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any vulnerability to cyber-attacks. +ITEM 1B. Unresolved Staff Comments +None. +ITEM 3. Legal Proceedings +We are a defendant in various legal proceedings and claims, which arise in the ordinary course of our business. We do not believe the ultimate resolution of any such actions will have a material effect on our financial position or results of operations. +ITEM 4. Mine Safety Disclosures +Not applicable. +34 +PART II. +ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Market Information +Our common stock trades on the New York Stock Exchange under the symbol “CPE”. The following table sets forth the high and low sale prices per share as reported for the periods indicated. +Stock Price +2013 +2012 +High +Low +High +Low +First quarter +$ +5.82 +$ +3.62 +$ +7.95 +$ +5.09 +Second quarter +4.00 +3.19 +6.45 +3.80 +Third quarter +5.49 +3.40 +6.55 +4.11 +Fourth quarter +7.60 +5.18 +6.36 +4.05 +Holders +As of March 10, 2014 the Company had approximately 3,111 common stockholders of record. +Dividends +We have not paid any cash dividends on our common stock to date and presently do not expect to declare or pay any cash dividends on our common stock in the foreseeable future as we intend to reinvest our cash flows and earnings into our business. The declaration and payment of dividends is subject to the discretion of our Board of Directors and to certain limitations imposed under Delaware corporate law and the agreements governing our debt obligations. The timing, amount and form of dividends, if any, will depend on, among other things, our results of operations, financial condition, cash requirements and other factors deemed relevant by our Board of Directors. +Holders of our Series A preferred stock are entitled to a cumulative dividend whether or not declared, of $5.00 per annum, payable quarterly, equivalent to 10% of the liquidation preference of $50.00 per share. Unless the full amount of the dividends for the Series A Preferred Stock is paid in full, we cannot declare or pay any dividend on our common stock. In addition, certain of our debt facilities contain restrictions on the payment of dividends to the holders of our common stock. +During the fourth quarter of 2013 , neither the Company nor any affiliated purchasers made repurchases of Callon’s equity securities. +Equity Compensation Plan Information +The following table summarizes information regarding the number of shares of our common stock that are available for issuance under all of our existing equity compensation plans as of December 31, 2013 (securities amounts are presented in thousands). +Outstanding Options +Plan Category +Number of securities to be issued upon exercise of outstanding options +Weighted-average exercise price of outstanding options +Number of securities remaining available for future issuance under equity compensation plans +Equity compensation plans approved by security holders +37 +$ +13.51 +1,192 +Equity compensation plans not approved by security holders +15 +14.37 +— +Total +52 +13.75 +1,192 +For additional information regarding the Company’s benefit plans and share-based compensation expense, see Notes 7 and 8 to the Consolidated Financial Statements. +35 +Performance Graph +The following stock price performance graph is intended to allow review of stockholder returns, expressed in terms of the performance of the Company’s common stock relative to four broad-based stock performance indices. The information is included for historical comparative purposes only and should not be considered indicative of future stock performance. +Consistent with the Company’s prior year performance graph, the graph below compares the yearly percentage change in the cumulative total stockholder return on the Company’s common stock with the cumulative total return of the New York Stock Exchange Market Index and New York Stock Exchange Market Index from December 31, 2008 , through December 31, 2013 . The Company plans to replace these indexes with S&P 500 Index and the SIG Oil Exploration & Production Index, which is believes provides a more meaningful comparison and is reflective of the indexes more commonly used by the Company’s peer group. Consequently, these indexes have also been added to the graph below, and we expect will be used in future year’s performance graphs. +The stock performance graph and related information shall not be deemed “soliciting material” or to be “filed” with the SEC, nor shall information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that the Company specifically incorporates it by reference into such filing. +Comparison of Five Year Cumulative Total Return +Assumes Initial Investment of $100 +December 2013 +For the Year Ended December 31, +Company/Market/Peer Group +2008 +2009 +2010 +2011 +2012 +2013 +Callon Petroleum Company +$ +100.00 +$ +57.69 +$ +227.69 +$ +191.15 +$ +180.77 +$ +251.15 +S&P 500 Index - Total Returns +100.00 +126.46 +145.51 +148.59 +172.37 +228.19 +NYSE Composite Index +100.00 +128.95 +146.69 +141.46 +164.45 +207.85 +SIG Oil Exploration & Production Index +100.00 +161.62 +198.98 +180.95 +168.41 +213.16 +Morningstar Group Index +100.00 +185.22 +194.51 +167.95 +189.60 +216.25 +36 +ITEM 6. Selected Financial Data +The following table sets forth, as of the dates and for the periods indicated, selected financial information about us. The financial information for each of the five years in the period ended December 31, 2013 has been derived from our audited Consolidated Financial Statements for such periods. The information should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and Notes thereto. The following information is not necessarily indicative of our future results. +For the year ended December 31, +2013 +2012 +2011 +2010 +2009 +Statement of Operations Data: +(In thousands, except per share amounts) +Operating revenues: +Oil and natural gas sales +$ +102,569 +$ +110,733 +$ +127,644 +$ +89,882 +$ +101,259 +Medusa BOEM royalty recoupment (a) +— +— +— +— +40,886 +Total operating revenues +$ +102,569 +$ +110,733 +$ +127,644 +$ +89,882 +$ +142,145 +Total operating expenses +$ +91,905 +$ +100,043 +$ +88,022 +$ +68,692 +$ +68,692 +Income (loss) from continuing operations +10,664 +10,690 +39,622 +21,179 +73,453 +Net income (loss) (b) +4,304 +2,747 +106,396 +8,386 +46,796 +Earnings (loss) per share ("EPS"): +Basic +$ +(0.01 +) +$ +0.07 +$ +2.81 +$ +0.29 +$ +2.12 +Diluted +$ +(0.01 +) +$ +0.07 +$ +2.76 +$ +0.28 +$ +2.11 +Weighted average number of shares outstanding for Basic EPS +40,133 +39,522 +37,908 +28,817 +22,072 +Weighted average number of shares outstanding for Diluted EPS +40,133 +40,337 +38,582 +29,476 +22,200 +Statement of Cash Flows Data: +Net cash provided by operating activities +$ +54,329 +$ +51,290 +$ +79,167 +$ +100,102 +$ +19,698 +Net cash used in investing activities +(79,804 +) +(93,703 +) +(91,511 +) +(59,738 +) +(43,189 +) +Net cash provided by (used in) financing activities +27,348 +(243 +) +38,703 +(26,252 +) +10,000 +Balance Sheet Data: +Oil and gas properties, net +$ +324,187 +$ +269,521 +$ +215,912 +$ +168,868 +$ +130,608 +Total assets +423,953 +378,173 +369,707 +218,326 +227,991 +Long-term debt (c) +75,748 +120,668 +125,345 +165,504 +179,174 +Stockholders' equity (deficit) +279,094 +205,971 +201,202 +15,810 +(80,854 +) +Proved Reserves Data: +Total oil (MMBbls) +11,898 +10,780 +10,075 +8,149 +6,479 +Total natural gas (MMcf) +17,751 +19,753 +35,118 +32,957 +19,103 +Total proved reserves (MBOE) +14,857 +14,072 +15,928 +13,641 +9,663 +Standardized measure (d) +$ +283,946 +$ +231,148 +$ +270,357 +$ +198,916 +$ +135,921 +(a) +Following the decisions resulting from several court cases brought by another oil and gas company, the court ruled that the BOEM was not entitled to receive these royalty payments. The amount above reflects royalty recoupments for production from the fields 2003 inception through December 31, 2008, which were accrued at December 31, 2009 and paid by the BOEM during 2010. +(b) +Net income for 2011 includes $69.3 million of income tax benefit related to the reversal of the Company’s deferred tax asset valuation allowance. See Note 10 for additional information. +(c) +2013 and 2012 long-term debt includes a non-cash deferred credit of $5,267 and $13,707 , respectively that will be amortized into earnings as a reduction to interest expense over the life of the 13% Senior Notes due 2016. See Note 4 for additional information. +(d) +Standardized measure is the future net cash flows related to estimated proved oil and natural gas reserves together with changes therein, including a reduction for estimated plugging and abandonment costs that are also reflected as a liability on the balance sheet. Prices are based on either the preceding 12-months’ average price, based on closing prices on the first day of each month, or prices defined by existing contractual arrangements. Future production and development costs are based on current estimates with no escalations. Estimated future cash flows have been discounted to their present values based on a 10% discount rate. +37 +ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +General +The following management’s discussion and analysis is intended to assist in understanding the principal factors affecting the Company’s results of operations, liquidity, capital resources and contractual cash obligations. This discussion should be read in conjunction with the accompanying audited consolidated financial statements, information about our business practices, significant accounting policies, risk factors, and the transactions that underlie our financial results, which are included in various parts of this filing. +We have been engaged in the exploration, development, acquisition and production of oil and natural gas properties since 1950. +Significant accomplishments for 2013 include: +• +Increased 2013 Permian Basin annual production by 38% to 813 MBOE as compared to 2012 ; +• +Exceeded our “exit rate” target production rate for 2013, producing 3,611 BOE/d from our Permian operations in the month of December; +• +Increased 2013 Permian Basin proved reserves by 58% to 14.9 MMBOE as compared to 2012 ; +• +Replaced 708% of Permian production with net Permian proved reserve additions, net of revisions; +• +Drilled a total of 17 horizontal wells in the Southern Midland Basin, producing from two established zones in the Wolfcamp B and the Wolfcamp A; +• +Acquired our Garrison Draw field inclusive of 2,186 net acres and associated production in Reagan County for $11 million, which further added to our inventory of horizontal well locations. Subsequently, we expanded this acreage position to accommodate the drilling of long laterals; +• +Accelerated offshore cash flows for onshore redeployment with the sale of our interest in the Medusa and our remaining shelf fields for $100 million before customary purchase price adjustments, and +• +Raised $70.0 million from the issuance of Series A Cumulative Preferred Stock, +• +Retired 50% of our Senior Notes, improving our cost of capital, and +• +Received the Midland Bruno Hanson/Midland College Award for Environmental Excellence recognizing our commitment to strong environmental stewardship in the Permian Basin. +Permian Production Growth and Well Counts +Following the sale of our remaining offshore and Haynesville properties in the fourth quarter of 2013, all of our producing properties are located in the Permian Basin. Our production in the Permian grew 38% in 2013 compared to 2012, increasing to 813 MBOE from 591 MBOE, respectively. Production in 2013 continued to benefit from high oil concentrations including 64% oil and 36% natural gas, which we anticipate to further increase following the sale of our offshore assets. +38 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Net Production (MBOE) +Twelve Months Ended December 31, +2013 +2012 +Change +% Change +Onshore: +Southern Midland Basin +612 +402 +210 +52 +% +Central Midland Basin +193 +189 +4 +2 +% +Northern Midland Basin +8 +— +8 +100 +% +Total Permian +813 +591 +222 +38 +% +Offshore: +Medusa +302 +464 +(162 +) +(35 +)% +Habanero +— +134 +(134 +) +(100 +)% +Total offshore +302 +598 +(296 +) +(49 +)% +Other: +Haynesville shale +18 +46 +(28 +) +(61 +)% +Gulf of Mexico shelf and other +280 +340 +(60 +) +(18 +)% +Total other +298 +386 +(88 +) +(23 +)% +Total +1,413 +1,575 +(162 +) +(10 +)% +On average, we operated 1.4 horizontal rigs and one vertical rig in 2013, and drilled a total of 26 gross ( 22.2 net) wells, of which 1 gross ( 0.4 net) well was recompleted during the year and 5 gross ( 4.7 net) were awaiting completion at December 31, 2013. +Drilled +Completed (a) +Awaiting Completion +Gross +Net +Gross +Net +Gross +Net +Southern Midland Basin +Vertical wells +1 +1.0 +1 +1.0 +— +— +Horizontal wells +17 +15.5 +15 +13.5 +3 +3.0 +Total +18 +16.5 +16 +14.5 +3 +3.0 +Central Midland Basin +Vertical wells +5 +3.0 +7 +4.4 +— +— +Horizontal wells +2 +1.7 +— +— +2 +1.7 +Total +7 +4.7 +7 +4.4 +2 +1.7 +Northern Midland Basin +Vertical wells +1 +1.0 +2 +1.8 +— +— +Horizontal wells +— +— +1 +0.8 +— +— +Total +1 +1.0 +3 +2.5 +— +— +Total +26 +22.2 +26 +21.4 +5 +4.7 +Total vertical wells +7 +5.0 +10 +7.1 +— +— +Total horizontal wells +19 +17.2 +16 +14.3 +5 +4.7 +Total +26 +22.2 +26 +21.4 +5 +4.7 +(a) Completions include wells drilled prior to 2013. +Permian Reserve Growth +As of December 31, 2013, our estimated Permian proved reserves increased 58% to 14.9 MMBOE compared to 9.4 MMBOE of Permian proved reserves at year-end 2012. In total, proved reserves increased 6% , or 0.8 MMBOE, to 14.9 MMBOE from 14.1 MMBOE for as of the same date in 2012 as our significant growth in Permian proved reserves was largely offset by the sale of our offshore and Haynesville properties and by the reclassification of previously recorded Permian vertical development proved undeveloped reserves as we focus on horizontal development. Our Permian Basin proved reserves at year-end 2013 were 80% oil and 20% natural gas, compared to 76% oil and 24% natural gas at year-end 2012. +39 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +2013 Preferred Equity Offering +On May 30, 2013, the Company issued $75.0 million of 10.0% Series A Cumulative Preferred Stock (the “Preferred Stock”) and received $70.0 million net proceeds after deducting the underwriting commissions and offering expenses. We used the proceeds of this equity offering to repay outstanding borrowings under our revolving Credit Facility, to fund accelerated capital expenditures to further develop and evaluate our Permian asset base, and for general corporate purposes. +Liquidity and Capital Resources +Historically, our primary sources of capital have been cash flows from operations, borrowings from financial institutions and the sale of debt and equity securities. Our primary uses of capital have been for the acquisition, development and exploration of oil and natural gas properties. Cash and cash equivalents increased $1.9 million during 2013 to $3.0 million compared to $1.1 million at December 31, 2012 . We recently entered into the Amended Credit Facility and Second Lien Facility to support the funding of our ongoing operations . For additional information, see Note 4 to the Consolidated Financial Statements. We believe that, as discussed below, our operating cash flows combined with our bank borrowing ability provides the liquidity necessary to meet our operational cash flow needs. +Liquidity and cash flow: +For the Year Ended December 31, +2013 +2012 +2011 +Net cash provided by operating activities +54.3 +51.3 +79.2 +Net cash used in investing activities +(79.8 +) +(93.7 +) +(91.5 +) +Net cash provided by (used in) financing activities +27.3 +(0.3 +) +38.7 +Net change in cash +1.8 +(42.7 +) +26.4 +Operating Activities. For the year ended December 31, 2013 , net cash provided by operating activities was $54.3 million , compared to $51.3 million for the same period in 2012 . The increase was related primarily to a 15% decrease in lease operating expenses coupled with a 3% increase in the average sales price on an equivalent basis partially offset by lower revenues as oil and natural gas production decreased 7% and 16% , respectively. Production and realized prices are discussed below in Results of Operations. +Investing Activities. For the year ended December 31, 2013 , net cash used in investing activities was $79.8 million as compared to $93.7 million for the same period in 2012 . The net $13.9 million decrease in cash used in investing activities is primarily attributable to a $50.1 million increase in proceeds from the sale of mineral interests and equipment offset by a 26.4 million increase in capital expenditures related to development activity on our Permian basin acreage and $10.9 million for producing property acquisitions. The $50.1 million increase in the previously mentioned proceeds relates to the proceeds in 2013 of $90.0 million , primarily attributable to the sale of our Medusa and offshore properties compared to proceeds in 2012 of $39.9 million , primarily related to the sale of our Habanero offshore property, which are both discussed below and in Note 12 to the financial statements. The $26.4 million increase in capital expenditures included the costs associated with expanding to a two-rig drilling program and the acquisition of the Garrison Draw property. +2014 Budgeted Capital Expenditures +In early February 2014, we announced our operational capital budget for 2014: +Gross Wells +Category +($ millions) +Drill +Complete +Horizontal wells +$ +155 +27 +26 +Vertical wells +15 +9 +8 +Facilities and equipment +15 +Total operational capital +$ +185 +40 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +We expanded our horizontal pad development efforts from two to four fields in late 2013, adding Carpe Diem in Midland County and Garrison Draw in Reagan County. We expect our 2014 horizontal drilling program will be primarily focused on program development of established Upper and Lower Wolfcamp zones in the Southern and Central Midland Basin, but will also include two wells in the Southern Midland Basin to evaluate the Wolfcamp A shale and a test of the Lower Spraberry shale formation in the Central Midland Basin. In addition, we anticipate the average lateral length of our horizontal wells in 2014 to be approximately 7,000’ per well. +Planned vertical drilling activity is anticipated to be limited to five deep Wolfberry wells in the Pecan Acres field, one well in the Garrison Draw field. We have included three vertical exploration wells in the Northern Midland Basin, the timing and location of which being subject to change as results are evaluated during the course of 2014. +In addition to the operational capital expenditures above, we budgeted approximately $25 million for capitalized expenses and certain retained plugging abandonment expenses related to divested Gulf of Mexico shelf assets. +Our 2014 capital program is 100% operated and, as a result, the amount and timing of these capital expenditures are largely discretionary depending on commodity prices and other factors. We expect to fund our 2014 capital program through a combination of cash flow from operations, bank borrowings and term debt issuance, including our recently executed Second Lien Facility. +Financing Activities. For the year ended December 31, 2013 , net cash provided by financing activities was $27.3 million compared to cash used by financing activities of $0.3 million during the same period of 2012 . Net cash provided by financing activities for 2013 included proceeds of $70.4 million, net from our Preferred Stock offering (see Note 9 for additional information) and a $12 million draw, net on our Credit Facility offset by the $50 million redemption of our Senior Notes, and approximately $4.6 million in preferred stock dividends. +Senior Secured Credit Facility (“Credit Facility”) +The Company’s $200 million Credit Facility, for which Regions Bank serves as the Administrative Agent, matures March 15, 2016 and includes Citibank, NA, IberiaBank, Whitney Bank and OneWest Bank, FSB as participating lenders. As of December 31, 2013, the Company’s Credit Facility had an approved borrowing base at December 31, 2013 of $83 million . The Credit Facility was secured by mortgages covering the Company’s major producing fields. As of December 31, 2013, the balance outstanding on the Credit Facility was $22 million with an interest rate of 2.92% , calculated as the London Interbank Offered Rate (LIBOR), plus a tiered rate ranging from 2.5% to 3.0% , which is determined by utilization of the facility. In addition, the Credit Facility carries a commitment fee of 0.5% per annum on the unused portion of the borrowing base, which is payable quarterly. +Subsequent to December 31, 2013, the Company amended its existing Credit Facility as discussed below. Additionally, the Company executed the Second Lien Facility also discussed below. +Amended Credit Facility (the “Amended Credit Facility”) and Second Lien Term Loan Facility (the “Second Lien Facility”) +On March 11, 2014, we entered into an amended senior secured revolving credit facility (the “Amended Credit Facility”) in the amount of $500 million with JPMorgan Chase Bank, N.A. as Administrative Agent (“J.P. Morgan”). The Credit Facility will have an initial borrowing base amount of $95 million and a maturity date of March 11, 2019. In conjunction with the Amended Credit Facility, we entered into a senior secured second lien term loan facility (the “Second Lien Facility”) in an aggregate amount of up to $125 million with J.P. Morgan as Administrative Agent and with a maturity date of September 11, 2019. See Note 4 for additional information. +13% Senior Notes due 2016 (the “Senior Notes”) and Deferred Credit +As of December 31, 2013 , following a $48.5 million principal redemption in December 2013, we had approximately $48.5 million principal amount of the 13% Senior Notes due 2016 outstanding with interest payable quarterly. +41 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Contractual Obligations +The following table includes the Company’s current contractual obligations and purchase commitments, at which time the Company had no product delivery commitments: +(amounts in thousands) +Payments due by Period +Total +< 1 Year +Years 2 - 3 +Years 4 - 5 +>5 Years +13% Senior Notes +$ +48,481 +$ +— +$ +48,481 +$ +— +$ +— +Drilling rig leases and related (a) +42,482 +19,732 +22,750 +— +— +Office space lease and other commitments +3,208 +618 +1,096 +717 +777 +Total +$ +94,171 +$ +20,350 +$ +72,327 +$ +717 +$ +1,124 +(a) +The <1 Year column includes $2,055 related to the early termination provisions of one of the Company’s horizontal drilling rigs (See Note 13), which the Company replaced with a different horizontal rig, and the amount assumes the lessor is unable to re-charter the rig and staffing personnel to another lessee. Should the lessor re-charter the rig and its related personnel to a new lessee, the $2,055 would be reduced by the value of the new lessee’s rentals. Also includes an anticipated contract renewal of our Cactus 1 Rig lease. +Income Taxes +The Company’s income tax expense varies from the statutory rate primarily due to the effect of state taxes, non deductible compensation under Section 162(m) and restricted stock offset by percentage depletion. Prior to 2012, we carried a full valuation allowance against our net deferred tax asset. The income tax benefit of $69.3 million in 2011 resulted primarily from the reversal of the valuation allowance established in 2008 against our net deferred tax assets. For additional information, see the Income Tax discussion included below in Results of Operations and Note 10 to the Consolidated Financial Statements. +42 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Results of Operations +The following table sets forth certain unaudited operating information with respect to the Company’s oil and natural gas operations for the periods indicated: +For the Year Ended December 31, +2013 +2012 +Change +% Change +2011 +Change +% Change +Net production: +Oil (MBbls) +911 +977 +(66 +) +(7 +)% +996 +(19 +) +(2 +)% +Natural gas (MMcf) +3,011 +3,588 +(577 +) +(16 +)% +5,081 +(1,493 +) +(29 +)% +Total production (MBOE) +1,413 +1,575 +(162 +) +(10 +)% +1,843 +(268 +) +(15 +)% +Average daily production (BOE) +3,871 +4,303 +(432 +) +(10 +)% +5,049 +(746 +) +(15 +)% +Average realized sales price (see below): +Oil (Bbl) +$ +97.65 +$ +98.86 +$ +(1.21 +) +(1 +)% +$ +101.34 +$ +(2.48 +) +(2 +)% +Natural gas (Mcf) +4.52 +3.94 +0.58 +15 +% +5.25 +(1.31 +) +(25 +)% +Total (BOE) +72.59 +70.31 +2.28 +3 +% +69.26 +1.05 +2 +% +Oil and natural gas revenues (in thousands): +Oil revenue +$ +88,960 +$ +96,584 +$ +(7,624 +) +(8 +)% +$ +100,962 +$ +(4,378 +) +(4 +)% +Natural gas revenue +13,609 +14,149 +(540 +) +(4 +)% +26,682 +(12,533 +) +(47 +)% +Total +$ +102,569 +$ +110,733 +$ +(8,164 +) +(7 +)% +$ +127,644 +$ +(16,911 +) +(13 +)% +Additional per BOE data: +Sales price +$ +72.59 +$ +70.31 +$ +2.28 +3 +% +$ +69.26 +$ +1.05 +2 +% +Lease operating expense +(14.00 +) +(14.81 +) +0.81 +5 +% +(9.92 +) +(4.89 +) +49 +% +Production taxes +(2.92 +) +(2.05 +) +(0.87 +) +(42 +)% +(1.12 +) +(0.93 +) +83 +% +Operating margin +$ +55.67 +$ +53.45 +$ +2.22 +4 +% +$ +58.22 +$ +(4.77 +) +(8 +)% +Below is a reconciliation of the average NYMEX price to the average realized sales price per Bbl of oil and Mcf of natural gas: +Average NYMEX oil price ($/Bbl) +$ +97.96 +$ +94.19 +$ +3.77 +4 +% +$ +95.14 +$ +(0.95 +) +(1 +)% +Basis differential and quality adjustments (a) +0.12 +3.97 +(3.85 +) +(97 +)% +7.58 +(3.61 +) +(48 +)% +Transportation +(0.43 +) +(0.75 +) +0.32 +43 +% +(1.00 +) +0.25 +(25 +)% +Hedging (b) +— +1.45 +(1.45 +) +100 +% +(0.38 +) +1.83 +100 +% +Average realized oil price ($/Bbl) +$ +97.65 +$ +98.86 +$ +(1.21 +) +(1 +)% +$ +101.34 +$ +(2.48 +) +(2 +)% +Average NYMEX natural gas price ($/MMBtu) +$ +3.73 +$ +2.82 +$ +0.91 +32 +% +$ +4.03 +$ +(1.21 +) +(30 +)% +Basis differential and quality adjustments (c) +0.79 +1.12 +(0.33 +) +(29 +)% +1.22 +(0.10 +) +(8 +)% +Average realized natural gas price ($/Mcf) +$ +4.52 +$ +3.94 +$ +0.58 +15 +% +$ +5.25 +$ +(1.31 +) +(25 +)% +(a) +Oil prices for production from our two divested deepwater fields reflect a premium over NYMEX pricing based on Mars WTI differential for Medusa production, prior to the sale of Medusa in December 2013, and Argus Bonita WTI differential for Habanero production, prior to the sale of Habanero during December 2012. +(b) +As discussed in Note 5 , the Company discontinued hedge accounting beginning with derivative contracts executed on January 1, 2012. Consequently, the gain or loss on derivative contracts, settled is now included in the statement of operations within Loss (Gain) on derivative contracts. The amounts reported above reflect the realized portion of derivative contracts designated as cash flow hedges. +(c) +Natural gas prices exceeded the related NYMEX prices, which are quoted on an MMBtu basis, primarily due to the value of the NGLs in our liquids-rich natural gas stream, primarily from our Permian basin production. +43 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Revenues +The following tables are intended to reconcile the change in oil, natural gas and total revenue for the respective periods presented by reflecting the effect of changes in volume, changes in the underlying commodity prices and the impact of our hedge program. (in thousands) +Oil +Natural Gas +Total +Revenues for the year ended December 31, 2010 +$ +65,243 +$ +24,639 +$ +89,882 +Volume increase +10,406 +952 +11,358 +Price increase +25,688 +1,091 +26,779 +Impact of hedges decrease +(375 +) +— +(375 +) +Net increase in 2011 +35,719 +2,043 +37,762 +Revenues for the year ended December 31, 2011 +$ +100,962 +$ +26,682 +$ +127,644 +Volume decrease +(1,926 +) +(7,840 +) +(9,766 +) +Price decrease +(3,872 +) +(4,693 +) +(8,565 +) +Impact of hedges increase +1,420 +— +1,420 +Net decrease in 2012 +(4,378 +) +(12,533 +) +(16,911 +) +Revenues for the year ended December 31, 2012 +$ +96,584 +$ +14,149 +$ +110,733 +Volume decrease +(10,065 +) +(540 +) +(10,605 +) +Price increase +2,441 +— +2,441 +Net decrease in 2013 +(7,624 +) +(540 +) +(8,164 +) +Revenues for the year ended December 31, 2013 +$ +88,960 +$ +13,609 +$ +102,569 +Oil Revenue +For the year ended December 31, 2013 , oil revenues of $89.0 million decreased $7.6 million , or 8% , compared to revenues of $96.6 million for the year ended December 31, 2012 . Lower production from our offshore properties, primarily related to the sale of Habanero field in December 2012 and our Medusa and shelf properties in the fourth quarter of 2013, drove the revenue decline. Also contributing to the production decline were 20 days of down time for scheduled downstream pipeline maintenance at our Medusa field in the second quarter of 2013, approximately five days of production downtime at our key producing Permian Basin fields in the fourth quarter of 2013 due to severe winter weather causing electricity outages and the extended curtailment of trucking capacity to transport offtake and due to normal and expected declines from other producing wells. Collectively, these declines were offset by the 222 MBbls increase in our oil production from our Permian properties. +For the year ended December 31, 2012, oil revenues of $96.6 million decreased $4.4 million, or 4%, compared to revenues of $101.0 million for the year ended December 31, 2011. A decrease in commodity prices and production resulted in decreased oil revenue. The average price realized decreased 2% to $98.86 per barrel compared to $101.34 for the same period of 2011. Similarly, production decreased by 2% to 977 MBbls compared to 996 MBbls during the same period in 2011. Oil prices for production from our two deepwater fields are adjusted and reflect a premium over NYMEX pricing based on Mars WTI differential for Medusa production and Bonita WTI differential for Habanero production. Production decreases relate primarily to the down-time at the Habanero and Medusa fields and the normal and expected declines from our other offshore properties. These production declines were offset by production from our new Permian wells, 22 vertical and two horizontal, brought onto production during 2012. +44 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Natural Gas Revenue +For the year ended December 31, 2013 , natural gas revenues of $13.6 million represented a decrease of 4% , or $0.5 million , compared to natural gas revenues of $14.1 million for the year ended December 31, 2012 . While the average realized price increased 15% , a 16% decrease in production reduced total revenue. The production declines were primarily attributable to the shut-in of production of our Mobile Bay 908 property, the sale of our offshore fields, the sale of our Haynesville well in the fourth quarter of 2013 as well as normal and expected declines from our existing wells. Offsetting these declines was a 248 MMcf increase in horizontal well production from our Permian properties. +For the year ended December 31, 2012, natural gas revenues of $14.1 million represented a decrease of 47%, or $12.5 million, when compared to natural gas revenues of $26.7 million for the year ended December 31, 2011. Natural gas production decreased 29%, driven primarily by down time at our Haynesville well, which was shut-in for 70 days during the first quarter of 2012 due to well interference from an offsetting well, and due to down time at our East Cameron 257 well, which was suspended in the fourth quarter of 2011 due to a natural gas leak in an upstream section of the Stingray Pipeline that transports production volumes from the field. Also contributing to the decline was down-time at our Habanero and Medusa fields and normal and expected declines in natural gas production from our offshore and Haynesville wells. In addition to production decreases, the average realized price decreased 25% to $3.94 per Mcf compared to an average realized price of $5.25 per Mcf in 2011. Our natural gas prices on an MMBtu equivalent basis exceeded the related NYMEX prices primarily due to the value of the NGLs in our natural gas stream, primarily from our Permian basin and deepwater production. +Operating Expenses +Principal components of our cost structure +Lease operating expenses. These are daily costs incurred to bring oil and natural gas out of the ground and to the market, together with the daily costs incurred to maintain our producing properties. Such costs also include maintenance, repairs and workover expenses related to our oil and natural gas properties. +Production taxes. Production taxes include severance and ad valorem taxes. Severance taxes are paid on produced oil and natural gas based on a percentage of revenues from products sold at fixed rates established by federal, state or local taxing authorities. Where available, we benefit from tax credits and exemptions in our various taxing jurisdictions. We are also subject to ad valorem taxes in the counties where our production is located. Ad valorem taxes are generally based on the valuation of our oil and gas properties. +Depreciation, depletion and amortization. Under the full cost accounting method, we capitalize costs within a cost center and then systematically expense those costs on a units of production basis based on proved oil and natural gas reserve quantities. We calculate depletion on the following types of costs: (i) all capitalized costs, other than the cost of investments in unproved properties and major development projects for which proved reserves cannot yet be assigned, less accumulated amortization; (ii) the estimated future expenditures to be incurred in developing proved reserves; and (iii) the estimated dismantlement and abandonment costs, net of estimated salvage values. Depreciation of other property and equipment is computed using the straight line method over their estimated useful lives, which range from three to fifteen years. +General and administrative . These are costs incurred for overhead, including payroll and benefits for our corporate staff, costs of maintaining our headquarters, costs of managing our production and development operations, franchise taxes, audit and other fees for professional services and legal compliance. +Accretion expense. The Company is required to record its estimate of the fair value of liabilities for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. Interest is accreted on the present value of the asset retirement obligations and reported as accretion expense within operating expenses in the consolidated statements of operations. +45 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +For the Year Ended December 31, +Total Change +BOE Change +2013 +Per BOE +2012 +Per BOE +$ +% +$ +% +Lease operating expenses +$ +19,779 +$ +14.00 +$ +23,330 +$ +14.81 +$ +(3,551 +) +(15 +)% +$ +(0.81 +) +(5 +)% +Production taxes +4,133 +2.92 +3,224 +2.05 +909 +28 +% +0.87 +42 +% +Depreciation, depletion and amortization +43,967 +31.12 +49,701 +31.56 +(5,734 +) +(12 +)% +(0.44 +) +(1 +)% +General and administrative +20,534 +14.53 +20,358 +12.93 +176 +1 +% +1.6 +12 +% +Accretion expense +1,785 +1.26 +2,253 +1.43 +(468 +) +(21 +)% +(0.17 +) +(12 +)% +Impairment of other property and equipment +1,707 +1.21 +1,177 +0.75 +530 +45 +% +0.46 +100 +% +Total operating expenses +$ +91,905 +$ +100,043 +For the Year Ended December 31, +Total Change +BOE Change +2012 +Per BOE +2011 +Per BOE +$ +% +$ +% +Lease operating expenses +$ +23,330 +$ +14.81 +$ +18,285 +$ +9.92 +$ +5,045 +28 +% +$ +4.89 +49 +% +Production taxes +3,224 +2.05 +2,062 +1.12 +1,162 +56 +% +0.93 +83 +% +Depreciation, depletion and amortization +49,701 +31.56 +48,701 +26.42 +1,000 +2 +% +5.14 +19 +% +General and administrative +20,358 +12.93 +16,636 +9.03 +3,722 +22 +% +3.90 +43 +% +Accretion expense +2,253 +1.43 +2,338 +1.27 +(85 +) +(4 +)% +0.16 +13 +% +Impairment of other property and equipment +1,177 +0.75 +— +— +1,177 +100 +% +0.75 +100 +% +Total operating expenses +$ +100,043 +$ +88,022 +Lease Operating Expenses (LOE) +For the year ended December 31, 2013 , LOE of $19.8 million decreased 15% , or $3.6 million , compared to $23.3 million for the year ended December 31, 2012 . The decrease was primarily due to $3.4 million of remediation costs on our Haynesville well in 2012, for which we had no similar costs in 2013, and an estimated decrease of $3.2 million of LOE resulting from the previously discussed sale of our interests in Habanero, Medusa, the Medusa Spar LLC, our Haynesville property and substantially all our remaining shelf properties. These decreases were partially offset by $3.0 million in LOE costs related to the growth in Permian production and operations, including an increase in workover expenses associated with accelerated horizontal well activity. +For the year ended December 31, 2012, LOE of $23.3 million increased 28%, or $5.0 million, compared to $18.3 million for the year ended December 31, 2011. The increase was primarily due to $3.0 million in costs related to growth in the number of wells producing from Permian Basin properties and $3.3 million in remediation work at our Haynesville well in 2012 for which we had no similar costs in 2011. These increases were partially offset by a $1.3 million decline in LOE for our deepwater properties due to lower throughput charges as a result of reduced production volumes. +Production Taxes +For the year ended December 31, 2013 , production taxes of $4.1 million increased 28% , or $0.9 million , compared to $3.2 million for the year ended December 31, 2012 . The increase was predominantly attributable to an increase of onshore production subject to these taxes and a decline in offshore production, resulting from the sale of our Gulf of Mexico position in 2013, which is exempt from production taxes. +For the year ended December 31, 2012 , production taxes of $3.2 million increased 56% , or $1.2 million , compared to $2.1 million for the year ended December 31, 2011. The increase was predominantly attributable to an increased proportion of onshore production subject to these taxes relative to offshore production, which was predominantly exempt from production taxes. +46 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Depreciation, Depletion and Amortization (DD&A) +For the year ended December 31, 2013 , DD&A of $31.12 per BOE was relatively flat compared to $31.56 per BOE for the year ended December 31, 2012 . +DD&A for the year ended December 31, 2012 increased 19% per BOE to $31.56 per BOE compared to $26.42 per BOE for the year ended December 31, 2011. Increases in the DD&A rate are attributable to our planned exploration and development expenditures related to our onshore reserve development including the ongoing onshore development cost increases in the Permian Basin area. +General and Administrative, net of amounts capitalized (G&A) +G&A remained relatively flat at $20.5 million (including $6.4 million non-cash) for the year ended December 31, 2013 compared to $20.4 million (including $4.7 million non-cash) for the same period of 2012 . The $0.1 million increase was due to an increase in non-cash charges of $1.7 million related to incentive compensation share-based instruments offset by a $1.6 million decrease primarily related to non-recurring employee-related expenses including early retirement and severance expense incurred in 2012. The non-cash portions primarily relate to our liability-based incentive compensation share based instruments (see Notes 7 and 8 ) and to depreciation and amortization expense (see Note 2 ). +For the year ended December 31, 2012, G&A, increased $3.7 million, or 22%, to $20.4 million (including $4.7 million non-cash) from $16.6 million (including $3.2 million non-cash) for the same period of 2011. The increase is due mainly to $1.6 million in costs for non-recurring employee-related expenses including early retirement and severance expense for which we had no expense during 2011. Additionally, we incurred an increase in non-cash charges of $1.2 million related to incentive compensation share-based instruments awarded during 2012. The remaining increase related primarily to higher compensation-related expenses including the costs associated with employing staff to support our onshore growth and 100% operated Permian production, as well as relocation and related costs. +Accretion Expense (ARO) +Accretion expense related to our asset retirement obligation decreased 21% for the year ended December 31, 2013 compared to the same periods of 2012 . Accretion expense correlates directionally with the Company’s ARO which was $6.7 million at December 31, 2013 versus $13.3 million at December 31, 2012 . See Note 11 for additional information regarding the Company’s ARO. +For the year ended December 31, 2012, accretion expense decreased 4% for the year ended December 31, 2012 compared to the same periods of 2011. At December 31, 2012, our ARO of $13.3 million was lower than the $13.9 million ARO at December 31, 2011. +Impairment of Other Property and Equipment +During 2012 and 2013, the Company recorded a write-down of the value of certain assets acquired in 2011 as part of a settlement reached with a former joint interest partner on a deepwater project. For information concerning the impairment of these assets, please see Note 13 to the Consolidated Financial Statements. +Other (Income) Expense +Interest expense. We finance a portion of our working capital requirements, capital expenditures and acquisitions with borrowings under our credit facility or with term debt. We incur interest expense that is affected by both fluctuations in interest rates and our financing decisions. We reflect interest paid to our lender in interest expense. In addition, we include the amortization of deferred financing costs (including origination and amendment fees), commitment fees and annual agency fees in interest expense. The amortization of the deferred credit related to our 13% Senior Notes is recorded as an offset to interest expense. +Gain/Loss on derivative instruments . We utilize commodity derivative financial instruments to reduce our exposure to fluctuations in the price of oil. This amount represents the (i) gain (loss) related to derivatives, net of settlement that relate to our open derivative contracts as commodity prices change and commodity derivative contracts expire or new ones are entered into and (ii) gains (losses) on derivatives, settled that is equal to the summation of gains and losses on positions that have settled within the period. We provide a reconciliation of the these components of the gain/loss on derivative contracts in Note 5 . +Income tax expense. We use the asset and liability method of accounting for income taxes, under which deferred tax assets and liabilities are recognized for the future tax consequences of (1) temporary differences between the financial statement carrying amounts and +47 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +the tax bases of existing assets and liabilities and (2) operating loss and tax credit carryforwards. Deferred income tax assets and liabilities are based on enacted tax rates applicable to the future period when those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period the rate change is enacted. When appropriate based on our analysis, we record a valuation allowance for deferred tax assets when it is more likely than not that the deferred tax assets will not be realized. +For the Year Ended December 31, +2013 +2012 +$ Change +% Change +2011 +$ Change +% Change +Interest expense +$ +6,094 +$ +9,108 +$ +(3,014 +) +(33 +)% +$ +11,717 +$ +(2,609 +) +(22 +)% +Gain on early extinguishment of debt +(3,696 +) +(1,366 +) +(2,330 +) +171 +% +(1,942 +) +576 +(30 +)% +Gain on acquired equipment +— +— +— +— +% +(5,041 +) +5,041 +(100 +)% +Loss (gain) on derivative contracts +1,360 +(1,717 +) +3,077 +(179 +)% +— +(1,717 +) +100 +% +Other income +(485 +) +(79 +) +(406 +) +514 +% +(1,426 +) +1,347 +(94 +)% +Total other expenses, net +$ +3,273 +$ +5,946 +$ +3,308 +Income tax expense (benefit) +$ +3,104 +$ +2,223 +$ +881 +(40 +)% +$ +(69,283 +) +$ +71,506 +103 +% +Equity in earnings of Medusa Spar LLC +17 +226 +(209 +) +(92 +)% +799 +(573 +) +(72 +)% +Preferred stock dividends +(4,627 +) +— +(4,627 +) +100 +% +— +— +— +% +Interest Expense +Interest expense on Callon’s debt obligations decreased 3.0 million to $6.1 million for the year ended December 31, 2013 compared to $9.1 million for the same period of 2012 . The decrease was related primarily to an additional $2.3 million of interest capitalized in 2013 versus 2012, to approximately $0.3 million of reduced interest payments attributable to the redemption of $48.5 million principal of the Company’s Senior Notes in December 2013 and to $0.1 million of additional deferred credit amortization recognized in 2013 compared with 2012. The additional capitalized interest was related to a higher balance year-over-year in average unevaluated oil and natural gas properties following the purchase of additional unevaluated acreage with exploration costs in the Permian Basin. +Interest expense on Callon’s debt obligations decreased 22% to $9.1 million for the year ended December 31, 2012 compared to $11.7 million for the same period of 2011. The decrease was related primarily to the redemption of $10 million principal of Senior Notes during June 2012 in addition to a $1.5 million increase in capitalized interest compared to 2011, partially offset by interest expense related to increased borrowings under our Credit Facility and decreases in the deferred credit amortization. The increase in capitalized interest was related to a higher balance year-over-year in average unevaluated oil and natural gas properties, mentioned above. +(Gain) Loss on Early Extinguishment of Debt +During December 2013, the Company redeemed $53.8 million carrying value of its Senior Notes using a portion of the proceeds from the Company’s May 2013 preferred equity offering. The $53.8 million of carrying value included $48.5 million of principal value and $5.3 million of unamortized deferred credit. The Company recognized a net gain of $3.7 million on the early extinguishment of debt, comprised of the recognition of $5.3 million in deferred credit, offset by $1.6 million of redemption expenses. See Note 4 for additional information concerning the gain on early extinguishment of debt. +During June 2012, the Company redeemed $10 million of its Senior Notes with a carrying value of $11.6 million, including $1.6 million of the Senior Notes’ deferred credit. The Company recognized a net gain of $1.4 million on the early extinguishment of debt, comprised of the recognition of $1.6 million in deferred credit, offset by $0.2 million of redemption expenses. +Gain on Acquired Equipment +See Note 13 for additional information concerning the gain on acquired equipment. +48 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Loss (Gain) on Derivative Contracts +Beginning in 2012, the Company elected to no longer designate its derivative contracts as accounting hedges. For the year ended December 31, 2013 , net losses on mark-to-market derivative instruments, net of settlements were $1.4 million , compared to $1.7 million gain in 2012 . See Notes 5 and 6 for a reconciliation of the components of the Company’s derivative contracts and disclosures related to derivative instruments including their composition and valuation. +Income Tax Expense (Benefit) +The income tax expense of $3.1 million in 2013 resulted primarily from pre-tax income earnings of $7.4 million . The effective tax rate of 42% in 2013 and 47% in 2012 differed from the federal income tax rate of 35% primarily due to the effect of state taxes, non-deductible compensation under Section 162(m) and restricted stock offset by percentage depletion. See Note 10 for a discussion of our effective tax rate. Prior to 2012, we carried a full valuation allowance against our net deferred tax asset. The income tax benefit of $69.3 million in 2011 resulted primarily from the reversal of the valuation allowance established in 2008 against our net deferred tax assets as we achieved income on an aggregate basis for a cumulative three-year period and expect to generate the taxable income necessary to fully utilize the deferred tax assets prior to their expiration. For additional information, see Note 11 to the Consolidated Financial Statements. +Preferred Stock Dividends +Preferred Stock dividends for the year ended December 31, 2013 increased $4.6 million compared to the same period of 2012 in which we had no dividend expense. The expense is reflective of the Preferred Stock being outstanding only since its issuance on May 30, 2013, resulting in a reduced stub period payment during the second quarter of 2013. +Summary of Significant Accounting Policies and Critical Accounting Estimates +The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect our reported results of operations and the amount of reported assets, liabilities and proved oil and natural gas reserves. Some accounting policies involve judgments and uncertainties to such an extent that there is reasonable likelihood that materially different amounts could have been reported under different conditions, or if different assumptions had been use. Actual results may differ from the estimates and assumptions used in the preparation of our consolidated financial statements. Described below are the most significant policies we apply in preparing our consolidated financial statements, some of which are subject to alternative treatments under GAAP. We also describe the most significant estimates and assumptions we make in applying these policies. See Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a discussion of additional accounting policies and estimates made by management. +Property and Equipment +The Company utilizes the full-cost method of accounting for its oil and natural gas properties whereby all costs incurred in connection with the acquisition, exploration and development of oil and natural gas reserves, including certain overhead costs, are capitalized into the “full-cost pool.” The amounts capitalized into the full-cost pool are depleted (charged against earnings) using the unit-of-production method. The full-cost method of accounting for our proved oil and natural gas properties requires that the Company makes estimates based on its assumptions of future events that could change. These estimates are described below. +Depreciation, Depletion and Amortization (DD&A) of Oil and Natural Gas Properties +The Company calculates depletion by using the depletable base, equal to the net capitalized costs in our full-cost pool plus estimated future development costs, and the estimated net proved reserve quantities. Capitalized costs added to the full-cost pool include the following: +• +costs of drilling and equipping productive wells, dry hole costs, acquisition costs of properties with proved reserves, delay rentals and other costs related to exploration and development of our oil and natural gas properties; +• +payroll costs including the related fringe benefits paid to employees directly engaged in the acquisition, exploration and/or development of oil and natural gas properties as well as other directly identifiable general and administrative costs +49 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +associated with such activities. Such capitalized costs do not include any costs related to the production of oil and natural gas or general corporate overhead; +• +costs associated with unevaluated properties, those lacking proved reserves, are excluded from the depletable base. These unevaluated property costs are added to the depletable base at such time as wells are completed on the properties, the properties are sold or the Company determines these costs have been impaired. The Company’s determination that a property has or has not been impaired (which is discussed below) requires assumptions about future events; +• +estimated costs to dismantle, abandon and restore properties that are capitalized to the full-cost pool when the related liabilities are incurred (see also the discussion below regarding Asset Retirement Obligations); +• +estimated future costs to develop proved properties are added to the full-cost pool for purposes of the DD&A computation. The Company uses assumptions based on the latest geologic, engineering, regulatory and cost data available to it to estimate these amounts. However, the estimates made are subjective and may change over time. The Company’s estimates of future development costs are reviewed at least annually and as additional information becomes available; and +• +capitalized costs included in the full-cost pool plus estimated future development costs are depleted and charged against earnings using the unit-of-production method. Under this method, the Company estimates the proved reserves quantities at the beginning of each accounting period. For each BOE produced during the period, the Company records a depletion charge equal to the amount included in the depletable base (net of accumulated depreciation, depletion and amortization) divided by our estimated net proved reserve quantities. +Because the Company uses estimates and assumptions to calculate proved reserves (as discussed below) and the amounts included in the depletable base, our depletion rates may materially change if actual results differ from these estimates. +Ceiling Test +Under the full cost method of accounting, the Company compares, at the end of each financial reporting period, the present value of estimated future net cash flows from proved reserves (excluding cash flows related to estimated abandonment costs), to the net capitalized costs of proved oil and natural gas properties net of related deferred taxes. The Company refers to this comparison as a “ceiling test.” If the net capitalized costs of proved oil and natural gas properties exceed the estimated discounted (at 10%) future net cash flows from proved reserves, the Company is required to write-down the value of its oil and natural gas properties to the value of the discounted cash flows. Estimated future net cash flows from proved reserves are based on a twelve-month average pricing assumption and include consideration of existing cash flow hedges. Given the volatility of oil and natural gas prices, it is reasonably possible that the Company’s estimates of discounted future net cash flows from proved oil and natural gas reserves could change in the near term. If oil and natural gas prices decline significantly, even if only for a short period of time, it is possible that write-downs of oil and natural gas properties could occur in the future. See Notes 2 and 12 for additional information regarding the Company’s oil and natural gas properties. +Estimating Reserves and Present Value of Estimated Future Net Cash Flows +Estimates of quantities of proved oil and natural gas reserves, including the discounted present value of estimated future net cash flows from such reserves at the end of each quarter, are based on numerous assumptions, which are likely to change over time. These assumptions include: +• +the prices at which the Company can sell its oil and natural gas production in the future. Oil and natural gas prices are volatile, but we are required to assume that they remain constant, using the twelve-month average pricing assumption. In general, higher oil and natural gas prices will increase quantities of proved reserves and the present value of estimated future net cash flows from such reserves, while lower prices will decrease these amounts; and +• +the costs to develop and produce the Company’s reserves and the costs to dismantle its production facilities when reserves are depleted. These costs are likely to change over time, but we are required to assume that they remain constant. Increases in costs will reduce estimated oil and natural gas quantities and the present value of estimated future net cash flows, while decreases in costs will increase such amounts. +Changes in these prices and/or costs will affect the present value of estimated future net cash flows more than the estimated quantities of oil and natural gas reserves for the Company’s properties that have relatively short productive lives. +50 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +In addition, the process of estimating proved oil and natural gas reserves requires that the Company’s independent and internal reserve engineers exercise judgment based on available geological, geophysical and technical information. We have described the risks associated with reserve estimation and the volatility of oil and natural gas prices under “Risk Factors.” +Sales of oil and natural gas properties are accounted for as adjustments to the net full cost pool with no gain or loss recognized unless the adjustment would significantly alter the relationship between capitalized costs and proved reserves. +Unproved Properties +Costs, including capitalized interest, associated with properties that do not have proved reserves are excluded from the depletable base, and are included in the line item “Unevaluated properties excluded from amortization.” Unproved property costs are transferred to the depletable base when wells are completed on the properties or the properties are sold. In addition, the Company is required to determine whether its unproved properties are impaired and, if so, include the costs of such properties in the depletable base. The Company determines whether an unproved property is impaired by periodically reviewing its exploration program on a property-by-property basis. This determination may require the exercise of substantial judgment by management. +Asset Retirement Obligations +We are required to record its estimate of the fair value of liabilities for obligations associated with the retirement of tangible long-life assets and the associated asset retirement costs. Interest is accreted on the present value of the asset retirement obligation and reported as accretion expense within operating expenses in the Consolidated Statements of Operations. See Note 11 for additional information. +Derivatives +To manage oil and natural gas price risk on a portion of our planned future production, we have historically utilized commodity derivative instruments (including collars, swaps, puts, and other structures) on approximately 50% of our projected production volumes in any given year. We do not use these instruments for trading purposes. Settlement of derivative contracts are generally based on the difference between the contract price and prices specified in the derivative instrument and a NYMEX price or other cash or futures index price. +Beginning in 2012, we elected to no longer designate derivative contracts executed after January 1, 2012 as accounting hedges under FASB ASC 815-20-25. As such and beginning with derivative contracts executed during 2012, all derivative positions are carried at their fair value on the balance sheet and are marked-to-market through earnings at the end of each period. Gains and losses on derivatives that are not designated as hedges are recorded in earnings as a component of gain (loss) on derivative contracts. Within gain (loss) on derivative contracts line in the statement of operations are gains (losses) on derivatives, net of settlement and gains (losses) on derivatives, settled. +Derivative contracts that were entered into at and prior to December 31, 2011 were accounted for as cash flow hedges, and were recorded at fair market value on its consolidated balance sheet. Changes in fair value were recorded through other comprehensive income (loss), net of tax, in stockholders’ equity. The changes in fair value related to ineffective derivative contracts were recognized as derivative expense (income). The estimated fair value of our derivative contracts is based upon closing exchange prices on NYMEX and in the case of collars and floors, the time value of options. For additional information regarding derivatives and their fair values, see Notes 5 and 6 to the Consolidated Financial Statements and Part II, Item 7A Commodity Price Risk. +Income Taxes +The amount of income taxes recorded requires interpretations of complex rules and regulations of federal and state tax jurisdictions. We recognize current tax expense based on estimated taxable income for the current period and the applicable statutory tax rates. We routinely assess potential uncertain tax positions and, if required, estimate and establish accruals for such amounts. We have recognized deferred tax assets and liabilities for temporary differences, operating losses and other tax carryforwards. We routinely assess our deferred tax assets and reduce such assets by a valuation allowance if we deem it is more likely than not that some portion or all of the deferred tax assets will not be realized. Numerous judgments and assumptions are inherent in the determination of future taxable income, including factors such as future operating conditions (particularly as related to prevailing oil and natural gas prices). See Note 10 for additional information regarding Income Taxes. +51 +Callon Petroleum Company +Management’s Discussion and Analysis of Financial Condition and Results of Operations +Table of Contents +Recent Accounting Standards +Various accounting standards and interpretations were issued in 2013 with effective dates subsequent to December 31, 2013 . We have evaluated the recently issued accounting pronouncements that are effective in 2014 and believe that none of them will have a material effect on our financial position, results of operations or cash flows when adopted. For a discussion of recently issued accounting standards, see Note 2 to the Consolidated Financial Statements. +In February 2013, the Financial Accounting Standards Board issued an Accounting Standards Update (ASU) that clarified the reclassification requirements from accumulated other comprehensive income to net income. This ASU requires disclosure of amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present either on the face of the financial statements or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income, but only if the amount is reclassified in its entirety to net income in the same reporting period. For amounts not reclassified in their entirety to net income, an entity is required to cross-reference to the related note on the face of the financial statements for additional information. Callon adopted this guidance effective January 1, 2013, which did not have a material impact on its financial statements. +ITEM 7A. Quantitative and Qualitative Disclosures about Market Risks +We are exposed to a variety of market risks including commodity price risk, interest rate risk and counterparty and customer risk. We address these risks through a program of risk management including the use of derivative instruments. +Commodity Price Risk +The Company’s revenues, earnings, cash flow, capital investments and, ultimately, future rate of growth are highly dependent on the prices we receive for our oil and natural gas, which have historically been very volatile due to unpredictable events such as economic growth or retraction, weather and climate, changes in supply and government actions. Oil and natural gas price declines and volatility could adversely affect the Company’s revenues, cash flows and profitability. Price volatility is expected to continue. Using the Company’s annual sales volumes for 2013 , excluding the effects of the Company’s hedging program, a 10% decline in the NYMEX price of oil and natural gas would have reduced our revenues by approximately $8.9 million and $1.2 million , respectively. +While the Company does not enter into derivative transactions for speculative purposes, the Company sometimes utilizes price collars, swaps, puts and other structures to reduce the risk of changes in oil and natural gas prices. Under a collar arrangements, no payments are due by either party as long as the market price is above the floor price and below the ceiling price set in the collar. If the price falls below the floor, the counterparty to the collar pays the difference to Callon, and if the price rises above the ceiling, Callon pays the difference to the counterparty. Fixed price swaps reduce the Company’s exposure to decreases in commodity prices, while simultaneously limiting the benefit the Company might otherwise have received from any increases in commodity prices. The Company’s derivatives policy also allows Callon to, at its discretion, purchase or sell puts. Purchased puts reduce the Company’s exposure to decreases in prices of the hedged commodity while allowing realization of the full benefit from any increases those prices. If the commodity price falls below the put price, the counter-party pays the difference to Callon. Conversely, sold puts expose the Company to risk whereby Callon would pay its counter-party if prices fall below the put price. See Note 5 to the Consolidated Financial Statements for a description of our hedged position at December 31, 2013 . +Interest Rate Risk +On December 31, 2013 , the majority of the Company’s debt consisted of its fixed-rate 13% Senior Notes. However, we are subject to market risk exposure related to changes in interest rates on our indebtedness under our revolving credit facility and our Second Lien Facility into which we entered during March 2014. As of December 31, 2013, the weighted average interest rate on our Credit Facility borrowings was 2.9%. An increase or decrease of 1% in the interest rate would have a corresponding decrease or increase in our net income of approximately $0.2 million based on the $22 million outstanding in the aggregate under our Credit Facility on December 31, 2013. +52 +Table of Contents +Counterparty and Customer Credit Risk +Our principal exposures to credit risk are through receivables resulting from derivatives financial contracts, joint interest receivables and the receivables from the sale of our oil and natural gas production, which we market to energy marketing companies. +At December 31, 2013 our receivables resulting from derivative financial contracts was approximately $0.1 million . Our oil and natural gas derivative arrangements expose us to credit risk in the event of nonperformance by counterparties. The counterparties on our derivative instruments currently in place are lenders under our revolving credit facility. We are likely to enter into additional derivative instruments with these or other lenders under our revolving credit facility, representing institutions with an investment grade ratings. We have existing International Swap Dealers Association Master Agreements (“ISDA Agreements”) with our derivative counterparties. The terms of the ISDA Agreements provide us and the counterparties with rights of set off upon the occurrence of defined acts of default by either us or a counterparty to a derivative, whereby the party not in default may set off all derivative liabilities owed to the defaulting party against all derivative asset receivables from the defaulting party. At December 31, 2013 we had a net derivative asset position of $0.1 million and a net derivative liability position of $1.1 million . +Joint interest receivables arise from billings to entities that own partial interests in the wells we operate. These entities participate in our wells primarily based on their ownership in leases on which we intend to drill. We have little ability to control whether these entities will participate in our wells. At December 31, 2013 our joint interest receivables were approximately $4.4 million . +We are subject to credit risk due to the concentration of our oil and natural gas receivables with several significant customers. We do not require any of our customers to post collateral, and the inability of our significant customers to meet their obligations to us or their insolvency or liquidation may adversely affect our financial results. For the year ended December 31, 2013, three purchasers accounted for more than 10% of our revenue: Enterprise Crude Oil, LLC ( 38% ); Shell Trading Company ( 31% ); and Plains Marketing, L.P. ( 15% ). At December 31, 2013 our receivables from the sale of our oil and natural gas production were approximately $13.2 million in total. +ITEM 8. Financial Statements and Supplementary Data +Page +Report of Independent Registered Public Accounting Firm +54 +Consolidated Balance Sheets as of December 31, 2013 and 2012 +55 +Consolidated Statements of Operations for Each of the Three Years in the Period Ended December 31, 201 3 +56 +Consolidated Statements of Comprehensive Income (Loss) for the Three Years in the Period Ended December 31, 2013 +57 +Consolidated Statements of Stockholders' Equity (Deficit) for Each of the Three Years in the Period Ended December 31, 201 3 +58 +Consolidated Statements of Cash Flows for Each of the Three Years in the Period Ended December 31, 201 3 +59 +Notes to Consolidated Financial Statements +60 +53 +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited the accompanying consolidated balance sheets of Callon Petroleum Company as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2013. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Callon Petroleum Company as of December 31, 2013 and 2012, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2013, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Callon Petroleum Company’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) and our report dated March 12, 2014 , expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 12, 2014 +54 +CALLON PETROLEUM COMPANY +CONSOLIDATED BALANCE SHEETS +(In thousands, except share data) +For the Year Ended December, 31 +2013 +2012 +ASSETS +Current assets: +Cash and cash equivalents +$ +3,012 +$ +1,139 +Accounts receivable +20,586 +15,608 +Fair market value of derivatives +60 +1,674 +Deferred tax asset, current +3,843 +— +Other current assets +2,063 +1,502 +Total current assets +29,564 +19,923 +Oil and natural gas properties, full-cost accounting method: +Evaluated properties +1,701,577 +1,497,010 +Less accumulated depreciation, depletion and amortization +(1,420,612 +) +(1,296,265 +) +Net oil and natural gas properties +280,965 +200,745 +Unevaluated properties excluded from amortization +43,222 +68,776 +Total oil and natural gas properties +324,187 +269,521 +Other property and equipment, net +7,255 +10,058 +Restricted investments +3,806 +3,798 +Investment in Medusa Spar LLC +— +8,568 +Deferred tax asset +57,765 +64,383 +Other assets, net +1,376 +1,922 +Total assets +$ +423,953 +$ +378,173 +LIABILITIES AND STOCKHOLDERS' EQUITY +Current liabilities: +Accounts payable and accrued liabilities +$ +57,637 +$ +36,016 +Asset retirement obligations +4,120 +2,336 +Fair market value of derivatives +1,036 +125 +Total current liabilities +62,793 +38,477 +13% Senior Notes: +Principal outstanding +48,481 +96,961 +Deferred credit, net of accumulated amortization of $20,814 and $17,800, respectively +5,267 +13,707 +Total 13% Senior Notes +53,748 +110,668 +Credit facility +22,000 +10,000 +Asset retirement obligations +2,612 +10,965 +Other long-term liabilities +3,706 +2,092 +Total liabilities +144,859 +172,202 +Stockholders' equity: +Preferred Stock, series A cumulative, $.01 par value and $50.00 liquidation preference, 2,500 shares authorized; 1,579 and 0 shares outstanding, respectively +16 +— +Common Stock, $.01 par value, 60,000 shares authorized; 40,345 and 39,801 shares outstanding at December 31, 2013 and 2012, respectively +404 +398 +Capital in excess of par value +401,540 +328,116 +Retained deficit +(122,866 +) +(122,543 +) +Total stockholders' equity +279,094 +205,971 +Total liabilities and stockholders' equity +$ +423,953 +$ +378,173 +The accompanying notes are an integral part of these financial statements. +55 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF OPERATIONS +(In thousands, except per share amounts) +For the Year Ended December 31, +2013 +2012 +2011 +Operating revenues: +Oil sales +$ +88,960 +$ +96,584 +$ +100,962 +Natural gas sales +13,609 +14,149 +26,682 +Total operating revenues +102,569 +110,733 +127,644 +Operating expenses: +Lease operating expenses +19,779 +23,330 +18,285 +Production taxes +4,133 +3,224 +2,062 +Depreciation, depletion and amortization +43,967 +49,701 +48,701 +General and administrative +20,534 +20,358 +16,636 +Accretion expense +1,785 +2,253 +2,338 +Impairment of other property and equipment +1,707 +1,177 +— +Total operating expenses +91,905 +100,043 +88,022 +Income from operations +10,664 +10,690 +39,622 +Other (income) expenses: +Interest expense +6,094 +9,108 +11,717 +Gain on early extinguishment of debt +(3,696 +) +(1,366 +) +(1,942 +) +Gain on acquired equipment +— +— +(5,041 +) +Loss (gain) on derivative contracts +1,360 +(1,717 +) +— +Other income +(485 +) +(79 +) +(1,426 +) +Total other expenses +3,273 +5,946 +3,308 +Income before income taxes +7,391 +4,744 +36,314 +Income tax expense (benefit) +3,104 +2,223 +(69,283 +) +Income before equity in earnings of Medusa Spar LLC +4,287 +2,521 +105,597 +Equity in earnings of Medusa Spar LLC, net of tax +17 +226 +799 +Net income +4,304 +2,747 +106,396 +Preferred stock dividends +(4,627 +) +— +— +Income (loss) available to common shareholders +$ +(323 +) +$ +2,747 +$ +106,396 +Income (loss) per common share: +Basic +$ +(0.01 +) +$ +0.07 +$ +2.81 +Diluted +$ +(0.01 +) +$ +0.07 +$ +2.76 +Shares used in computing income per common share: +Basic +40,133 +39,522 +37,908 +Diluted +40,133 +40,337 +38,582 +The accompanying notes are an integral part of these financial statements. +56 +Table of Contents +CALLON PETROLEUM COMPANY +CONSOLIDATE STATEMENTS OF COMPREHENSIVE INCOME +(In thousands) +For the Year Ended December 31, +2013 +2012 +2011 +Net income +$ +4,304 +$ +2,747 +$ +106,396 +Other comprehensive income (loss): +Change in fair value of derivatives designated as hedges, net of tax +— +(1,624 +) +2,561 +Comprehensive income +4,304 +1,123 +108,957 +Preferred stock dividends +(4,627 +) +— +— +Comprehensive income (loss) available to common shareholders +$ +(323 +) +$ +1,123 +$ +108,957 +The accompanying notes are an integral part of these consolidated financial statements. +57 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(In thousands) +Preferred Stock +Common Stock +Capital in Excess of Par +Accumulated Other Comprehensive Income (Loss) +Retained Earnings (Deficit) +Total Stockholders’ Equity +Balance at 12/31/2010 +$ +— +$ +290 +$ +248,160 +$ +(937 +) +$ +(231,703 +) +$ +15,810 +Comprehensive income: +Net income +— +— +— +106,396 +Other comprehensive income +2,561 +Total comprehensive income +108,957 +Shares issued pursuant to employee benefit plans +— +— +207 +— +— +207 +Restricted stock +— +3 +2,446 +— +— +2,449 +Common stock issued +— +101 +73,661 +— +— +73,762 +Reconsolidated subsidiary (See Note 13) +— +— +— +— +17 +17 +Balance at 12/31/2011 +$ +— +$ +394 +$ +324,474 +$ +1,624 +$ +(125,290 +) +$ +201,202 +Comprehensive income: +Net income +— +— +— +2,747 +Other comprehensive loss +(1,624 +) +Total comprehensive income +1,123 +Shares issued pursuant to employee benefit plans +— +— +235 +— +— +235 +Restricted stock +— +4 +3,407 +— +— +3,411 +Balance at 12/31/2012 +$ +— +$ +398 +$ +328,116 +$ +— +$ +(122,543 +) +$ +205,971 +Comprehensive income: +Net income and comprehensive income +— +— +— +— +4,304 +4,304 +Shares issued pursuant to employee benefit plans +— +— +243 +— +— +243 +Restricted stock +— +6 +3,162 +— +— +3,168 +Preferred stock issued +16 +70,019 +70,035 +Preferred stock dividend +(4,627 +) +(4,627 +) +Balance at 12/31/2013 +$ +16 +$ +404 +$ +401,540 +$ +— +$ +(122,866 +) +$ +279,094 +The accompanying notes are an integral part of these financial statements. +58 +CALLON PETROLEUM COMPANY +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In thousands) +For the Year Ended December 31, +2013 +2012 +2011 +Cash flows from operating activities: +Net income +$ +4,304 +$ +2,747 +$ +106,396 +Adjustments to reconcile net income to cash provided by operating activities: +Depreciation, depletion and amortization +45,393 +51,043 +49,753 +Accretion expense +1,785 +2,253 +2,338 +Amortization of non-cash debt related items +471 +402 +461 +Amortization of deferred credit +(3,164 +) +(3,086 +) +(3,155 +) +Equity in earnings of Medusa Spar LLC +(17 +) +(226 +) +(799 +) +Deferred income tax expense +2,778 +2,223 +10,928 +Valuation allowance +— +— +(80,211 +) +Net loss (gain) on derivatives, net of settlements +2,730 +(1,683 +) +— +Impairment of other property and equipment +1,707 +1,176 +— +Gain on acquired equipment +— +— +(4,995 +) +Non-cash gain for early debt extinguishment +(3,696 +) +(1,366 +) +(1,942 +) +Non-cash expense related to equity share-based awards +2,092 +1,697 +1,337 +Change in the fair value of liability share-based awards +2,903 +1,620 +761 +Payments to settle asset retirement obligations +(721 +) +(1,314 +) +(2,563 +) +Changes in current assets and liabilities: +Accounts receivable +(3,497 +) +(883 +) +(3,734 +) +Other current assets +(560 +) +100 +180 +Current liabilities +3,583 +1,753 +4,695 +Payments to settle vested liability share-based awards +(239 +) +(3,383 +) +— +Change in natural gas balancing receivable +22 +51 +252 +Change in natural gas balancing payable +(527 +) +(102 +) +(115 +) +Change in other long-term liabilities +(206 +) +205 +100 +Change in other assets, net +(812 +) +(1,937 +) +(520 +) +Net cash provided by operating activities +54,329 +51,290 +79,167 +Cash flows from investing activities: +Capital expenditures +(159,724 +) +(133,299 +) +(100,243 +) +Acquisitions +(10,885 +) +(2,075 +) +— +Proceeds from sale of mineral interests and equipment +89,992 +39,936 +7,615 +Investment in restricted assets related to plugging and abandonment +— +— +(150 +) +Distribution from Medusa Spar LLC +813 +1,735 +1,267 +Net cash used in investing activities +(79,804 +) +(93,703 +) +(91,511 +) +Cash flows from financing activities: +Borrowings on credit facility +80,000 +53,000 +— +Payments on credit facility +(68,000 +) +(43,000 +) +— +Redemption of 13% Senior Notes +(50,060 +) +(10,225 +) +(35,062 +) +Issuance of preferred stock +70,035 +— +— +Issuance of common stock +— +— +73,765 +Payment of preferred stock dividends +(4,627 +) +— +— +Taxes paid related to exercise of employee stock options +— +(18 +) +— +Net cash provided by (used in) financing activities +27,348 +(243 +) +38,703 +Net change in cash and cash equivalents +1,873 +(42,656 +) +26,359 +Cash and cash equivalents: +Balance, beginning of period +1,139 +43,795 +17,436 +Balance, end of period +$ +3,012 +$ +1,139 +$ +43,795 +The accompanying notes are an integral part of these financial statements. +59 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +Note +Description +Note +Description +1. +Description of Business and Basis of Presentation +8. +Share-Based Compensation +2. +Summary of Significant Accounting Policies +9. +Equity Transactions +3. +Earnings (loss) per Share +10. +Income Taxes +4. +Borrowings +11. +Asset Retirement Obligations +5. +Derivative Instruments and Hedging Activities +12. +Supplemental Information on Oil and Natural Gas Operations (Unaudited) +6. +Fair Value Measurements +13. +Other +7. +Employee Benefit Plans +14. +Summarized Quarterly Financial Information (Unaudited) +NOTE 1 – Description of Business and Basis of Presentation +Callon Petroleum Company is an independent oil and natural gas company established in 1950, which has been focused on building reserves and production both onshore and offshore through efficient operations and low finding and development costs. In 2013, the Company completed the onshore strategic repositioning it initiated in 2009, shifting its operations from the offshore waters in the Gulf of Mexico to the Permian Basin region in Texas. The Company has built seasoned technical and operational teams with extensive experience in the Permian Basin to manage and progress its growth plan. In the fourth quarter of 2012, Callon sold its interest in its deepwater Habanero field. Similarly, in the fourth quarter of 2013, the Company sold its interest in its only remaining deepwater property, the Medusa field, including the sale of the Medusa Spar facility and substantially all remaining offshore shelf properties. These transactions completed the Company’s long-term strategic goal of becoming an onshore operator with an asset base concentrated in the Permian Basin. +The Company was incorporated under the laws of the state of Delaware in 1994 and succeeded to the business of a publicly traded limited partnership, a joint venture with a consortium of European investors and an independent energy company partially owned by a member of current management. As used herein, the “Company,” “Callon,” “we,” “us,” and “our” refer to Callon Petroleum Company and its predecessors and subsidiaries unless the context requires otherwise. +The Consolidated Financial Statements include the accounts of the Company, and its subsidiary, Callon Petroleum Operating Company (“CPOC”). CPOC also includes the subsidiaries Callon Offshore Production, Inc. and Mississippi Marketing, Inc. All intercompany accounts and transactions have been eliminated. Certain prior year amounts have been reclassified to conform to presentation in the current year. To the extent these amounts are material, we have either footnoted them within the Company’s disclosures or have noted the items within this footnote. The Company reclassified on its 2012 and 2011 Consolidated Statements of Operations $3,224 and $2,062 , respectively, from “Lease operating expenses” to “Production taxes” to conform to current year presentation. +Unless otherwise indicated, all amounts included within the footnotes to the financial statements are presented in thousands, except for share, well, acreage and per-derivative instrument data. +NOTE 2 – Summary of Significant Accounting Policies +A. +Use of Estimates +The preparation of financial statements in conformity with United States generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. +B. +Cash and Cash Equivalents +The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. +C. +Accounts Receivable +Accounts receivable consists primarily of accrued oil and natural gas production receivables. The balance in the reserve for doubtful accounts netted within accounts receivable was $73 and $34 at December 31, 2013 and 2012 , respectively. During 2013 , 2012 , and 2011 the Company recorded $45 , $0 and $(281) , respectively of bad debt expense. The negative bad debt expense in 2011 relates to the collection of an amount charged to bad debt expense during 2010. +60 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +D. +Revenue Recognition and Natural Gas Balancing +The Company recognizes revenue under the entitlement method of accounting. Under this method, revenue is deferred for deliveries in excess of the Company’s net revenue interest, while revenue is accrued for the undelivered volumes. Production imbalances are generally recorded at the lower of cost or market. The revenue we receive from the sale of NGLs is included in natural gas sales. Natural gas balancing receivables were $71 and $93 as of 2013 and 2012 , respectively. Natural gas balancing payables were $126 and $653 as of 2013 and 2012 , respectively. +E. +Major Customers +The Company’s production is generally sold on month-to-month contracts at prevailing prices. The following table identifies customers to whom it sold a greater than 10% of its total oil and natural gas production during each of the years ended: +For the Year Ended December 31, +2013 +2012 +2011 +Enterprise Crude Oil, LLC +38 +% +32 +% +16 +% +Shell Trading Company +31 +% +39 +% +45 +% +Plains Marketing, L.P. +15 +% +15 +% +17 +% +Other +16 +% +14 +% +22 +% +Total +100 +% +100 +% +100 +% +Because alternative purchasers of oil and natural gas are readily available, the Company believes that the loss of any of these purchasers would not result in a material adverse effect on its ability to market future oil and natural gas production. +F. +Oil and Natural Gas Properties +The Company uses the full-cost method of accounting for its exploration and development activities. Under this method of accounting, the cost of both successful and unsuccessful exploration and development activities are capitalized as property and equipment. Such amounts include the cost of drilling and equipping productive wells, dry hole costs, lease acquisition costs, delay rentals, interest capitalized on unevaluated leases, other costs related to exploration and development activities, and site restoration, dismantlement and abandonment costs capitalized in accordance with asset retirement obligation accounting guidance. Costs capitalized also include any internal costs that are directly related to exploration and development activities, including salaries and benefits, but do not include any costs related to production, general corporate overhead or similar activities. The Company capitalized $14,753 , $13,331 and $11,857 of these internal costs during 2013 , 2012 and 2011 , respectively. +When applicable, proceeds from the sale or disposition of oil and natural gas properties are accounted for as a reduction to capitalized costs unless the sale would significantly alter the relationship between capitalized costs and proved reserves, in which case a gain or loss is recognized in income. +Costs of oil and natural gas properties, including future development costs, which have proved reserves and properties which have been determined to be worthless, are depleted using the unit-of-production method based on proved reserves. Excluded from this amortization are costs associated with unevaluated properties, including capitalized interest on such costs. Unevaluated property costs are transferred to evaluated property costs at such time as wells are completed on the properties or management determines that these costs have been impaired. +Under the full-cost accounting rules of the SEC, the Company reviews the carrying value of its proved oil and natural gas properties each quarter. Under these rules, capitalized costs of oil and natural gas properties, net of accumulated depreciation, depletion and amortization and deferred income taxes, may not exceed the present value of estimated future net cash flows from proved oil and natural gas reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of related tax effects (the full-cost ceiling amount). These rules generally require pricing based on the preceding 12-months’ average oil and natural gas prices based on closing prices on the first day of each month and require a write-down if the “ceiling” is exceeded. See Note 12 for additional information regarding the Company’s oil and natural gas properties. +Upon the acquisition or discovery of oil and natural gas properties, the Company estimates the future net costs to dismantle, abandon and restore the property by using available geological, engineering and regulatory data. Such cost estimates are periodically updated for changes in conditions and requirements. In accordance with asset retirement obligation guidance issued +61 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +by the FASB, such costs are capitalized to the full-cost pool when the related liabilities are incurred. In accordance with SEC’s rules, assets recorded in connection with the recognition of an asset retirement obligation are included as part of the costs subject to the full-cost ceiling limitation. The future cash outflows associated with settling the recorded asset retirement obligations are excluded from the computation of the present value of estimated future net revenues used in determining the full-cost ceiling amount. +G. +Other Property and Equipment +The Company depreciates its other property and equipment of $7,255 and $6,424 at December 31, 2013 and 2012 , respectively, using the straight-line method over estimated useful lives of three to 20 years. Depreciation expense of $750 , $760 and $645 relating to other property and equipment was included in general and administrative expenses in the Company’s consolidated statements of operations for the years ended December 31, 2013 , 2012 and 2011 , respectively. The accumulated depreciation on other property and equipment was $13,240 and $13,238 as of December 31, 2013 and 2012 , respectively. As discussed in Note 13 , during 2013, the Company recorded an impairment charge to reduce to zero the carrying values of its assets held for sale. The Company reviews its other property and equipment for impairment when indicators of impairment exist. +H. +Capitalized Interest +The Company capitalizes interest on expenditures made in connection with exploration and development projects that are not subject to current amortization (e.g. unevaluated properties). Interest is capitalized only for the period that activities are in progress to bring these projects to their intended use. Capitalized interest cannot exceed gross interest expense. During the years ended December 31, 2013, 2012 and 2011, the Company capitalized $4,410 , $2,109 and $573 of interest expense. +I. +Asset Retirement Obligations +The Company is required to record its estimate of the fair value of liabilities for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. Interest is accreted on the present value of the asset retirement obligations and reported as accretion expense within operating expenses in the consolidated statements of operations. See Note 11 for additional information. +J. +Derivatives +The Company’s derivative contracts executed prior to 2012 were designated as cash flow hedges, and were recorded at fair market value with the changes in fair value recorded net of tax through other comprehensive income (loss) (“OCI”) in stockholders’ equity. Ineffective derivative contracts or ineffective portions of contracts designated as cash flow hedges were recognized as derivative expense (income). The last of the Company’s derivative contracts designated as cash flow hedges expired on December 31, 2012. Derivative contracts executed during 2013 and outstanding as of December 31, 2013 were not designated as accounting hedges, and are carried on the balance sheet at their fair market value. Changes in the fair value of derivative contracts not designated as accounting hedges are reflected in earnings as a gain or loss on derivative contracts. See Notes 5 and 6 for additional information regarding the Company’s derivative contracts. +K. +Income Taxes +Provisions for income taxes include deferred taxes resulting primarily from temporary differences due to different reporting methods for oil and natural gas properties for financial reporting purposes and income tax purposes. GAAP requires the recognition of a deferred tax asset for net operating loss carryforwards, statutory depletion carryforward and tax credit carryforwards, net of a valuation allowance. A valuation allowance is provided for that portion, if any, of the asset for which it is deemed more likely than not that it will not be realized. See Note 10 for additional information. +L. +Share-Based Compensation +The Company grants to directors and employees stock options, restricted stock awards (“RS awards”), and restricted stock unit awards (“RSU awards”) that may be settled in cash or common stock at the option of the Company and RSU awards that may only be settled in cash (“Cash-settleable RSU awards”). +Stock Options. For stock options the Company expects to settle in common stock, share-based compensation expense is based on the grant-date fair value as calculated using the Black-Scholes option pricing model and recognized straight-line over the vesting period (generally three years). +62 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +RS awards, RSU awards and Cash-settleable RSU awards. For RS and RSU awards that the Company expects to settle in common stock, share-based compensation expense is based on the grant-date fair value and recognized straight-line over the vesting period (generally three years). For Cash-settleable RSU awards that the Company expects or is required to settle in cash, share-based compensation expense is based on the fair value remeasured at each reporting period as calculated using a Monte Carlo pricing model, because vesting of these awards is subject to a market condition, with the estimated value recognized over the vesting period (generally three years). +M. +Statements of Cash Flows Supplemental Information +During the three year period ended 2013 , the Company paid no federal income taxes. During the years ended December 31, 2013 , 2012 and 2011 , the company made cash interest payments of $13,189 , $13,920 and $14,922 , respectively. +N. +Investment in Medusa Spar LLC +During the fourth quarter of 2013 , the Company closed on the sale of its 15.0% working interest in the Medusa field, its 10.0% membership interest in Medusa Spar LLC (“LLC”), and substantially all of its remaining Gulf of Mexico shelf properties. Prior to the sale, the Company’s ownership interest in the LLC was accounted for under the equity method of accounting for investments. The LLC held a 75% undivided ownership interest in the deepwater spar production facilities at the Medusa field in the Gulf of Mexico and earned a tariff based upon production volume throughput from the Medusa area. The Company was obligated to process through the spar production facilities its share of production from the Medusa field and any future discoveries in the area. The balance of the LLC was owned by Oceaneering International, Inc. and Murphy Oil Corporation. See Note 12 for additional information on the Medusa divestiture. +O. +Consolidation of Variable Interest Entities +In June 2009, the FASB issued an accounting standard which became effective for and was adopted by the Company on January 1, 2010. Upon adoption, the Company reevaluated its interest in its subsidiary, Callon Entrada. Based on the evaluation performed, management concluded that a VIE reconsideration event had taken place resulting in the determination that Callon Entrada is a VIE, for which the Company is not the primary beneficiary. Therefore, effective January 1, 2010, Callon Entrada was deconsolidated from the consolidated financial statements of the Company. During the second quarter of 2011 and through the formal execution of a wind-down agreement with its former joint interest partner in the Entrada deepwater project, which resulted in Callon gaining the power to direct the activities of Callon Entrada, the Company became the primary beneficiary of Callon Entrada. Consequently, effective April 29, 2011, Callon Entrada was reconsolidated in the Company’s financial statements. Callon Entrada was later dissolved in 2011. +P. +Earnings per Share (EPS) +The Company’s basic EPS amounts have been computed based on the weighted-average number of shares of common stock outstanding for the period. Diluted EPS, using the treasury-stock method, reflects the potential dilution caused by the exercise of all options and vesting of all restricted stock and restricted stock units settleable in shares. +Q. +Recent Accounting Pronouncements +From time to time, new accounting pronouncements are issued by FASB that are adopted by the Company as of the specified effective date. If not discussed, management believes that the impact of recently issued standards, which are not yet effective, will not have a material impact on the Company’s financial statements upon adoption. +In February 2013, the Financial Accounting Standards Board issued an Accounting Standards Update (ASU) that clarified the reclassification requirements from accumulated other comprehensive income to net income and required disclosure of amounts reclassified out of accumulated other comprehensive income by component. In addition, it requires that the Company present either on the face of its financial statements or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income, but only if the amount is reclassified in its entirety to net income in the same reporting period. For amounts not reclassified in their entirety to net income, the Company is required to cross-reference to the related note on the face of the financial statements for additional information. Callon adopted this guidance effective January 1, 2013, which did not have a material impact on its financial statements. +63 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +NOTE 3 - Earnings (loss) per Share +Basic earnings (loss) per share is computed by dividing income available to common stockholders by the weighted average number of shares outstanding for the periods presented. The calculation of diluted earnings (loss) per share includes the potential dilutive impact of non-vested restricted shares and unexercised options outstanding during the periods presented, as calculated using the treasury stock method, unless their effect is anti-dilutive. A reconciliation of the basic and diluted net income per share computation is as follows (in thousands, except per share amounts): +For the year ended December 31, +2013 +2012 +2011 +Net income +$ +4,304 +$ +2,747 +$ +106,396 +Preferred stock dividends +(4,627 +) +— +— +(a) Income (loss) available to common shareholders +$ +(323 +) +$ +2,747 +$ +106,396 +(b) Weighted average shares outstanding +40,133 +39,522 +37,908 +Dilutive impact of stock options +— +8 +18 +Dilutive impact of restricted stock +— +807 +656 +(c) Weighted average shares outstanding +for diluted net income (loss) per share (1) +40,133 +40,337 +38,582 +Basic Income (loss) per share (a/b) +$ +(0.01 +) +$ +0.07 +$ +2.81 +Diluted Income (loss) per share (a/c) +$ +(0.01 +) +$ +0.07 +$ +2.76 +The following were excluded from the diluted EPS calculations because their effect would be anti-dilutive: +Stock options +52 +52 +67 +Restricted stock +398 +123 +816 +(1) +Because the Company reported a loss for the year ended December 31, 2013, no unvested stock awards were included in computing loss per share because the effect was anti-dilutive. +NOTE 4 - Borrowings +For the year ended December 31, +2013 +2012 +Principal components: +Credit Facility +$ +22,000 +$ +10,000 +13% Senior Notes due 2016, principal +48,481 +96,961 +Total principal outstanding +$ +70,481 +$ +106,961 +Non-cash components: +13% Senior Notes due 2016 unamortized deferred credit +5,267 +13,707 +Total carrying value of borrowings +$ +75,748 +$ +120,668 +Senior Secured Revolving Credit Facility (the “Credit Facility”) +The Company’s $200,000 Credit Facility, for which Regions Bank serves as the Administrative Agent, matures March 15, 2016 and includes Citibank, NA, IberiaBank, Whitney Bank and OneWest Bank, FSB as participating lenders. The Company’s Credit Facility had an approved borrowing base at December 31, 2013 of $83,000 . The Credit Facility was secured by mortgages covering the Company’s major producing fields. As of December 31, 2013, the balance outstanding on the Credit Facility was $22,000 with an interest rate of 2.92% , calculated as the London Interbank Offered Rate (LIBOR), plus a tiered rate ranging from 2.5% to 3.0% , which is determined by utilization of the facility. In addition, the Credit Facility carries a commitment fee of 0.5% per annum on the unused portion of the borrowing base, which is payable quarterly. +Subsequent to December 31, 2013, the Company amended its existing Credit Facility as discussed below. Additionally, the Company executed the Second Lien Facility also discussed below. +64 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +Amended Credit Facility (“the Amended Credit Facility”) +On March 11, 2014, the Company entered into the Fifth Amended and Restated Credit Agreement million with JPMorgan Chase Bank, National Association as Administrative Agent. +The Amended Credit Facility includes the following key provisions: +• +$500,000 notional amount, with an initial borrowing base of $95,000 ; +• +Maturity date of March 11, 2019; +• +First redetermination scheduled with an effective date of May 30, 2014, with subsequent redeterminations occurring every six months beginning on September 1, 2014; +• +Pricing grid providing from Eurodollar-based draws ranging from LIBOR plus 1.75% to 2.75% depending on utilization; +• +A quarterly commitment fee equal to 0.5% per year of the unused portion of the borrowing base; and +• +Secured by mortgages covering all major producing fields. +The Amended Credit Facility contains various affirmative and restrictive covenants. +Second Lien Term Loan Facility (the “Second Lien Facility”) +In conjunction with the Amended Credit Facility, the Company entered into the Second Lien Facility in an aggregate amount of up to $125,000 with JPMorgan Chase Bank, National Association as Administrative Agent. The Second Lien Facility is structured as a multiple advance term loan facility, with initial commitments of $100,000 . If any portion of the committed Second Lien Facility remains undrawn on the first anniversary of the closing date, then the unfunded commitments under the Second Lien Facility, if any, will terminate on such date. +The Second Lien Facility includes the following key provisions: +• +$125,000 master note, with initial commitments $100,000 and additional availability of $25,000 with consent of 66 2/3% of the lenders and compliance with financial covenants after giving effect to such increase; +• +Maturity date of September 11, 2019; +• +No mandatory prepayments unless new debt is issued; +• +Prepayable at any time. The prepayment premium shall be applicable to the amount of the applicable prepayment multiplied by (i) 102% if such prepayment event occurs prior to the first anniversary of the Closing Date and (ii) 101% if such prepayment event occurs on or after the first but prior to the second anniversary of the Closing Date. No such prepayment premium shall be payable for prepayments made on or after the second anniversary of the closing date; +• +Interest expense at a rate of LIBOR plus 7.75% , calculated on a per annum basis; +• +A commitment fee equal to 0.5% calculated on a per annum basis on the unused portion of the initial commitment amount until March 11, 2015; +• +The amounts funded on the initial draw date shall be issued with an original issue discount of 1.00% and each subsequent draw shall be subject to the same 1.00% original issue discount on the drawn amount, applied on the date such draw is funded; and +• +Secured by junior liens on properties mortgaged under the Amended Credit Facility, subject to an intercreditor agreement. +The Second Lien Facility contains various affirmative and restrictive covenants. +65 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +13% Senior Notes due 2016 (the “Senior Notes”) and Deferred Credit +As of December 31, 2013 , the Company had principal outstanding of $48,481 related to its 13% Senior Notes. The interest coupon is payable on the last day of each quarter. Certain of the Company’s subsidiaries guarantee the Company’s obligations under the unsecured Senior Notes. The subsidiary guarantors are 100% owned, all of the guarantees are full and unconditional and joint and several, the parent company has no independent assets or operations, and any subsidiaries of the parent company other than the subsidiary guarantors are minor. Upon issuing the Senior Notes in November 2009, the Company reduced the carrying amount of the Old Notes by the fair value of the common and preferred stock issued in the amount of $11,527 . The $31,507 difference between the adjusted carrying amount of the Old Notes and the face value of the Senior Notes was recorded as a deferred credit, which is being amortized as a reduction in interest expense over the life of the Senior Notes at an 8.5% effective interest rate. +The following table summarizes the Company’s deferred credit balance at December 31, 2013 : +Gross Carrying +Accumulated Amortization at +Carrying Value at +Amortization Recorded during Current Year +Estimated Annual Amortization Expense Expected to be Recognized in +Amount +December 31, 2013 +December 31, 2013 +(a) +2014 +$31,507 +$26,240 +$5,267 +$8,440 +$5,267 +(a) +Of the amount recorded as amortization during the current year, $3,165 was recorded as a reduction of interest expense and $5,275 (discussed below) was recorded as a component of the gain on early extinguishment of debt. +Using a portion of the proceeds from the sale of our interest in Medusa on December 17, 2013, the Company redeemed $48,481 of its Senior Notes, which resulted in a net $3,696 gain on the early extinguishment of debt. The gain represents the difference between the $50,057 paid (inclusive of $1,576 of redemption expenses, primarily the call premium) for Senior Notes with a carrying value of $53,756 (inclusive of the $5,275 of accelerated deferred credit amortization). +In June 2012, the Company redeemed $10,000 of its Senior Notes, which resulted in a net $1,366 gain on the early extinguishment of debt. The gain represents the difference between the $10,225 paid (inclusive of $225 of redemption expenses, primarily the call premium) for Senior Notes with a carrying value of $11,591 (inclusive of the $1,591 of accelerated deferred credit amortization). +In March 2011, the Company redeemed $31,000 of its Senior Notes using proceeds from its February 2011 equity offering, which resulted in a $1,974 gain on the early extinguishment of debt. The gain represents the difference between the $35,062 paid (inclusive of the $4,062 of redemption expenses, primarily the call premium) for Senior Notes with a carrying value of $37,004 (inclusive of the $6,004 of accelerated deferred credit amortization). +On March 11, the Company provided notice to holders of its outstanding Senior Notes that it expects to redeem those notes on April 11, 2014 using proceeds from the previously discussed Second Lien Facility. The redemption will result in the acceleration of the amortization of the remaining $5,267 of deferred credit as reflected in the table above. +Restrictive Covenants +The Indenture governing our Senior Notes and the Company’s Credit Facility contains various covenants including restrictions on additional indebtedness and payment of cash dividends. In addition, Callon’s Credit Facility contains covenants for maintenance of certain financial ratios. The Company was in compliance with these covenants at December 31, 2013 . +66 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +NOTE 5 – Derivative Instruments and Hedging Activities +Objectives and Strategies for Using Derivative Instruments +The Company is exposed to fluctuations in oil and natural gas prices on the majority of its production. Consequently, the Company believes it is prudent to manage the variability in cash flows on a portion of its oil and natural gas production. The Company utilizes primarily a mix of collar, swap, put and call derivative financial instruments to manage fluctuations in cash flows resulting from changes in commodity prices. The Company does not use these instruments for speculative or trading purposes. +Counterparty risk and offsetting +The use of derivative transactions exposes the Company to the risk that a counterparty will be unable to meet its commitments. While the Company monitors counterparty creditworthiness on an ongoing basis, it cannot predict sudden changes in counterparties’ creditworthiness. In addition, even if such changes are not sudden, the Company may be limited in its ability to mitigate an increase in counterparty credit risk. Should one of these counterparties not perform, the Company may not realize the benefit of some of its derivative instruments under lower commodity prices. Counterparty credit risk is considered when determining a derivative instruments’ fair value; See Note 6 for additional information regarding fair value. +The Company executes commodity derivative transactions under master agreements that have netting provisions that provide for offsetting payables against receivables. In general, if a party to a derivative transaction incurs an event of default, as defined in the applicable agreement, the other party will have the right to demand the posting of collateral, demand a cash payment transfer or terminate the arrangement. +Financial statement presentation and settlements +Settlements of the Company’s derivative instruments are based on the difference between the contract price or prices specified in the derivative instrument and a New York Mercantile Exchange (“NYMEX”) price. The fair value of the Company’s derivative instruments, depending on the type of instruments, was determined by the use of present value methods or standard option valuation models with assumptions about commodity prices based on those observed in underlying markets. See Note 6 for additional information regarding fair value. +Beginning in 2012, the Company elected not to designate its executed derivative contracts, nor does it expect to designate future derivative contracts, as an accounting hedge under FASB ASC 815. Consequently, any derivative contract not designated as an accounting hedge will be carried at its fair value on the balance sheet and marked-to-market at the end of each period, with the change in value reflected as a gain or loss on the statement of operations. Gains and losses on derivatives that are not designated as hedges are recorded in earnings as a component of gain (loss) on derivative contracts. Within the gain (loss) on derivative contracts line of the statement of operations are gains (losses) on derivatives, net of settlement and gains (losses) on derivatives, settled. +Prior to 2012, the Company’s derivative contracts recorded on the Consolidated Balance Sheets were designated as cash flow hedges, and were recorded at fair market value with the changes in fair value recorded net of tax through OCI in stockholders’ equity. The cash settlements on effective derivative contracts were recorded as an increase or decrease in oil and natural gas sales. +The following table reflects the fair values of the Company’s derivative instruments for the periods presented (none of which were designated as hedging instruments under ASC 815): +Balance Sheet Presentation +Asset Fair Value +Liability Fair Value +Net Derivative Fair Value +Commodity +Classification +Line Description +12/31/13 +12/31/12 +12/31/13 +12/31/12 +12/31/13 +12/31/12 +Derivatives not designated as Hedging Instruments under ASC 815 +Natural gas +Current +Fair market value of derivatives +$ +60 +$ +— +$ +— +$ +(125 +) +$ +60 +$ +(125 +) +Natural gas +Non-current +Other long-term liabilities +— +— +(72 +) +(116 +) +(72 +) +(116 +) +Oil +Current +Fair market value of derivatives +— +1,674 +(1,036 +) +— +(1,036 +) +1,674 +Oil +Non-current +Other long-term assets +— +250 +— +— +— +250 +Totals +$ +60 +$ +1,924 +$ +(1,108 +) +$ +(241 +) +$ +(1,048 +) +$ +1,683 +67 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +The Company’s derivative contracts are subject to netting arrangements and, being representative of the way in which the contracts settle, are presented in the balance sheet at their fair values on a net basis based on the underlying commodity being hedged. The following presents the impact of this presentation to the Company’s recognized assets and liabilities at December 31, 2013 : +Presented without +As Presented with +Effects of Netting +Effects of Netting +Effects of Netting +Current assets: Fair value of hedging contracts +$ +8 +$ +52 +$ +60 +Long-term assets: Fair value of hedging contracts +— +— +— +Current liabilities: Fair value of hedging contracts +1,088 +(52 +) +1,036 +Long-term liabilities: Fair value of hedging contracts +(72 +) +— +(72 +) +Derivatives not designated as hedging instruments under ASC 815 +For the periods indicated, the Company recorded the following related to its derivative instruments that were not designated as accounting hedges and are recorded in the Statement of Operations as gain or loss on derivative contracts: +For the year ended December 31, +2013 +2012 +2011 +Natural gas derivatives +Net (loss) gain on derivatives, settled +$ +(147 +) +$ +34 +$ +— +Net gain (loss) on derivatives, net of settlements +229 +(241 +) +— +Subtotal gain (loss), net +$ +82 +$ +(207 +) +$ +— +Oil derivatives +Net gain, on derivatives, settled +$ +1,518 +$ +— +$ +— +Net (loss) gain on derivatives, net of settlements +(2,960 +) +1,924 +— +Subtotal (loss) gain, net +$ +(1,442 +) +$ +1,924 +$ +— +Total (loss) gain on derivative instruments included in Statement of Operations +$ +(1,360 +) +$ +1,717 +$ +— +Derivatives designated as hedging instruments under ASC 815 +The table below presents the effect of the Company’s derivative financial instruments on the consolidated statements of operations as an increase (decrease) to oil and natural gas sales for the effective portion and as an increase (decrease) to other (income) expense for the ineffective portion and amounts excluded from effectiveness testing: +For the year ended December 31, +2013 +2012 +2011 +Amount of gain (loss) reclassified from OCI into income (effective portion) +$ +— +$ +1,420 +$ +(375 +) +Amount of gain (loss) recognized in income (ineffective portion and amount excluded from effectiveness testing) +— +— +— +68 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +Derivative positions +In the first quarter of 2013, the Company monetized the remaining portion of its 2013 oil collar positions (for the period February - December 2013) of 40 Bbls per month. The proceeds from this transaction, combined with the proceeds from the sale of the below listed put for 30 Bbls per month, were used to finance the uplift in the oil swap for the period February - December 2013. +Listed in the table below are the outstanding oil and natural gas derivative contracts as of December 31, 2013 : +Commodity +Instrument +Average Notional Volumes per Month +Quantity Type +Put/Call Price +Fixed-Price Swap +Period +Designation under ASC 815 +Natural gas +Call Option +38 +MMBtu +$ +4.75 +n/a +Jan14 - Mar14 +Not Designated +Natural gas +Swap +60 +MMBtu +n/a +$ +4.36 +Jan14 - Mar14 +Not Designated +Natural gas +Call Option +38 +MMBtu +$ +4.75 +n/a +Jan14 - Dec14 +Not Designated +(a) +Oil +Swap +30 +Bbls +n/a +$ +93.35 +Jan14 - Dec14 +Not Designated +Oil +Put Option +30 +Bbls +$ +70.00 +n/a +Jan14 - Dec14 +Not Designated +Oil +Swap +9 +Bbls +n/a +$ +94.58 +Jan14 - Dec14 +Not Designated +Natural gas +Swap +46 +MMBtu +n/a +$ +4.25 +Apr14 - Dec14 +Not Designated +Natural gas +Call Option +38 +MMBtu +$ +4.75 +n/a +Apr14 - Dec14 +Not Designated +Natural gas +Call Option +37 +MMBtu +$ +5.00 +n/a +Jan15 - Dec15 +Not Designated +(a) +The short natural gas call option, when combined with the Company’s long production position, represents a “covered call,” and creates a $4.75 /MMbtu ceiling during the covered period. +Subsequent Event Activity: +Derivative contracts executed subsequent to December 31, 2013 include the following: +Commodity +Instrument +Average Notional Volumes per Month +Quantity Type +Put/Call Price +Fixed-Price Swap +Period +Designation under ASC 815 +Oil +Swap +15 +Bbls +n/a +$ +94.15 +Feb14 - Mar14 +Not Designated +Oil +Swap +15 +Bbls +n/a +$ +92.80 +Apr14 - Jun14 +Not Designated +Oil +Swap +15 +Bbls +n/a +$ +90.40 +Jul14 - Sep14 +Not Designated +Oil +Swap +15 +Bbls +n/a +$ +88.64 +Oct14 - Dec14 +Not Designated +NOTE 6 – Fair Value Measurements +Fair value is defined within the accounting rules as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The rules established a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. As presented in the tables below, this hierarchy consists of three broad levels: +Level 1 +Valuations consist of unadjusted quoted prices in active markets for identical assets and liabilities and has the highest priority. +Level 2 +Valuations rely on quoted prices in markets that are not active or observable inputs over the full term of the asset or liability. +Level 3 +Valuations are based on prices or third party or internal valuation models that require inputs that are significant to the fair value measurement and are less observable and thus have the lowest priority. +69 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +Fair Value of Financial Instruments +Cash, Cash Equivalents, and Short-Term Investments. The carrying amounts for these instruments approximate fair value due to the short-term nature or maturity of the instruments. +Debt. The Company’s debt is recorded at the carrying amount on its Consolidated Balance Sheet. The fair value of Callon’s fixed-rate debt, which is valued using Level 2 inputs, is based upon estimates provided by an independent investment banking firm. The carrying amount of floating-rate debt approximates fair value because the interest rates are variable and reflective of market rates. +The following table summarizes the respective carrying and fair values at: +For the year ended December 31, +2013 +2012 +Carrying Value +Fair Value +Carrying Value +Fair Value +Credit Facility +$ +22,000 +$ +22,000 +$ +10,000 +$ +10,000 +13% Senior Notes due 2016 (a) +53,748 +50,299 +110,668 +100,112 +Total +$ +75,748 +$ +72,299 +$ +120,668 +$ +110,112 +(a) +2013 and 2012 fair values are calculated only in relation to the $48,481 and $96,961 face value outstanding of the 13% Senior Notes, respectively. The remaining $5,267 and $13,707 , respectively represents the Company’s deferred credits and have been excluded from the fair value calculation. See Note 4 for additional information. +Assets and Liabilities Measured at Fair Value on a Recurring Basis +Certain assets and liabilities are reported at fair value on a recurring basis (unless otherwise noted below) in Callon’s Consolidated Balance Sheet. The following methods and assumptions were used to estimate the fair values: +Commodity Derivative Instruments. The fair value of commodity derivative instruments is derived using a valuation model that utilizes market-corroborated inputs that are observable over the term of the derivative contract, and the values are corroborated by quotes obtained from counterparties to the agreements. The Company’s fair value calculations also incorporate an estimate of the counterparties’ default risk for derivative assets and an estimate of the Company’s default risk for derivative liabilities. The Company believes that the majority of the inputs used to calculate the commodity derivative instruments fall within Level 2 of the fair-value hierarchy based on the wide availability of quoted market prices for similar commodity derivative contracts. See Note 5 for additional information regarding the Company’s derivative instruments. +The following tables present the Company’s assets and liabilities measured at fair value on a recurring basis for each hierarchy level: +December 31, 2013 +Balance Sheet Presentation +Level 1 +Level 2 +Level 3 +Total +Assets +Derivative financial instruments - current Portion +Fair market value of derivatives +$ +— +$ +60 +$ +— +$ +60 +Derivative financial instruments - non-current +Other assets, net +— +— +— +— +Sub-total assets +$ +— +$ +60 +$ +— +$ +60 +Liabilities +Derivative financial instruments - current portion +Fair market value of derivatives +$ +— +$ +1,036 +$ +— +$ +1,036 +Derivative financial instruments - non-current +Other long-term liabilities +— +72 +— +72 +Sub-total liabilities +$ +— +$ +1,108 +$ +— +$ +1,108 +Total +$ +— +$ +(1,048 +) +$ +— +$ +(1,048 +) +70 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +December 31, 2012 +Balance Sheet Presentation +Level 1 +Level 2 +Level 3 +Total +Assets +Derivative financial instruments - current portion +Fair market value of derivatives +$ +— +$ +1,674 +$ +— +$ +1,674 +Derivative financial instruments - non-current +Other assets, net +— +250 +— +250 +Sub-total assets +$ +— +$ +1,924 +$ +— +$ +1,924 +Liabilities +Derivative financial instruments - current portion +Fair market value of derivatives +$ +— +$ +125 +$ +— +$ +125 +Derivative financial instruments - non-current +Other long-term liabilities +— +116 +— +116 +Sub-total liabilities +$ +— +$ +241 +$ +— +$ +241 +Total +$ +— +$1,683 +$ +— +$1,683 +The derivative fair values above are based on analysis of each contract. Derivative assets and liabilities with the same counterparty are presented here on a gross basis, even where the legal right of offset exists. See Note 5 for a discussion of net amounts recorded in the Consolidated Balance Sheet at December 31, 2013 . +Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis +Certain assets and liabilities are reported at fair value on a nonrecurring basis in Callon’s Consolidated Balance Sheet. The following methods and assumptions were used to estimate the fair values: +Other Property and Equipment. As discussed in Note 13 , the Company’s decision to abandon certain of its other property and equipment, that had been classified as held for sale, resulted in an impairment charge of $1,707 which is included in the Company’s Statement of Operations for the year ended December 31, 2013 . The impairment charge was valued using level 3 inputs. +Acquisition. During the second quarter of 2013 , the Company acquired approximately 2,468 gross ( 2,186 net) acres in Reagan and Upton Counties, Texas, which is located in the southern portion of the Midland Basin for a purchase price of $11,000 . The acquisition also included seven gross vertical wells and 1,301 barrels of oil equivalent proved reserves. The Company valued the acquired assets in accordance with the method described below. In accordance with the acquisition method of accounting, the purchase price of the Company’s acquisition during the period has been allocated to the assets acquired and liabilities assumed based on their estimated fair values on the acquisition date. In valuing the acquired assets and liabilities assumed, fair values were based on expected future cash flows based on estimated reserve quantities; costs to produce and develop reserves; and oil and gas forward prices. The purchase price of the Company’s acquisition during the period was $11,000 with approximately $2,000 allocated to unevaluated oil and gas properties and approximately $9,000 allocated to evaluated oil and gas properties. Asset retirement obligations assumed in connection with the transaction were insignificant due to the nature of the properties acquired. The unaudited pro forma results of the properties acquired are immaterial to the Company’s financial statements. The fair value measurements were based on significant inputs not observable in the market and thus represent a level 3 measurement. +NOTE 7 – Employee Benefit Plans +The Company utilizes various forms of incentive compensation designed to align the interest of the executives and employees with those of its stockholders. Tabular disclosures related to the share-based awards are presented in Note 8 . The narrative that follows provides a brief description of each plan, summarizes the overall status of each plan and discusses current year awards under each plan: +Savings and Protection Plan +The Savings and Protection Plan (“401-K Plan”) provides employees with the option to defer receipt of a portion of their compensation, and the Company may, at its discretion, match a portion of the employee’s deferral with cash. The Company may also elect, at its discretion, to contribute a non-matching amount in cash and Company Common Stock to employees. The amounts held under the 401-K Plan are invested in various funds maintained by a third party in accordance with the directions of each employee. An employee is fully vested, including Company discretionary contributions, immediately upon participation in the 401-K Plan. The total amounts contributed by the Company, including the value of the common stock contributed, were $923 , $918 and $811 in the years 2013 , 2012 and 2011 , respectively. +71 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +2011 Omnibus Incentive Plan (the “2011 Plan”) +The 2011 Plan, which became effective May 12, 2011 following shareholder approval, authorized and reserved for issuance 2,300 shares of common stock, which may be issued upon exercise of vested stock options and/or the vesting of any other share-based equity award that is granted under this plan. The 2011 Plan is the Company’s only active plan, and included a provision at inception whereby all remaining, un-issued and authorized shares from the Company’s previous share-based incentive plans became issuable under the 2011 Plan. This transfer provision resulted in the transfer of an additional 841 shares into the plan, increasing the quantity authorized and reserved for issuance under the Plan to 3,141 at the inception of the plan. Another provision provided that shares which would otherwise become available for issue under the previous plans as a result of vesting and/or forfeiture of any equity awards existing as of May 12, 2012, would also increase the authorized shares available to the 2011 Plan. As of December 31, 2013 , the 2011 Plan had 1,192 shares remaining and eligible for future issuance. +Equity awards issued under this plan may be subject to various vesting, accelerated vesting, and forfeiture provisions upon the occurrence of certain events. Any vested but unexercised options contractually expire 10 years from the date of grant. Equity awards under the 2011 Plan generally vest over time but may also be subject to attaining a specified performance metrics and may be immediate or cliff vest at a specified date. The Company will recognize expense on the grant date for all immediately vesting awards, while it will recognize expense ratably over the requisite service (i.e. vesting) period for both cliff and ratably vesting awards. For performance-based awards, the Company recognizes expense based on its analysis of the performance criteria, and records or reverses expense as necessary based on its analysis. For market-based awards, the Company recognizes expense based on its analysis of the market criteria, and records expense as necessary based on its analysis. Awards with a market-based provision do not allow for the reversal of previously recognized expense, even if the market metric is not achieved and no shares ultimately vest or are awarded. +Cash-Settleable RSU Awards +Certain of the Company’s RSUs awarded require cash-settlement. Cash-settleable RSU awards are accounted for as liabilities as the Company is contractually obligated to settle these awards in cash, and are recorded in the Company’s consolidated balance sheet for the ratable portion of their fair values. The fair value of the Company’s market-based RSU is calculated using a Monte Carlo valuation model, which considers such inputs as the Company’s and its peer group’s stock prices, a risk-free interest rate, and an estimated volatility for the Company and its peer group. Changes in the fair value of cash-settleable awards are recorded as adjustments to compensation expense. +Market-based RSUs : A significant portion of the Company’s cash-settleable RSU awards include a market-based vesting condition and may ultimately vest at a quantity different than the base RSUs awarded. The number of RSUs that cliff-vest is based on a calculation that compares the Company’s total shareholder return to the same calculated return of a group of peer companies as selected by the Company, and the number of units that will vest can range between 0% and 200% of the base units awarded. +As of December 31, 2013 , the Company had the following cash-settleable RSU awards outstanding (including those that are not based on a market condition): +Base Units +Potential Minimum +Potential Maximum +Outstanding at +Units at Vesting at +Units at Vesting at +Vesting in 2014 +510 +45 +975 +Vesting in 2015 +909 +60 +1,758 +Vesting in 2016 +66 +66 +66 +Other +92 +92 +92 +Total cash-settleable RSU awards +1,577 +263 +2,891 +For the year ended December 31, 2013 , 260 market-based cash-settleable RSUs subject to the peer market-based vesting described above vested at 100% of their issued units, resulting in a cash payment of $1,669 . Also during 2013, 65 non-market-based cash settleable RSUs vested, resulting in a cash payment of $239 . During 2012, 364 market-based cash-settleable RSUs vested at 150% , resulting in a cash payment of $2,626 . Also during 2012, 143 non-market-based cash settleable RSUs vested, resulting in a cash payment of $763 . See Note 8 for additional information regarding cash-settleable RSUs. +72 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +NOTE 8 - Share-Based Compensation +As discussed in Note 7 , the Company grants various forms of share-based compensation awards to employees of the Company and its subsidiaries and to non-employee members of the Board of Directors. At December 31, 2013 , shares available for future share-based awards, including stock options or restricted stock grants, under the Company’s only active plan, the 2011 Plan, were 1,192 . +The following table presents share-based compensation expense for each respective period: +For the year ended December 31, +2013 +2012 +2011 +Share-based compensation expense for: +Equity-based +Liability-based +Equity-based +Liability-based +Equity-based +Liability-based +Options +$ +— +$ +— +$ +— +$ +— +$ +24 +$ +— +RSU equity awards +3,975 +— +4,210 +— +2,832 +— +Cash-settleable RSU awards +— +5,347 +— +2,916 +— +1,335 +401(k) contributions in shares +219 +— +218 +— +202 +— +Total share-based compensation expense (a) +$ +4,194 +$ +5,347 +$ +4,428 +$ +2,916 +$ +3,058 +$ +1,335 +(a) +The portion of this share-based compensation expense that was included in general and administrative expense totaled $5,751 , $4,081 and $2,502 for the same years respectively, and the portion capitalized to oil and gas properties was $3,791 , $3,263 and $1,891 , respectively. +The following table presents the specified share-based compensation expense for the indicated periods: +For the year ended December 31, +Unrecognized compensation costs related to: +2013 +2012 +2011 +Unvested RSU equity awards +5,331 +6,320 +5,748 +Unvested cash-settleable RSU awards +7,669 +2,826 +2,498 +The Company’s future expected share-based compensation cost related to unvested RSU and cash-settleable RSU awards is expected to be recognized over a weighted-average period of 1.4 years. +The following table summarizes the Company’s cash-settleable RSU awards for the periods indicated: +Consolidated Balance Sheets Classification +2013 +2012 +2011 +Accounts payable and accrued liabilities - current portion +$ +4,173 +$ +1,429 +$ +604 +Other long-term liabilities - non-current portion +3,409 +1,017 +2,309 +Total cash-settleable RSU awards +$ +7,582 +$ +2,446 +$ +2,913 +Stock Options +The Company issued no stock options for the past three years and had no options vest or forfeit during 2013 . Additionally, no options were exercised, 15 options expired unexercised during the year. As of December 31, 2013 , the Company had 52 options outstanding and exercisable at a weighted average exercise price per option of $13.75 , with no aggregate intrinsic value and with a weighted-average remaining contract life per unit of 2.3 years. +As of December 31, 2012 , the Company had 67 options outstanding and exercisable at a weighted average exercise price per option of $11.82 , with no aggregate intrinsic value and with a weighted-average remaining contract life per unit of 2.7 years. The Company net-share settles option exercises and therefore receives no cash proceeds from the exercise of stock options. +73 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +Restricted Stock Units +The following table represents unvested restricted stock activity for the year ended December 31, 2013 : +Weighted average +Number of Shares +Grant-Date Fair Value per Share +Period over which expense is expected to be recognized +Outstanding at the beginning of the period +2,295 +$ +5.58 +Granted +944 +3.82 +Vested (a) +(754 +) +5.10 +Forfeited +(223 +) +5.37 +Outstanding at the end of the period +2,262 +$ +5.03 +1.5 +a. +The fair value of shares vested was $2,689 . +NOTE 9 – Equity Transactions +On May 30, 2013, the Company issued 78,947 of 10.0% Series A Cumulative Preferred Stock (the “Preferred Stock”) and received $70,035 net proceeds after deducting the underwriting commissions and offering expenses. The sale consisted of 1,579 shares of Preferred Stock, par value $0.01 per share, public offering price of $47.50 per share and liquidation preference of $50.00 per share in an underwritten public offering. The Preferred Stock ranks senior to the Company’s common stock with respect to the payment of dividends and distribution of assets upon liquidation or dissolution. The Preferred Stock has no stated maturity and is not subject to mandatory redemption or any sinking fund. The Preferred Stock will remain outstanding indefinitely unless repurchased by the Company or converted into Callon common stock in connection with certain changes in control as defined in the Preferred Stock prospectus. +Holders of the Preferred Stock are entitled to receive, when, as and if declared by our Board of Directors (the “Board”), out of funds legally available for the payment of dividends, cumulative cash dividends at a rate of 10.0% per annum of the $50.00 liquidation preference per share (equivalent to $5.00 per annum per share). Dividends are payable quarterly in arrears on the last day of each March, June, September and December when, as and if declared by our Board. The first dividend date for the Preferred Stock was June 30, 2013, and these dividends were paid on June 28, 2013 (as June 30 fell on a weekend) in the amount of $0.43 per share or $679 for the stub period beginning with the issuance on May 30, 2013 through the dividend date on June 30, 2013. For the subsequent quarters ended September 30 and December 31, 2013, the Board of Directors declared for each quarter a dividend of $1.25 per share, or a total of $1,974 , on the Company’s Preferred Stock, resulting in total dividend expense recognized in 2013 of $4,627 . +Beginning on May 30, 2018, the Company may, solely at its option, redeem the Preferred Stock in whole at any time, or in part from time to time, for cash at a redemption price of $50.00 per share, plus accrued and unpaid dividends (whether or not declared) to the redemption date. The Company may redeem the Preferred Stock following certain changes of control as defined in the Preferred Stock prospectus, in whole or in part, within 120 days after the date on which the change of control has occurred, for cash at $50.00 per share, plus accrued and unpaid dividends (whether or not declared) to the redemption date. If the Company elects not to exercise this option, the holders of the Preferred Stock have the option to convert each share of Preferred Stock into a predefined number of Company common shares, subject to certain adjustments. +As defined in a provision of the Preferred Stock prospectus, the common shares reserved for issuance vary based on the number of authorized common shares. Based on the Company’s 60,000 authorized shares at December 31, 2013, 16,800 shares were reserved for a potential conversion. Subsequent to December 31, 2013, via a majority shareholder vote, the number of authorized shares of common stock was increased from 60,000 to 110,000 with a corresponding increase in the number of common shares reserved for a potential conversion to a maximum of 42,200 shares. Based on the Company’s closing common stock price of $6.53 per share on December 31, 2013, the Company reserved 12,090 shares to satisfy the potential conversion. +Except as required by law, holders of the Preferred Stock will have no voting rights unless dividends fall into arrears for six or more quarterly periods (whether or not consecutive). In that event and until such dividends in arrears are paid in full, the holders will be entitled to elect two directors to the Board, which will increase in size by that same number of directors. +74 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +During February, 2011, the Company received $73,765 in net proceeds from the public offering of 10.1 million shares of its common stock, which included the issuance of 1.1 million shares pursuant to the underwriters’ over-allotment option. The Company used $35,062 of the proceeds to repurchase $31,000 principal amount of its Senior Notes, with the remaining proceeds intended for general corporate purposes including the planned development of the Company’s Permian basin and other onshore assets. +NOTE 10 – Income Taxes +The following table presents Callon’s net tax benefits relating to its reported net losses and other temporary differences from operations: +For the Year Ended December 31 +2013 +2012 +Deferred tax asset +Federal net operating loss carryforward +$ +70,365 +$ +87,774 +Statutory depletion carryforward +8,880 +8,184 +Alternative minimum tax credit carryforward +208 +208 +Asset retirement obligations +1,024 +3,357 +Other +7,575 +9,571 +Total deferred tax asset +88,052 +109,094 +Deferred tax liability +Oil and natural gas properties +26,412 +41,336 +Other +32 +3,375 +Total deferred tax liability +26,444 +44,711 +Net deferred tax asset +$ +61,608 +$ +64,383 +Prior to 2012, the Company carried a full valuation allowance against its net deferred tax assets. The Company considered both the positive and negative evidence in determining whether it was more likely than not that its deferred tax assets were recoverable. The Company incurred a loss in 2008, primarily as a result of a write-down of its oil and natural gas properties following the ceiling test, which created a loss on an aggregate basis for the three -year period ended December 31, 2008. Primarily as a result of recent cumulative losses, the Company established a full valuation allowance as of December 31, 2008, and continued to carry the full valuation allowance each reporting period until December 31, 2011. At December 31, 2011, after considering all available positive and negative evidence, including the Company’s profitable operations from 2009 to 2011 which resulted in income on an aggregate basis for the three year period ended December 31, 2011, and future operating results based on proved reserves, the Company determined that it was more likely than not that it would fully utilize its deferred tax assets recorded at December 31, 2011. Therefore, the Company reversed its valuation allowance at December 31, 2011. +If not utilized, the Company’s federal operating loss (“NOL”) carryforwards will expire as follows: +Year Expiring +Total +2014-2019 +2020-2022 +2023-2025 +2026-2028 +2029-2033 +Federal NOL carryforwards +$ +201,042 +$ +— +$ +48,986 +$ +65,878 +$ +32,714 +$ +53,464 +The Company has limited state taxable income. Accordingly, the Company has established a full valuation allowance on the tax benefits associated with the state net operating loss carryforwards of approximately $167,795 which expire in years through 2033, as the Company does not anticipate generating taxable state income in the states in which these carryforwards apply. These amounts are not included in the deferred tax summary table above. +In 2009, the Company began to shift its operational focus from exploration, development and production in the Gulf of Mexico to the acquisition and development of onshore properties. This shift in exploration and development activity resulted in an increase in Texas income from production. This, coupled with the Company’s exit from the Gulf of Mexico (the sale of its interest in the Habanero field in December 2012 and the Medusa field in December 2013), results in a change in the projected future Texas state tax rate beyond 2013 as a component of overall anticipated future taxes. +75 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +The Company had no significant unrecognized tax benefits at December 31, 2013 . Accordingly, the Company does not have any interest or penalties related to uncertain tax positions. However, if interest or penalties were to be incurred related to uncertain tax positions, such amounts would be recognized in income tax expense. Tax periods for years 2001 through 2013 remain open to examination by the federal and state taxing jurisdictions to which the Company is subject. +Below is a reconciliation of the reported amount of income tax expense attributable to continuing operations to the amount of income tax expense that would result from applying domestic federal statutory tax rates to pretax income from continuing operations. +For the Years Ended December 31, +Component of Income Tax Rate Reconciliation +2013 +2012 +2011 +Income tax expense computed at the statutory federal income tax rate +35 +% +35 +% +35 +% +Change in valuation allowance +— +% +— +% +(227 +)% +Percentage depletion carryforward +(8 +)% +(22 +)% +(3 +)% +State taxes net of federal benefit +4 +% +6 +% +— +% +Restricted stock and stock options +5 +% +2 +% +— +% +Section 162(m) +6 +% +22 +% +— +% +Other +— +% +4 +% +4 +% +Effective income tax rate +42 +% +47 +% +(191 +)% +For the Years Ended December 31, +Components of Income Tax Expense +2013 +2012 +2011 +Current federal income tax benefit +$ +— +$ +— +$ +— +Current state income tax expense +326 +110 +— +Deferred federal income tax expense +2,652 +1,777 +13,176 +Deferred state income tax expense +126 +336 +— +Valuation allowance +— +— +(82,459 +) +Total income tax expense (benefit) +$ +3,104 +$ +2,223 +$ +(69,283 +) +NOTE 11 – Asset Retirement Obligations +The following table summarizes the activity for the Company’s asset retirement obligations: +For the Year Ended December 31, +2013 +2012 +Asset retirement obligations at beginning of the period +$ +13,301 +$ +13,938 +Accretion expense +1,785 +2,253 +Liabilities incurred +679 +205 +Liabilities settled +(457 +) +(1,073 +) +Liabilities related to oil and gas properties sold +(4,765 +) +(877 +) +Revisions to estimate +(3,811 +) +(1,145 +) +Asset retirement obligations at end of period +6,732 +13,301 +Less: current asset retirement obligations +(4,120 +) +(2,336 +) +Long-term asset retirement obligations at the end of the period +$ +2,612 +$ +10,965 +Certain of the Company’s operating agreements require that assets be restricted for future abandonment obligations. Amounts recorded on the Consolidated Balance Sheets at December 31, 2013 as long-term restricted investments were $3,806 . These assets, which primarily include short-term U.S. Government securities, are held in abandonment trusts dedicated to pay future abandonment costs for several of the Company’s oil and natural gas properties. +On December 5, 2013 , the Company closed on its agreement to sell its interest in the Medusa field, Medusa Spar LLC, and substantially all of its Gulf of Mexico shelf properties to W&T Offshore, Inc. (“W&T”). Under the agreement, W&T will assume an estimated $4,765 of the ARO related to these offshore assets. +76 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +The Company’s total revisions to estimates of $3,811 for the year ended December 31, 2013 relate to downward revisions related to the changes in the expecting timing of the abandonment. +NOTE 12 – Supplemental Information on Oil and Natural Gas Operations (Unaudited) +Oil and Natural Gas Properties +The following table discloses certain financial data relating to the Company’s oil and natural gas activities, all of which are located in the United States. +For the Year Ended December 31, +Capitalized costs incurred: +2013 +2012 +2011 +Evaluated Properties- +Beginning of period balance +$ +1,497,010 +$ +1,421,640 +$ +1,316,677 +Capitalized G&A +10,014 +12,148 +11,205 +Property acquisition costs +10,885 +2,075 +— +Exploration costs +147,164 +22,703 +5,473 +Development costs +36,504 +38,444 +88,285 +End of period balance +$ +1,701,577 +$ +1,497,010 +$ +1,421,640 +Unevaluated Properties (excluded from amortization): +Beginning of period balance +$ +68,776 +$ +2,603 +$ +8,106 +Acquisitions +2,259 +29,590 +2,422 +Exploration +10,767 +34,674 +1,372 +Capitalized interest +4,410 +2,109 +573 +Transfers to evaluated +(42,990 +) +(200 +) +(9,870 +) +End of period balance +$ +43,222 +$ +68,776 +$ +2,603 +Accumulated depreciation, depletion and amortization: +Beginning of period balance +$ +1,296,265 +$ +1,208,331 +$ +1,155,915 +Provision charged to expense +42,251 +48,524 +52,416 +Sale of mineral interests +82,096 +39,410 +— +End of period balance +$ +1,420,612 +$ +1,296,265 +$ +1,208,331 +Unevaluated property costs primarily include lease acquisition costs incurred at federal lease sales, unevaluated drilling costs, seismic, capitalized interest and certain overhead costs related to exploration and development. These costs are directly related to the acquisition and evaluation of unproved properties and major development projects. The excluded costs and related reserves are included in the amortization base as the properties are evaluated and proved reserves are established or impairment is determined. The Company expects that the majority of these costs will be evaluated over the next three but within five years. The Company’s unevaluated property balance decreased by $25,554 to $43,222 at December 31, 2013 compared to December 31, 2012 . A significant portion of this decrease relates to the transfer of drilling and completion costs from the unevaluated property base to the evaluated property base. +Subsequent to December 31, 2013 and through March 10, 2014 , the Company completed six horizontal exploration wells, drilled four horizontal wells and had two in progress. Additionally, the Company drilled two vertical exploratory wells and will be evaluating the results. +Depletion per unit-of-production (BOE) amounted to $31.12 , $31.56 and $26.42 for the years ended December 31, 2013 , 2012 , and 2011 , respectively. Lease operating expense per unit-of-production (BOE) amounted to $14.00 , $14.81 , and $9.92 for the years ended December 31, 2013 , 2012 , and 2011 , respectively. +77 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +Under the full-cost accounting rules of the SEC, the Company reviews the carrying value of its proved oil and natural gas properties each quarter. Under these rules, capitalized costs of oil and natural gas properties, net of accumulated depreciation, depletion and amortization and deferred income taxes, may not exceed the present value of estimated future net cash flows from proved oil and natural gas reserves, discounted at 10%, plus the lower of cost or fair value of unevaluated properties, net of related tax effects (the full-cost ceiling amount). These rules generally require pricing based on the preceding 12-months’ average oil and natural gas prices based on closing prices on the first day of each month and require a write-down if the “ceiling” is exceeded. Given the volatility of oil and natural gas prices, it is reasonably possible that the Company’s estimate of discounted future net cash flows from proved oil and natural gas reserves could change in the near term. If oil and natural gas prices decline significantly, even if only for a short period of time, it is possible that write-downs of oil and natural gas properties could occur in the future. For the years ended December 31, 2013 , 2012 , and 2011 , the Company recorded no impairment charges related to its oil and natural gas properties as a result of this calculation. +Estimated Reserves +The Company’s proved oil and natural gas reserves at December 31, 2013 , 2012 and 2011 have been estimated by Huddleston & Co., Inc., the Company’s independent petroleum engineers. The reserves were prepared in accordance with guidelines established by the SEC. Accordingly, the following reserve estimates are based upon existing economic and operating conditions. +There are numerous uncertainties inherent in establishing quantities of proved reserves. The following reserve data represents estimates only, and should not be deemed exact. In addition, the standardized measure of discounted future net cash flows should not be construed as the current market value of the Company’s oil and natural gas properties or the cost that would be incurred to obtain equivalent reserves. +78 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +Changes in the estimated net quantities of oil and natural gas reserves, all of which are located onshore within the continental United States and offshore within the Gulf of Mexico, are as follows: +Reserve Quantities +For the year ended December 31, +2013 +2012 +2011 +Proved developed and undeveloped reserves: +Oil (MBbls): +Beginning of period +10,780 +10,075 +8,149 +Revisions to previous estimates +(2,540 +) +(488 +) +(110 +) +Purchase of reserves in place +150 +38 +— +Sale of reserves in place +(3,294 +) +(504 +) +(30 +) +Extensions and discoveries +7,713 +2,636 +3,062 +Production +(911 +) +(977 +) +(996 +) +End of period +11,898 +10,780 +10,075 +Natural Gas (MMcf): +Beginning of period +19,753 +35,118 +32,957 +Revisions to previous estimates +(5,351 +) +(10,838 +) +486 +Purchase of reserves in place +317 +115 +— +Sale of reserves in place +(4,576 +) +(4,404 +) +(308 +) +Extensions and discoveries +10,619 +3,350 +7,064 +Production +(3,011 +) +(3,588 +) +(5,081 +) +End of period +17,751 +19,753 +35,118 +Proved developed reserves: +Oil (MBbls): +Beginning of period +4,955 +5,069 +4,503 +End of period +5,960 +4,955 +5,069 +Natural Gas (MMcf): +Beginning of period +10,680 +11,605 +12,715 +End of period +9,059 +10,680 +11,605 +MBOE: +Beginning of period +6,735 +7,003 +6,622 +End of period +7,470 +6,735 +7,003 +Proved undeveloped reserves: +Oil (MBbls): +Beginning of period +5,825 +5,006 +3,645 +End of period +5,938 +5,825 +5,006 +Natural Gas (MMcf): +Beginning of period +9,073 +23,513 +20,241 +End of period +8,692 +9,073 +23,513 +MBOE +Beginning of period +7,337 +8,925 +7,019 +End of period +7,387 +7,337 +8,925 +Total Proved Reserves: The Company ended 2013 with estimated net proved reserves of 14,857 MBOE, representing a 6% increase over 2012 year-end estimated net proved reserves of 14,072 MBOE. The increase is primarily due the Company’s development of its Permian basin, on which it drilled a total of 26 oil wells during 2013 . The increase is offset by the sale of the Company’s interest in the Medusa field and due to the Company’s reclassification of certain vertical PUD locations to the horizontal probable and PUD categories. +Extrapolation of performance history and material balance estimates were utilized by the Company’s independent petroleum and geological firm to project future recoverable reserves for the producing properties where sufficient history existed to suggest performance trends and where these methods were applicable to the subject reservoirs. The projections for the remaining producing properties were necessarily based on volumetric calculations and/or analogy to nearby producing completions. Reserves assigned to nonproducing zones and undeveloped locations were projected on the basis of volumetric calculations and analogy to nearby production, and to a small extent, horizontal PDP and PUD categories. +79 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +Proved Undeveloped Reserves: The Company annually reviews its proved undeveloped reserves (“PUDs”) to ensure an appropriate plan for development exists. Generally, reserves for the Company’s onshore properties are booked as PUDs only if the Company has plans to convert the PUDs into proved developed reserves within five years of the date they are first booked as PUDs. The Company’s PUDs increased 1% to 7,387 MBOE from 7,337 MBOE at December 31, 2013 and 2012 , respectively. The Company added 5,168 MBOE to its PUDs, primarily from the continued horizontal development of its Permian Basin properties. The increase in Permian Basin PUDs was partially offset by the reclassification of 3,724 MBOE, or 51% , included in the year-end 2012 PUD reserves related to vertical PUD locations that were reclassified to the horizontal probable, and to a small extent, horizontal PDP and PUD categories. The reclassified vertical PUDs include Wolfberry PUD locations that included certain target zones that are now expected to be more efficiently developed by the Company’s multi-level horizontal drilling programs initiated in 2012. Also offsetting the Permian Basin PUD growth were the sale of 1,297 MBOE, or 18% , included in the year-end 2012 PUD reserves related to our Medusa field and the conversion of a small portion of 2012 PUD reserves to PDPs during 2013 from the drilling of vertical wells. +The Company’s PUDs decreased 18% to 7,337 MBOE from 8,925 MBOE at December 31, 2012 and 2011, respectively. Additions during the year added 2,344 MBOE to the Company’s PUDs, offset by (1) 557 MBOE primarily comprised of transfers to PDPs as a result of our development program, (2) 1,148 MBOE related to the sale of Habanero, and (3) 2,227 MBOE related to reductions in our PUD reserves, primarily related to the Haynesville Shale, by amounts no longer deemed to be economic PUDs at year-end. Of the Company’s year-end 2011 PUD reserves, 6% were converted to proved developed producing reserves by year end 2012, at a total cost of approximately $19 million , net. +Of the Company’s 2012 PUDs, 1,297 MBOE were attributable to the Company’s offshore properties in the Medusa field in the Gulf of Mexico. As previously noted, the Company sold its interest in the Medusa field during 2013. +Standardized Measure +The following tables present the standardized measure of future net cash flows related to estimated proved oil and natural gas reserves together with changes therein, including a reduction for estimated plugging and abandonment costs that are also reflected as a liability on the balance sheet at December 31, 2013 . You should not assume that the future net cash flows or the discounted future net cash flows, referred to in the tables below, represent the fair value of our estimated oil and natural gas reserves. Prices are based on either the preceding 12-months’ average price based on closing prices on the first day of each month, or prices defined by existing contractual arrangements. The following table summarizes the average 12-month oil and natural gas prices net of differentials for the respective periods: +2013 +2012 +2011 +Average 12-month price, net of differentials, per Mcf of natural gas +$ +5.45 +$ +4.81 +$ +5.60 +Average 12-month price, net of differentials, per barrel of oil +$ +92.16 +94.68 +98.98 +Future production and development costs are based on current costs with no escalations. Estimated future cash flows net of future income taxes have been discounted to their present values based on a 10% annual discount rate. +Natural gas production from our deepwater and Permian Basin properties has a high Btu content of separator natural gas. The natural gas Mcf prices of $5.45 and $4.81 used in the 2013 and 2012 reserve estimates include adjustments to reflect the Btu content, transportation charges and other fees specific to the individual properties. The oil prices of $92.16 and $94.68 used in the 2013 and 2012 reserve estimates have been adjusted to reflect all wellhead deductions and premiums on a property-by-property basis, including transportation costs, location differentials and crude quality. +80 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +Standardized Measure +For the year ended December 31, +2013 +2012 +2011 +Future cash inflows +$ +1,193,299 +$ +1,115,570 +$ +1,194,079 +Future costs - +Production +(357,005 +) +(249,329 +) +(356,653 +) +Development and net abandonment +(155,667 +) +(273,817 +) +(268,628 +) +Future net inflows before income taxes +680,627 +592,424 +568,798 +Future income taxes +(68,239 +) +(55,772 +) +(78,813 +) +Future net cash flows +612,388 +536,652 +489,985 +10% discount factor +(328,442 +) +(305,504 +) +(219,628 +) +Standardized measure of discounted future net cash flows +$ +283,946 +$ +231,148 +$ +270,357 +Changes in Standardized Measure +For the year ended December 31, +2013 +2012 +2011 +Standardized measure at the beginning of the period +$ +231,148 +$ +270,357 +$ +198,916 +Changes +Sales and transfers, net of production costs +(78,661 +) +(84,044 +) +(107,297 +) +Net change in sales and transfer prices, net of production costs +(46,088 +) +47,261 +125,518 +Net change due to purchases and sales of in place reserves +(145,711 +) +(35,665 +) +1,275 +Extensions, discoveries, and improved recovery, net of future production and development costs incurred +212,431 +53,446 +22,598 +Changes in future development cost +153,983 +39,815 +(83,110 +) +Revisions of quantity estimates +(68,958 +) +(77,322 +) +(949 +) +Accretion of discount +25,010 +30,989 +68,384 +Net change in income taxes +1,751 +13,969 +(32,918 +) +Changes in production rates, timing and other +(959 +) +(27,658 +) +77,940 +Aggregate change +52,798 +(39,209 +) +71,441 +Standardized measure at the end of period +$ +283,946 +$ +231,148 +$ +270,357 +NOTE 13 – Other +Commitments and Contingencies: The Company is involved in various claims and lawsuits incidental to its business. In the opinion of management, the ultimate liability hereunder, if any, will not have a material adverse effect on the financial position or results of operations of the Company. +The Company’s activities are subject to federal, state and local laws and regulations governing environmental quality and pollution control. Although no assurances can be made, the Company believes that, absent the occurrence of an extraordinary event, compliance with existing federal, state and local laws, rules and regulations governing the release of materials into the environment or otherwise relating to the protection of the environment are not expected to have a material effect upon the capital expenditures, earnings or the competitive position of the Company with respect to its existing assets and operations. The Company cannot predict what effect additional regulation or legislation, enforcement policies hereunder, and claims for damages to property, employees, other persons and the environment resulting from the Company’s operations could have on its activities. +Global Settlement with Joint Interest Partner: During 2011, the Company and a joint interest partner entered into a settlement agreement related to various disputes. All matters were settled and as result of the settlement agreement the Company received an interest in other specialized deep water property and equipment. The Company recognized a gain of $5,041 as a result of the settlement and classified the property and equipment received as held for sale assets, included within other property and equipment since the Company had no use for this type of equipment in its operations. Since the settlement with its joint interest partner, the Company has sold a portion of these assets and has continued to actively market the remaining assets throughout 2012 and 2013. During 2012, after selling assets valued at $527 during the year, the Company determined that certain equipment components were not usable without additional rework and thus recorded an impairment charge to its Statement of Operations of $1,177 during +81 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +2012. During 2013, after selling assets value at $114 during the year, the Company has made a decision to abandon the equipment. As such the Company recorded an impairment charge of $1,707 to its Statement of Operations, representing the remaining value of this equipment. +Operating Leases: In April 2012, the Company took delivery of a drilling rig (the “Cactus 1 Rig”) for a term of two years, which it subsequently renewed on March 6, 2014 for an additional two year term ending April 2016. On August 1, 2013, the Company contracted a second horizontal drilling rig (the “Patterson Rig”) for a one -year term, though the Company provided notice on February 17, 2014 that it will cancel its Patterson rig contract on or about March 17, 2014. Under the early termination provisions of the agreement, estimated termination payments for this rig will be approximately $2,055 in 2014 . Should the lessor be able to re-charter the rig, the termination payments would be reduced. To replace the Patterson Rig, the Company contracted a replacement rig (the “Cactus 2 Rig”) for a term of two years , which is scheduled to commence operations on April 1, 2014. Similar to the Patterson Rig, the Cactus 1 and 2 Rig lease agreements also include early termination provisions that would reduce the minimum rentals under the agreement, assuming the lessor is unable to re-charter the rig and staffing personnel to another lessee. Lease costs recorded during 2013 were $12,860 . Lease payments as of December 31, 2013 will approximate $13,954 , $9,308 and $2,295 in 2014 , 2015 and 2016 , respectively. Including the additional lease commitments executed subsequent to December 31, 2013 , the Company’s drilling rig lease commitments as of March 10, 2014 are $19,732 , $18,250 and $4,500 in 2014 , 2015 , and 2016 , respectively. +Property Acquisitions and Dispositions +Acquisitions +During the second quarter of 2013 , the Company acquired approximately 2,468 gross ( 2,186 net) acres in Reagan and Upton Counties, Texas, which is located in the southern portion of the Midland Basin and which is prospective for both horizontal and vertical drilling. The acquisition also included seven gross vertical wells and 1,301 barrels of oil equivalent proved reserves. The purchase price of $11,000 was funded using a portion of the proceeds from the preferred stock offering (discussed in Note 9 ). +During the first quarter of 2012, the Company acquired approximately 16,233 gross ( 14,653 net) acres in Borden County, which is located in the northern Midland basin. The northern Midland basin has had limited drilling activity compared with the southern Midland basin (where our current production is located), increasing the economic risk related to these drilling activities. The purchase price of $14,538 was funded from existing cash balances. During the third quarter of 2012, we acquired an additional 8,095 gross acres ( 6.964 net) in this area for a total consideration of $4,835 . +During the second quarter of 2012, the Company signed a purchase and sale agreement to acquire 2,319 gross ( 1.762 net) acres in southern Reagan County, Texas for a total purchase price of $12,012 , which was financed with a draw on the Credit Facility. The transaction had an effective date of May 1, 2012 and closed on July 5, 2012. +Dispositions +During the fourth quarter of 2013 , the Company closed on the sale of its 15.0% working interest in the Medusa field (Mississippi Canyon blocks 582 and 538), our 10.0% membership interest in Medusa Spar LLC, and substantially all of our remaining Gulf of Mexico shelf properties. The Company sold its interest in Medusa to W&T, an unrelated third-party, for a total net cash consideration of approximately $88,000 after customary purchase price adjustments. Also during the fourth quarter of 2013 , the Company closed on the sale of its 69% interest in the Swan Lake field for $2,000 . This was the Company’s only field in the Haynesville shale. Consistent with the Company’s accounting policy discussed in Note 2 , the proceeds from these sales were accounted for as a reduction to capitalized costs as the sale did not significantly alter the relationship between capitalized costs and proved reserves. +Effective December 28, 2012, the Company closed on the sale of its 11.25% working interest in the Habanero field (Garden Banks Block 341). The Company sold its interest in Habanero to Shell Offshore Inc., a subsidiary of Royal Dutch Shell Plc, for an estimated net cash consideration of $39,410 after customary purchase price adjustments. As noted above, the proceeds from this sale were accounted for as a reduction to capitalized costs as the sale did not significantly alter the relationship between capitalized costs and proved reserves. +82 +Callon Petroleum Company +Notes to the Consolidated Financial Statements +(All amounts in thousands, except well, acreage, per-share and per-derivative instrument data) +Table of Contents +NOTE 14 – Summarized Quarterly Financial Information (Unaudited) +2013 +First Quarter +Second Quarter +Third Quarter +Fourth Quarter +Total revenues +$ +22,541 +$ +22,760 +$ +30,797 +$ +26,471 +Income from operations +898 +957 +6,345 +2,464 +Net income (loss) +(800 +) +758 +1,082 +3,264 +Income (loss) available to common shares +(800 +) +78 +(892 +) +1,291 +Income (loss) per common share - basic +$ +(0.02 +) +$ +0.00 +$ +(0.02 +) +$ +0.03 +Income (loss) per common share - diluted +$ +(0.02 +) +$ +0.00 +$ +(0.02 +) +$ +0.03 +2012 +First Quarter +Second Quarter +Third Quarter +Fourth Quarter +Total revenues +$ +29,294 +$ +25,360 +$ +27,402 +$ +28,677 +Income from operations +2,716 +2,759 +2,563 +2,652 +Income (loss) available to common shares +488 +3,799 +(1,105 +) +(435 +) +Income (loss) per common share - basic +$ +0.01 +$ +0.10 +$ +(0.03 +) +$ +(0.01 +) +Income (loss) per common share - diluted +$ +0.01 +$ +0.09 +$ +(0.03 +) +$ +(0.01 +) +83 +ITEM 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure +There have been no disagreements with the independent auditors on any matters of accounting principles or practices, financial statement disclosure, or auditing scope or procedures. +ITEM 9A. Controls and Procedures +Disclosure Controls and Procedures. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is accumulated and communicated to the issuer’s management, including its principal executive and financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. The Company’s principal executive and principal financial officers have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were effective as of December 31, 2013 . +Management’s Report on Internal Control over Financial Reporting . Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control structure is designed to provide reasonable assurance to our management and Board of Directors regarding the reliability of financial reporting and the preparation and fair presentation of our financial statements prepared for external purposes in accordance with U.S. generally accepted accounting principles. Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2013 based on the framework in Internal Control – Integrated Framework published by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission (1992 framework)(the COSO criteria). Based on that evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2013 . +Because of its inherent limitations, internal control over financial reporting can provide only reasonable assurance that the objectives of the control system are met and may not prevent or detect misstatements. In addition, any evaluation of the effectiveness of internal controls over financial reporting in future periods is subject to risk that those internal controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +The Company’s independent registered public accounting firm has issued an attestation report regarding its assessment of the Company’s internal control over financial reporting as of December 31, 2013 , which follows Part II, Item 9B of this filing. Additionally, the financial statements for each of the years covered in this Annual Report on Form 10-K have been audited by an independent registered public accounting firm, Ernst & Young LLP whose report is presented immediately preceding the Company’s financial statements included in Part II, Item 8 of this Annual Report on Form 10-K. +Changes in Internal Control over Financial Reporting. There were no changes to our internal control over financial reporting during our last fiscal quarter that have materially affected, or are reasonable likely to materially affect, our internal control over financial reporting. +ITEM 9A (T). Controls and Procedures +See Item 9A. +ITEM 9B. Other Information +Submissions of Matters to a Vote of the Security Holders +None. +84 +Table of Contents +Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders of +Callon Petroleum Company +We have audited Callon Petroleum Company’s internal control over financial reporting as of December 31, 2013 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework)(the COSO criteria). Callon Petroleum Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, Callon Petroleum Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on the COSO criteria. +We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Callon Petroleum Company as of December 31, 2013 and 2012, and the related statements of operations, comprehensive income, cash flow, and changes in stockholders’ equity (deficit) for each of the three years in the period ended December 31, 2013, and our report dated March 12, 2014 expressed an unqualified opinion thereon. +/s/Ernst & Young LLP +New Orleans, Louisiana +March 12, 2014 +85 +PART III. +ITEM 10. Directors, Executive Officers and Corporate Governance +For information concerning Item 10, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 15, 2014 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +The Company has adopted a code of ethics that applies to the Company’s chief executive officer, chief financial officer and chief accounting officer. The full text of such code of ethics has been posted on the Company’s website at www.callon.com, and is available free of charge in print to any shareholder who requests it. Request for copies should be addressed to the Secretary at mailing address Post Office Box 1287, Natchez, Mississippi 39121. +ITEM 11. Executive Compensation +For information concerning Item 11, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 15, 2014 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +For information concerning the security ownership of certain beneficial owners and management, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 15, 2014 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 13. Certain Relationships and Related Transactions and Director Independence +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 15, 2014 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +ITEM 14. Principal Accountant Fees and Services +For information concerning Item 14, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 15, 2014 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. +86 +PART IV. +ITEM 15. Exhibits +Exhibit +Description +1 +The following is an index to the financial statements and financial statement schedules that are filed in Part II, Item 8 of this report on Form 10-K. +Report of Independent Registered Public Accounting Firm +Consolidated Balance Sheets as of December 31, 2013 and 2012 +Consolidated Statements of Operations for each of the three years in the period ended December 31, 2013 +Consolidated Statements of Stockholders’ Equity (Deficit) for each of the three years in the Period Ended December 31, 2013 +Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2013 +Notes to Consolidated Financial Statements +2 +Schedules other than those listed above are omitted because they are not required, not applicable or the required information is included in the financial statements or notes thereto. +3 +Exhibits +2 +Plan of acquisition, reorganization, arrangement, liquidation or succession* +3 +Articles of Incorporation and Bylaws +3.1 +Certificate of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +3.2 +Bylaws of the Company (incorporated by reference from Exhibit 3.2 of the Company’s Registration Statement on Form S-4, filed August 4, 1994, Reg. No. 33-82408) +3.3 +Certificate of Amendment to Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.3 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +3.4 +Certificate of Amendment to the Certificate of Incorporation of the Company +(incorporated by reference to Exhibit 3.4 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, File No. 001-14039) +4 +Instruments defining the rights of security holders, including indentures +4.1 +Specimen Common Stock Certificate (incorporated by reference from Exhibit 4.1 of the Company’s Registration Statement on Form S-4, filed August 4, 1994, Reg. No. 33-82408) +4.2 +Rights Agreement between Callon Petroleum Company and American Stock Transfer & Trust Company, Rights Agent, dated March 30, 2000 (incorporated by reference from Exhibit 99.1 of the Company’s Registration Statement on Form 8-A, filed April 6, 2000, File No. 001-14039) +4.3 +Indenture for the Company’s 13.00% Senior Notes due 2016, dated November 24, 2009, between Callon Petroleum Company, the subsidiary guarantors described therein, Regions Bank and American Stock Transfer & Trust Company (incorporated by reference to Exhibit T3C to the Company’s Form T3, filed November 19, 2009, File No. 022-28916) +4.4 +Certificate of Designations of 10% Cumulative Preferred Stock (incorporated by reference to Exhibit 3.5 of the Company’s Form 8-A filed May 23, 2013) +4.5 +Certificate for the Company’s 10% Cumulative Preferred Stock (incorporated by reference to Exhibit 4.1 of the Company’s Form 8-A filed May 23, 2013 +4.6 +Amendment to the Certificate of Incorporation increasing the number of authorized shares of common stock [Filed herewith] +9 +Voting trust agreement +None +10 +Material contracts +10.1 +Callon Petroleum Company 1994 Stock Incentive Plan (incorporated by reference from Exhibit 10.5 of the Company’s Registration Statement on Form 8-B, filed October 3, 1994) +10.2 +Callon Petroleum Company 1996 Stock Incentive Plan as amended on May 9, 2000 (incorporated by reference from Appendix I of the Company’s Definitive Proxy Statement on Schedule 14A, filed March 28, 2000, File No. 001-14039) +87 +10.3 +Callon Petroleum Company 2002 Stock Incentive Plan (incorporated by reference to Exhibit 10.13 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, File No. 001-14039) +10.4 +Amendment No. 3 to the Callon Petroleum Company 1996 Stock Incentive Plan (incorporated by reference from Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.5 +Amendment No. 1 to the Callon Petroleum Company 2002 Stock Incentive Plan (incorporated by reference from Exhibit 10.2 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.6 +Callon Petroleum Company Amended and Restated 2006 Stock Incentive Plan (incorporated by reference from Exhibit 10.3 of the Company’s Current Report on Form 8-K, filed January 5, 2009, File No. 001-14039) +10.7 +Callon Petroleum Company 2009 Stock Incentive Plan effective as of April 30, 2009 (incorporated by reference from Exhibit A to the Company’s Definitive Proxy Statement on Schedule 14A, filed March 30, 2009, File No. 001-14039) +10.8 +Amendment to the Callon Petroleum Company 1996 Stock Incentive Plan effective as of August 7, 2009 (incorporated by reference from Exhibit 10.1 of the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2009, File No. 001-14039) +10.9 +Callon Petroleum Company 2010 Phantom Share Plan, adopted May 4, 2010 (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on May 7, 2010) +10.10 +Form of Callon Petroleum Company Phantom Share Award Agreement, adopted May 4, 2010 (incorporated by reference to Exhibit 10.2 of the Company’s current Report on Form 8-K filed on May 7 , 2010) +10.11 +Deferred Compensation Plan for Outside Directors; Callon Petroleum Company (effective as of January 1, 2011) (incorporated by reference to Exhibit 10.17 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, File No. 001-14039) +10.12 +Amended and Restated Severance Compensation Agreement, dated as of March 15, 2011 and effective as of January 1, 2011, by and between Fred L. Callon and Callon Petroleum Company (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on March 18, 2011) +10.13 +Form of Amended and Restated Severance Compensation Agreement, dated as of March 15, 2011 and effective as of January 1, 2011, by and between Callon Petroleum Company and its executive officers (incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K filed on March 18, 2011) +10.14 +Severance Compensation Agreement, dated as of September 21, 2011, by and between Gary A. Newberry and Callon Petroleum Company (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on September 21, 2011) +10.15 +Fourth Amended and Restated Credit Agreement dated as of June 20, 2012, by and among the Company, the “Lenders” described therein, and Regions Bank as the sole arranger and administrative agent (incorporated by reference from Exhibit 10.1 on Form 8-K, filed June 25, 2012, File No. 001-14039) +10.16 +Fourth Amended and Restated Revolving Promissory Note dated June 20, 2012 (incorporated by reference from Exhibit 10.1 on Form 8-K, filed June 25, 2012, File No. 001-14039) +10.17 +Fourth Amended and Restated Guaranty Agreement dated June 20, 2012 (incorporated by reference from Exhibit 10.1 on Form 8-K, filed June 25, 2012, File No. 001-14039) +10.18 +Master Assignment, Agreement and Amendment No. 1 to the Fourth Amended and Restated Credit Agreement (incorporated by reference from Exhibit 10.1 on Form 8-K, filed October 16, 2012, File No. 001-14039) +10.19 +Purchase and Sale Agreement by and between Shell Offshore Inc. and Callon Petroleum Operating Company dated as of November 27, 2012. +10.20 +Callon Petroleum Company 2011 Omnibus Incentive Plan (incorporated by reference from Exhibit A of the Company’s Definitive Proxy Statement on Schedule 14A filed March 21, 2011, File No. 14039) +10.21 +Purchase and Sale Agreement by and between W&T Offshore, Inc. and Callon Petroleum Company dated as of December 5, 2013 +10.22 +Underwriting Agreement relating to the Company’s 10% Cumulative Preferred Stock (incorporated by reference to Exhibit 1.1 of the Company’s Form 8-K filed on May 28, 2013). +88 +10.23 +Agreement, dated March 9, 2014, among the Company and Lone Star Value Investors, L.P., Lone Star Value Co-Invest I, L.P., Lone Star Value Investors GP, LLC, Lone Star Value Management, LLC, Jeffery E. Eberwein and Matthew R. Bob (incorporated by reference from Exhibit 10.1 on Form 8-K, filed on March 10, 2014, File No. 001-14039) +11 +Statement re computation of per share earnings* +12 +Statements re computation of ratios* +13 +Annual Report to security holders, Form 10-Q or quarterly reports* +14 +Code of Ethics +14.1 +Code of Ethics for Chief Executive Officers and Senior Financial Officers (incorporated by reference to Exhibit 14.1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, File No. 001-14039) +16 +Letter re change in certifying accountant* +18 +Letter re change in accounting principles* +21 +Subsidiaries of the Company +21.1 +Subsidiaries of the Company +22 +Published report regarding matters submitted to vote of security holders* +23 +Consents of experts and counsel +23.1 +Consent of Ernst & Young LLP +23.2 +Consent of Huddleston & Co., Inc. +24 +Power of attorney* +31 +Rule 13a-14(a) Certifications +31.1 +Certification of Chief Executive Officer pursuant to Rule 13(a)-14(a) +31.2 +Certification of Chief Financial Officer pursuant to Rule 13(a)-14(a) +32 +Section 1350 Certifications of Chief Executive and Financial Officers pursuant to +Rule 13(a)-14(b) +99 +Additional Exhibits +99.1 +Reserve Report Summary prepared by Huddleston and Co. as of December 31, 2013 +101 +Interactive Data Files ** +* +Not applicable to this filing +** +Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability. +89 +SIGNATURES +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Date: +March 12, 2014 +/s/ Fred L. Callon +Fred L. Callon (principal executive officer, director) +Date: +March 12, 2014 +/s/ B. F. Weatherly +B. F. Weatherly (principal financial officer, director) +Date: +March 12, 2014 +/s/ Rodger W. Smith +Rodger W. Smith (principal accounting officer) +Date: +March 12, 2014 +/s/ L. Richard Flury +L. Richard Flury (director) +Date: +March 12, 2014 +/s/ John C. Wallace +John C. Wallace (director) +Date: +March 12, 2014 +/s/ Anthony J. Nocchiero +Anthony J. Nocchiero (director) +Date: +March 12, 2014 +/s/ Larry D. McVay +Larry McVay (director) +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +Date: +March 12, 2014 +/s/ B. F. Weatherly +B. F. Weatherly, Executive Vice President and +Chief Financial Officer (Principal Financial Officer) +90 \ No newline at end of file diff --git a/raw/filings/0000928022/2013/0000928022-14-000049/filing_metadata.csv b/raw/filings/0000928022/2013/0000928022-14-000049/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..6f98066dc72b751f897136f9fa97251ed1ec33ac --- /dev/null +++ b/raw/filings/0000928022/2013/0000928022-14-000049/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000928022,CPE,Callon Petroleum Co,10-K,2014-03-13,2013-12-31,2014-03-12T21:40:57.000Z,0000928022-14-000049,cpe-20131231x10k.htm,10-K,15929091,1,0,https://www.sec.gov/Archives/edgar/data/928022/000092802214000049/cpe-20131231x10k.htm,https://www.sec.gov/Archives/edgar/data/928022/000092802214000049/,2013,2013,1 diff --git a/raw/filings/0000928022/2013/0000928022-14-000049/item1.txt b/raw/filings/0000928022/2013/0000928022-14-000049/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2013/0000928022-14-000049/item13.txt b/raw/filings/0000928022/2013/0000928022-14-000049/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..30d8b91487001c44eceafb6a15409ee818175e4a --- /dev/null +++ b/raw/filings/0000928022/2013/0000928022-14-000049/item13.txt @@ -0,0 +1,2 @@ +ITEM 13. Certain Relationships and Related Transactions and Director Independence +For information concerning Item 13, see the definitive proxy statement of Callon Petroleum Company relating to the Annual Meeting of Stockholders to be held on May 15, 2014 which will be filed with the Securities and Exchange Commission and is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000928022/2013/0000928022-14-000049/item9a.txt b/raw/filings/0000928022/2013/0000928022-14-000049/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..9d81d7d011bff0506bd642b301ddbb00cdb8ac21 --- /dev/null +++ b/raw/filings/0000928022/2013/0000928022-14-000049/item9a.txt @@ -0,0 +1,8 @@ +ITEM 9A. Controls and Procedures +Disclosure Controls and Procedures. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is accumulated and communicated to the issuer’s management, including its principal executive and financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. The Company’s principal executive and principal financial officers have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were effective as of December 31, 2013 . +Management’s Report on Internal Control over Financial Reporting . Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control structure is designed to provide reasonable assurance to our management and Board of Directors regarding the reliability of financial reporting and the preparation and fair presentation of our financial statements prepared for external purposes in accordance with U.S. generally accepted accounting principles. Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2013 based on the framework in Internal Control – Integrated Framework published by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission (1992 framework)(the COSO criteria). Based on that evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2013 . +Because of its inherent limitations, internal control over financial reporting can provide only reasonable assurance that the objectives of the control system are met and may not prevent or detect misstatements. In addition, any evaluation of the effectiveness of internal controls over financial reporting in future periods is subject to risk that those internal controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +The Company’s independent registered public accounting firm has issued an attestation report regarding its assessment of the Company’s internal control over financial reporting as of December 31, 2013 , which follows Part II, Item 9B of this filing. Additionally, the financial statements for each of the years covered in this Annual Report on Form 10-K have been audited by an independent registered public accounting firm, Ernst & Young LLP whose report is presented immediately preceding the Company’s financial statements included in Part II, Item 8 of this Annual Report on Form 10-K. +Changes in Internal Control over Financial Reporting. There were no changes to our internal control over financial reporting during our last fiscal quarter that have materially affected, or are reasonable likely to materially affect, our internal control over financial reporting. +ITEM 9A (T). Controls and Procedures +See Item 9A. \ No newline at end of file diff --git a/raw/filings/0000928022/2013/0000928022-14-000049/rp_note.txt b/raw/filings/0000928022/2013/0000928022-14-000049/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000928022/2013/0000928022-14-000049/rpt_disclosure.txt b/raw/filings/0000928022/2013/0000928022-14-000049/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391